April 12 2024

The Rules of the Fight Club

The first rule of the fight club: Don’t fight the Fed. The Fed said in Oct23 that they thought we had reached peak rates, and the necessity for rate cuts would be “data-dependent”.

Everybody and his sister priced rate cuts aggressively, sending the 2y US treasury down from 5.2% to 4.2% in the span of 2 months from the Fed speech. It has been all disappointment from then on, as the sticky story is that US rates have to remain high to put a lid on consumer prices.

This week, the door was slammed shut on a June rate cut, after CPI data for Mar24 revealed a 3.5% year-on-year increase, higher than expected. The probability of a rate cut in Jun24 was instantly revised down from 60% to 18%, with not much faith for other meaningful rate cuts this year. Those betting on lower rates were in for a tough trading day, as the curve jumped up by 20bps.

CME 3-month SOFR futures Dec24 – Bloomberg

Inflation is indeed stubbornly high, with structurally high shelter cost and a rebound of energy prices. While it poses a predicament to Fed’s forecasters, the cocktail of high interest, and high prices, might not be to the taste of all consumers and businesses either.

The second rule of the fight club: Mind fiscal policy. Governments have sway over the biggest pot of money. Their printing power seems like infinite, really.

Markets have been trading on fiscal stimuli since the Great Financial Crisis of 2007. Needless to say that fiscal spending has been lavish, so much so that US debt is running close to $35tn, 123% of GDP as of Sep23, and its interest charge is higher than the US defense budget. Debt now stands at ~$270,000 per tax payer, and both side of the political aisle promise yet more tax cuts.

At some point, the maths won’t stand and short of a more restrictive fiscal policy, investors will require a higher premium for buying US treasuries. Stubbornly-high long-term rates are a forerunner sign. If the IMF’s forecast of the “tepid twenties” is to be trusted, short of higher productivity, the US are probably bond to slower growth and high debt levels for the coming decade.

A keen eye would have noticed a marked preference by investors for the short-end of the treasuries curve, and that central banks have been buying gold as a diversifier, just in case.

The third rule of the fight club: Watch the fundamentals. We had it so good. Global economy kept surprising on the upside this year. Corporate profits and the consumer have been resilient across the developed world. Now surprises look less likely.

Citi surprises index, global (orange), China (violet), Europe (blue), US (white) – Bloomberg

Approaching the first quarter earnings season, profit estimates look hopeful with S&P500’s EPS around 250, and P/E ratio of about 21x. The recent stock rally has been backed by a constant upside revision of companies’ profit, but what got you here might not get you there.

High expectations in companies’ estimates – Bloomberg

The notable exception is probably China. While it did not fail to disappoint over the past year, it looks like negativity has run its course. Goldman Sachs and Morgan Stanley have been the latest to revise upward China’s growth outlook in 2024, to 5% and 4.8% respectively. The reasons? Factory activity and exports accelerated in 1Q24. More on this on 12Apr24 with exports number for Mar24. The bump in coal consumption in China at the end of 2023 probably have something to say to their renewed manufacturing activity.

Now, property sector and consumer demand remain weak. Despite 10-year rates at 2.3%, consumer prices remain depressed. Also, exports data of March24 cold-showered the expectations of a bounce back, with exports dropping more than expected (-7.5% vs -1.9% YoY) dragged down by lower export prices. In trading, after an uptick early Feb24, equities have been range-bound over the past month, while EM ex China enjoyed a strong support and outperformed China’s CSI300 by ~35% over the past year.

Comparative performance of EM ex China and China themes 11Apr24 – Bloomberg

The fourth rule of the fight club: see where the money flows. Money has flocked to quality across equities and bonds, with sturdy inflows for investment grade bonds and profitable large Tech companies (hello AI👋). Liquidity has been very supportive of risk assets, with a market rally broadening to smaller cap, high yield credit and speculative assets (hello BTC👋). There has been an emphasis of cyclical recovery, with PMIs back in expansion, and Industrials getting a bid. Commodities also benefited from a mix of continued geopolitical unrest and demand expansion (hello oil, cocoa, and copper👋).

How do you prepare for your next fight now? I am wary of complacency. High valuations, low VIX, bullish sentiment, and an upbeat economic outlook, are all warning signals. With the recent increase in yield, I am constructive on quality fixed income in the 5-7y range even though spreads are close to a 20-year tight. As high rates bite, I foresee a more drastic widening of spreads for high-yield and lower quality, and stay clear of that. In equities, large cap is a force too big to ignore, yet I am taking any opportunity to rebalance out of it, although it is by default a big chunk of our exposure. I am appreciative of the broadening market breadth, and rate-sensitive sectors offer relatively better entry points following the recent spike in rates. On alternatives, considering high funding rates, appetite is there only for niche players, typically “liquidity provider of last resort” in private credit.

Overall, what would keep the juice flowing for our fighters is the economic strength, until the bell of the final round tolls.

Stay safe out there !

About –

360 Advisory LLC is a Boston-based RIA managing investments