April 05 2024

Surprising & Uncomfortable

Two words come to mind to describe the state of the market after the first quarter: Surprising and Uncomfortable. Just like you unexpectedly received a gift of a 11% performance from the S&P500, but it feels a little out of kilter.

Surprising first, as the salient macro factors in the first quarter 2024 assuaged concerns of an imminent stagflation.

  • US softer landing, and Europe short of negative economic surprises
  • Inflation slowing down, yet commodity prices bounce back
  • High interest rates absorbed for now, yet national deficits very much in focus
  • Geopolitical tensions still contained, but reaching boiling point

Compared to what analysts expected, as they assessed the 2024 outlook in Dec23, the global economic slowdown and the inflation persistence were the main risk factors. News were overall positive on those two.

Key Risks as per Nov-Dec23 – 360 Advisory LLC

The other risks remained muted too, with the major exception of geopolitical tensions. Europe muscled up its rhetoric to counter Russia, Israel pushed further its all-out war against Hamas, and US-China tensions are still trending high.

The latter, coupled with ongoing supply constraints for raw materials, have been sending commodity prices up. Year-to-date, crude is up 21%, copper +9%, rubber 29%, palm oil 20%, and cocoa +128%.

Uncomfortable second. Yes, employment is good, and the latest non-farm payroll is proof of that with 303k additional employees in Mar24 (vs 214k expected and 275k prior). Yes also, economy is tagging along, but positive surprises in the US may have run their course. I spare you the chapter on rising delinquencies in Commercial Real Estate, credit cards and auto loans. This disproportionately affects certain portions of the market i.e. subprime, younger generations, commercial retail, while the “average” looks fine. Keep in mind the story of the 6-foot-tall guy who drowned in a river that was 5-feet deep on average.

How was the overall market performance? Great, thank you. Too great, maybe.

Performance trickled down from Large Cap growth (+11.4% 1Q24) to Small cap value (+2.9%). Investors consolidated their positions on blue chip quality stocks, and few ventured out into smaller companies, which are still exposed to high interest rates and economic downturn.

The “bonds-are-back” trade has not paid off as expected. While credit spreads remain tight, yields have widened as investors pushed back their expectations of a US rate cut. US Treasuries widened by a third of a percent YTD24.

By asset class, the 60/40 portfolio posted about 4% gains YTD24. Sectors leading the pack were Tech (surprise, surprise), Energy, Industrials, and Financials. Silver (+12%) and Gold (+11%) did well, as a hedge against inflation, geopolitics, and weaker USD.

Guide to the Markets – JP Morgan 31Mar24

A keen eye would notice though, that Large Caps have been constantly in the top 3 best performing asset classes over the past 10 years, but in 2018.

A lot has to do with investment flows. Investors favored following momentum, and crowded into market-cap weighted strategies.

In year-to-date 2024 investment flows, alternatives is where the action took place, according to Bloomberg data. As ETF got approved for Bitcoin, the new asset class took home $14bn, with iShares IBIT representing the bulk of it. Risk-on specialty strategies also had inflows well above their relative size, with 2x-long Nvidia typically flavor of the moment.

Flows were also disproportionately allocated to fixed income, across an array of US sovereign and corporate bonds. The expectation that US interest rates have peaked is not foreign to that.

As always, equities took home the lion’s share, representing 67% of inflows. Among the top 10 equity ETFs, no surprise to find S&P500 and total-US-shares trackers. Two notable exceptions though, (1) DYNF based on style factors, including momentum, quality, value, size, and low volatility, and (2) EM ex-China. The two reaped $6.7bn and $3.4bn year-to-date respectively.

The two are the epitome of combined trends, the rise of active ETFs, the high churn between style investing to adapt market uncertainty, and the disaffection for China in the EM trade.

What comes next? I am glad you asked. The center-piece assumption remains that rates are going to decrease over the medium term, but stay high in the short-term. On fixed income, I increase cash allocation, and play duration mainly in 5-7 years high-quality bonds. In developed markets high-yield, spreads look too tight. Overall, positive surprises may have run their course, and I’m inclined to some profit-taking on equities. I maintain a neutral view on Europe, as economy slows down, and recommend some profit-taking on EM-ex-China. The latter is concentrated on Taiwan e.g. TSMC, and I fear signs of over-crowding in the other smaller markets e.g. India. I turn more constructive on gold, as I see it a a jack-of-all-trades benefiting from lower expected rates, a rebalancing out of the USD, and a potential risk-off.

Asset allocation change as of 5Apr24 – 360 Advisory LLC
Model allocation as of 5Apr24 – 360 Advisory LLC

Bear in mind that these allocations are not to be seen as a recommendation to buy or sell any asset in particular. This is a model portfolio that provides a framework to our discussions on market.

Stay safe out there !

About –

360 Advisory LLC is a Boston-based RIA managing investments