January 08 2024

Christmas Came Early, Didn’t it?

A classic stop and go. In order to curb the post-covid inflationary pressure, central banks embarked onto a tighter monetary policy. Typically, US rates increased continuously from early 2022 to this very day. As the economy weakens, and inflation cools down, it is time for a policy re-think, or a “pivot”.

Actually, the market already started pricing in a decline in rates since mid-October, sensing that slower job growth and rising defaults were probably the last straws that break the camel’s back. This week, the Fed seemed to acknowledge it openly, sending yields further down, and rate-sensitive stocks to the pinnacle, in a classic “bad news – a slowing growth – is good news – lower rates”.

In a sense, lower rates should give a breath of fresh air to households and corporates, reducing their interest rate charge. Likewise, higher stocks and bonds prices could boost the wealth effect, and therefore cheer-up the consumer troops before Christmas. Last but not least, lower rates mathematically boosts equity valuations on a like-for-like basis.

Lower rates also weakens the USD, thus making import goods more expensive, chipping at purchasing power. Remember, prices are lower, but still about 20% higher than 3 years ago.

I don’t want to play Cassandra, but just add some chill to the everything rally we experimented this past 2 months. From 15Nov23 to 15Dec23, S&P500 was up ~5%, Nasdaq +5%, US small cap +11%, real estate +12%. Sharp. Financial conditions eased but remain elevated.

The path is set. There is no question that asset allocation should continue to pivot out of money market, into riskier assets. But going forward, bad news is more likely to actually be bad news. Therefore, the winners of a rally in valuation are not exactly going to be the weaker ones, who are actually too distressed to be saved. And the winners are:

  • Non-USD assets, typically developed Europe and Japan, but also Emerging Markets. I believe that China can bounce back meaningfully too.
  • Mid-duration bonds, from the 5-year US treasuries to US investment grade.
  • US midcaps, which are disproportionately benefiting from a lift on rates.
  • Capital-intensive sectors: real estate, utilities, banks, and industrials.
  • VC and PE-backed companies that can also but rejoice about a loosening of financial conditions. Look at biotech that rallied ~30% since mid Oct23.

Of course the market will take this too far. For one, yields have only decreased by ~1.2% from peak, and remain elevated. Besides, valuations were already looking stretched before the post-Fed-speech rally. MSCI Large Cap US had been that expensive only 12% of the time in the past.

Looking at valuations per sector relative to the overall market, it confirms that Price-Earning-Ratios are elevated for Tech and Consumer Discretionary. The Magnificent 7 are grandly to blame. Now, Energy and Real Estate both look cheap on a relative and absolute level, pointing to room for expansion for the long-term investors.

Don’t stray too far away from the idea that we are still in a restrictive rate cycle, albeit at the end of it. That trees don’t grow to the sky, and valuations in some sectors are closing to their post-covid peaks, in the absence of the loose monetary policy that was, and in a slowdown cycle.

On this cheerful note, I wish you a very happy Christmas with friends, family and tapping yourself on the back because you almost made it through this year of hardship.

Stay safe out there !

About –

360 Advisory LLC is a Boston-based RIA managing investments