INSIGHTS WITH EVALESCO

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In early 2024, the US stock market demonstrated remarkable resilience, with a bullish trend continuing despite concerns about prolonged higher interest rates. The first quarter saw significant gains, with the S&P 500 returns exceeding 10%, culminating in nearly 30% total returns over the past 12 months, with almost all of these gains occurring since 1 November. Technology stocks, fuelled by the artificial intelligence boom, and value stocks led the charge, while the bond market grappled with the expectation of delayed Federal Reserve rate cuts. This dynamic period in the markets underscores the robust performance of the economy, which so far has managed to avert a recession that many had anticipated, thanks in part to strong GDP growth and a robust labour market, challenging the earlier consensus that the Fed would commence rate cuts as early as March 2024.

The resilience of the U.S. economy can be attributed to several unique factors throughout the Federal Reserve’s recent aggressive monetary policy tightening cycle. The economy sidestepped the recession forecasted for 2023, benefiting from solid private sector balance sheets, labour hoarding due to pandemic-induced workforce shortages, and a staggered recovery across different sectors that precluded any singularly adverse quarter. Immigration boosts and an unexpectedly expansionary fiscal policy further cushioned the economy against the potential blow from heightened borrowing costs. Despite eased financial conditions and reduced near-term recession risks, uncertainties such as the potential stress from commercial real estate on small banks, underscore that the threat of recession, while diminished, is not entirely off the table.

The inflation narrative remains complex, with initial 2024 figures disrupting the market and U.S. Federal Reserve’s confidence in a steady march towards the 2% inflation target. Resilient economic growth and specific sectors accelerating have stoked fears of persistent, if not escalating, inflation. However, a detailed look at the economy reveals that the typical inflation drivers have been offset by a faster expansion of the supply side, including healing supply chains, increased workforce participation due to immigration, and recovering worker productivity. These developments suggest that despite tight labour markets, the economy may continue to balance strong growth with moderating inflation, navigating through what has been termed an “immaculate disinflation.”

Credit market conditions have also shown signs of improvement, with credit spreads tightening and a notable shift in bank lending practices. The Senior Loan Officer Opinion Survey indicated a potential leveling off in the tightening of standards for commercial and industrial loans, pointing towards a fragmented credit landscape that may affect large and small firms differently. This scenario is further complicated by the ongoing challenges posed by high interest rates, especially for borrowers with floating rate liabilities, signalling a need for strategic financial adjustments to navigate a potentially higher-for-longer rate environment.

The synthesis of these factors paints a picture of a U.S. economy and financial market at a crossroads. The resilience against a recession, coupled with the counterbalance of robust economic growth against inflationary pressures, sets a nuanced stage for investors and policymakers alike. The anticipation of Federal Reserve rate cuts, the adaptation to a divided credit market, and strategic adjustments to corporate leverage in response to interest rate challenges reflect a broader economic environment that remains ripe with both opportunities and risks.

Navigating this landscape demands a nuanced understanding of the interplay between monetary policy, economic indicators, and market dynamics. The resilience of the stock market, despite the spectre of persistent inflation and higher interest rates, underscores the complex calculus investors must engage with. Similarly, the bond market’s cautious stance in anticipation of Federal Reserve policy shifts speaks to the broader uncertainty permeating financial markets.

The economic resilience observed through strong private sector fundamentals, labour market dynamics, and fiscal policies suggests a buffer against immediate downturns, yet vigilance remains crucial. As analysts project a cautiously optimistic outlook, emphasizing a pro-risk stance while hedging against potential inflationary pressures and interest rate risks, the strategic positioning within equities and credit markets suggests a preference for quality and diversification.

Ultimately, the evolving economic narrative of 2024 is marked by its complexity and the balancing act between fostering growth and managing inflation, within a backdrop of cautious monetary policy anticipation. As the year unfolds, the strategies employed by investors, businesses, and policymakers will continue to adapt to the dynamic interplay of these factors, aiming to sustain the momentum of the current economic expansion while preparing for the inevitable challenges that lie ahead.

Domestically, economic growth is anticipated to be subdued in the near term, as inflation and the aftermath of prior interest rate hikes dampen demand, particularly consumer spending. This tempered outlook stems from declines in real income over recent years, which are expected to suppress consumption, especially in the first half of 2024. The economy faces further headwinds from high construction costs and skilled labour shortages, affecting new building approvals and dwelling investment, although a robust pipeline of construction work and factors like strong population growth and a rebound in tourism are expected to underpin overall investment levels. Despite robust demand, it currently surpasses the economy’s supply capacity, contributing to inflationary pressures and a period of growth below the trend, anticipated to aid in rebalancing demand and supply. The cash rate is predicted to remain at its current peak until mid-2024, with the impacts of monetary policy tightening and high inflation being felt unevenly across households.

