Q1 2024 Review; Q2 Outlook

Market & Macro Review for Q1 2024

The table below sets out performance for Q1 2024 just ended by various asset classes and styles:

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A quick comparison to Q4 2023 reveals similarities. Growth, Value and DM (Developed Market) equities put in strong gains again as did Small cap and MSCI EM (just to a much lesser extent). That’s where the similarity ends. Global REITs and Global Agg (Bonds) declined over the Quarter (though still significantly up over the combined six-month period. Commodities, helped by the energy component, turned positive.

In Q4 of 2023, there was plenty of market talk around rate cuts (ranging from 3 to 6 cuts). Markets were clearly getting ahead of themselves and much of that expectation has reversed. The other reason was around the future path of inflation which, while coming down overall, remains persistent and slow to budge. This is evident from rising service price inflation and a slow but steady pick up taking pace across the global economy. All of this is pointing to central bankers questioning when (or even if) rates will actually start to come down. Each delay renews volatility. All of this has had an impact on interest-rate sensitive sectors such as REITs and Bonds. The rise in commodities, especially energy, will have an impact going forward on markets. Oil prices have rallied this year booking three consecutive months of gains. US crude is up +19% while Brent is up +16%. In the US, this passed through to gas prices at the pumps of $3.57 per gallon, the highest since 18^thOctober. The crude oil rally has been boosted by wars in Eastern Europe and the Middle East with Ukraine repeatedly striking oil refineries in Russia.

By region, Japan was the best performer, again! The Topix index gained +18.1% in local currency while Europe and the US registered about +10% each. In the case of Japan, we also witnessed the first step to normalisation of interest rates as the BoJ (Bank of Japan) by removing the negative yield target (Yield Curve Control). This also true of purchases of equity ETFs and REITs (Real estate Investment Trusts).

Ems delivered a subdued performance as concerns linger around China’s growth prospects. Markets perceive inaction from the government in terms of meaningful fiscal stimulus. Despite this, MSCI China rebounded +12.3% from its January low as economic activity picked up over the Lunar New Year period. It also cut its 5y LPR (loan Prime Rate) to help with sentiment in the property market. The 5y LPR sets mortgage rates.

RE: Outlook for Q2

A we enter Q2, the following factors will be key (as far as possible, I have made this current as of the time of writing and therefore included most recent post Q1 events/developments):

Valuations:

The latest valuation summary of markets (using the MSCI Indices) is shown below:

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Clearly, markets have had a good run – but it has been skewed to the US & Japan for two very different reasons: in the US (almost entirely) it comes down to Tech. Much has been said about the Magnificent (“Mag”) 7 stocks - Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia & Tesla. Collectively, these names were up +13% to the end of February but the dispersion between them is huge. Nvidia led the way with +64% while Tesla was down -19%! The US looks pricey on a nearly 22X forward P/E ratio (this is a ratio that compares its current, combined, MSCI US market cap of all companies in the index divided by its combined, future earnings projections for the same companies). Historically, this has been between 14X to 18X. Today, it is well above its range and stands within its highest 21% 10-year percentile range. This is specifically (and no surprise) down to the tech component aided by these same Mag 7 names which are on fire due to the AI theme in play.

Separately, and for different reasons, Japan has been  top performer for a host of reasons to do with better corporate governance, activism and finally an end to the famous “Yield Curve Control” tactics deployed for so many years that targeted 0% to negative interest rates. For the first time recently, rates were raised. The discussions now are around when, not if, the next rate hike happens.

Take together, both the above factors are unlikely to recede! They will be volatile but there is momentum. AI is rapidly changing the way we work and live and the pace of it is proving to be even quicker that most had expected. We are seeing a “dot.com part II” in play only this time we are dealing with mega companies that are cash rich, profitable and have vast capital investment programmes to keep improving what they have to stay ahead of the game. Arguably, market corrections are an opportunity to buy rather than to sell out. There are secular moves underway – these are not technical moves.

A final word on this – look how incredibly cheap (by comparison) markets of Europe, Asia Pacific (ex. Japan) and EM are. All these regions are set to benefit from value as well as currency appreciation. These same regions harbour highly attractive companies in tech and beyond. As risk sentiment changes (for the better), it means a move to more Risk-On. The latter benefits these same regions. A balanced portfolio should contain exposure to these regions.

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Inflation:

This will be a major indicator of economic direction and market reaction going forward and, consequently, a direct (but exclusive) determinant of interest rates. We have already witnessed, especially since the start of the year, the back and forth in terms of rate cute expectations. It has been a constant rollercoaster of “will they (cut rates) or won’t they” with the result that decisions have been pushed out. Towards the end of 2023, markets got ahead of themselves with as many as six rate cut expectations. This has changed dramatically as reality dawned. Inflation continues to be challenging for central bankers and is evidenced by corporates who cite this as their number one concern. Worryingly, energy prices have been on the up and both Oil and Natural Gas prices are on the rise. Oil has settled in the mid-$80s. It is now starting to feed back into headline inflation rates and the second derivative of this is to feed into core (services) inflation at consumer level. At the time of writing, the March US CPI inflation figure has just been released and showed a rose of +0.4% m/m to put the annual rate at 3.5%. March’s figure is +0.3% HIGHER than February’s! Even excluding energy and food, core inflation also rose +0.4% m/m to take it to 3.8% y/y. The main drivers of this higher-than-expected inflation are energy (+1.1% m/m in March and +2.3% in February) and shelter (i.e. accommodation whether simple rentals or leased rental) which rose +0.4% m/m to 5.7% y/y. Shelter accounts for one-third of the US inflation index!

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China:

Initial signs are that China is picking up – albeit slowly. There have been a range of mostly fiscally driven stimulus measures (targeted measures at encouraging investment, a cut in the 5-year LPR rate which is used in setting mortgages and a rise in factory & service activity. Other indicators (such as export data of surrounding Asian countries’ exports to China) supports a mild pickup. Coupled with regions such as Europe appearing to have reached a floor with clear signs of a turnaround setting in (e.g. recent German data), it all points to some sort of synchronised pickup.

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Geopolitics:

The next evolution in the Israel-Gaza crisis and its impact on surrounding Middle Eastern (ME) states (such as Iran) will determine the risk premium embedded in markets from geopolitical risk. The ME saga has dragged on since 7^th October 2023 and spread to involve Iran. The recent attack, allegedly by Israel on an Iranian embassy in Syria, is an example of such escalation. Since then, there is partial talk of withdrawal of Israeli troops from Gaza and the start of peace talks. If this really progresses, risk premium will fall and will be a boon for the ME as a region. I am sceptical but one thing is certain – the cost to both sides has been so huge (human lives & economically) that incentives are in place to act. On the other hand, it could be a stalling tactic till the outcome of the US election in November. Time – which is in short supply – will tell!

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There have not been any changes to our portfolios since their redesign in late summer last year. They continue to deliver on the upside when markets are in risk-on mode. At the same time, should corrections happen in markets – which they will undoubtedly – then they have features to limit the shocks e.g. short duration maturity bonds (these are least prone to interest rate volatility), our equity exposure remain skewed to undervalued (therefore less likely to lose money in further, market downswings) and cash-generating, quality defensive (these have better pricing power and dominant market share) companies.