As the economy moves forward, a gradual uptick in GDP growth is forecasted, primarily fuelled by an increase in household consumption and public demand. This improvement in consumption is likely supported by a recovery in real income growth as inflation eases and dwelling investment is expected to climb from 2025 onwards due to robust population growth and a surge in housing demand. The labour market is poised to adjust towards conditions consistent with full employment in the forthcoming years, with nominal wages growth remaining strong in the short term and then moderating as the labour market softens. This economic projection hinges on the assumption that labour productivity growth will return to its long-run average, essential for achieving the inflation target, albeit with the acknowledgment of potential risks associated with weaker-than-expected productivity enhancements

USA

In Q1, U.S. equities, notably the S&P 500, achieved all-time highs with a 10.6% total return, despite a shift from expectations of a dovish Federal Reserve pivot to a more hawkish monetary policy stance. Initially, markets anticipated up to seven rate cuts in 2024, but this outlook adjusted to just three cuts amid signs of economic strengthening and a deceleration in disinflation. The GDP growth exceeded expectations, and the labour market showed resilience, contributing to an optimistic economic scenario. Although some inflation measures indicated rising prices early in the year, the Federal Reserve’s preferred inflation gauge showed a slight cooling. Despite smaller and micro-cap stocks leading in the final two months of 2023, they lagged behind large-cap indices in Q1. Nonetheless, the markets remain hopeful about an upcoming cycle of rate cuts, reflected in the strong performance across equity benchmarks during this period.

The table below highlights the month on month and Q1 change across several US equity markets. There are a couple of key takeaways:

January saw micro, small and mid cap companies struggle against the NASDAQ 100 and S&P500. February and March highlights a contrasting outcome.

Over the quarter all US benchmarks represented are positive, despite their differing journey’s.

• Numerous U.S. equity benchmarks reached new all-time highs
• S&P 500 registers historic 5-month gain.

Europe

European markets concluded the first quarter of 2024 on a positive note, rising by 6.8%, buoyed by cooling inflation pressures. The Stoxx 600 index achieved a new all-time high, surpassing 513 points, marking its best quarter in a year and the most robust month since December 2023, according to LSEG data. Amidst this upward trend, travel stocks led the gains, increasing by 0.95% in a day, while utilities have experienced daily dips as high as 0.50%. JD Sports Fashion saw a significant share price jump of 16% following a trading update that alleviated investor concerns about the company’s future performance. Concurrently, economic data revealed the UK entering a recession in 2023, with a 0.3% GDP contraction in Q4, even as Germany reported a slight increase in employment for February.

Japan

On March 19, 2024, the Bank of Japan (BoJ) marked a pivotal shift in its monetary policy by ending the negative interest rate policy (NIRP) and slightly raising rates to a range of 0.0%–0.1%. This move, signalling confidence in overcoming deflation, is expected to gradually strengthen the yen against the dollar, though the initial impact may be muted due to prior signalling of the policy shift. The anticipation is for a conservative rate hike to 0.25% by year’s end, aligning with rising inflation expectations that buoyed the Japanese equity market. The long-standing low and negative rates facilitated a substantial carry trade, seeing Japanese yen loans to foreign investors surge by US$460 billion over three years. However, the potential unwinding of these trades in response to yen strengthening could inject volatility into global markets. Nonetheless, the policy shift is seen as a boon for Japanese banks, industrials, and consumer sectors, promising improved profitability, investment revival, and increased consumer spending. Despite the optimism, there’s caution over potential adverse reactions in the USD-JPY exchange rate and the global financial markets due to the possible repatriation of overseas investments by Japanese investors.

Emerging Markets

Emerging market (EM) economies are projected to grow at 3.9% in 2024, slightly down from 4.3% in 2023, yet still showing robust expansion. The growth differential between EMs and developed markets, or EM growth alpha, is expected to increase to 2.9% in 2024, up from 2.6% in 2023, marking the highest level since 2013, primarily driven by Asian countries, while Latin American economies may see a slowdown. This anticipated growth comes amidst an investor-friendly emerging market inflation trend, with headline inflation easing due to lower commodity prices, though services inflation stays above pre-2020 levels. This disinflationary trend potentially allows EM central banks more leeway to cut rates, though market expectations for 2024 rate cuts may have peaked unless unforeseen economic challenges arise. The U.S. inflation trajectory, trending downward, bodes well for EM debt (EMD) assets, yet the possibility of U.S. rate cuts could hinge on further labour market softening or economic downturns, signalling a cautious outlook for investors. Nonetheless, EM central banks might independently pursue rate reductions, supported by ongoing disinflation within their economies.

Australia

The past decade’s investment landscape has been characterized by abnormal trends due to efforts to avert financial crises, resulting in unusually low interest rates and heavy monetary intervention. This environment has skewed the market, favouring speculative behaviours and growth-focused sectors like technology and green energy, leading to inflated valuations for these popular assets. The COVID-19 pandemic further heightened this disconnect between the real and financial economies. Now, as inflation returns and interest rates rise, there’s a growing realization that returns might normalize, moving away from the era of ‘free money.’ This shift suggests that future returns may be more modest and uneven, especially as market trends concentrate around technology and high-growth themes. The investment landscape is also being reshaped by factors like demographics, decarbonisation, and deglobalisation, which will impact future returns, particularly in areas like renewable energy and infrastructure. Investors are advised to focus on sensible and reasonably valued investments, recognizing that the transition to a more sustainable economy will be complex and may not align with current market expectations.

You can download the entire Quarterly Investment Update HERE

Regards,

Marshall Brentnall and the AAN AM Investment Committee

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