Whilst we remain optimistic on the outlook for markets for the remainder of 2024, we are reminded that equity markets do not move in a straight line (as they have done so since November), and a pullback would be healthy for a sustained longer term bull market.
What has surprised us, as we mentioned last month, is the number of investors and advisers we have talked to who have not supported or participated in this global equity rally – despite resilient economic growth, especially in the United States, and stronger than expected corporate earnings growth.
We are strongly of the view that this earnings growth is important and, just because a company or a market hasn’t performed, doesn’t mean that it will catch up. We have entered a period where we believe quality conviction management and stock selection will outperform index exposure.
We believe that interest rate cuts in the US will still occur in the second quarter of 2024 but more likely in June, as opposed to our previous view of April, and we are still anticipating 3 or 4 cuts over the calendar year and not the 7-8 that many were anticipating late last year. Interest rate cuts in the absence of a recession add to our optimism.
We have cautioned before about complacency and whilst market performance has been strong, noting we believe a pullback would be healthy, we have been surprised how many investors remain on the sidelines in cash and/or term deposits.
Inflation did disappoint at the end of the first quarter with US inflation in February increasing marginally to 3.2 per cent, but we believe forward indicators such as shelter, as illustrated in the chart below, will continue to see US inflation fall below the crucial 3 per cent level and towards the US Federal Reserve’s 2 per cent target by the end of 2024.
The equity market rally has been quite narrow in its composition. It has been lead by the tech sector with significant investment in Artificial Intelligence (“AI”) and the expectation that AI will drive economic growth and productivity improvement in the years to come. This creates some fragility and any sign of weakness in the sector would see a sharp pull back. A broadening of the rally would be healthy and global mid-caps especially do stand out as an area where we believe outperformance can be achieved, but again growth in earnings is crucial and this is why we support a conviction style approach.
We have always supported diversification amongst and within asset classes. This could never be truer as we enter the second quarter of the calendar year after five months of strong equity-based performance.
Equities
We added to our Developed Market Equity exposure during calendar quarter one, increasing our large cap exposure to match our mid cap Overweight that we have held since October 2023. We lifted our Emerging Market Equities exposure to Overweight in January as growth momentum appeared to have turned to the upside however, we remain underweight Australian Equities, a stance we have held since early 2023.
This tactical positioning has provided strong portfolio attribution above strategic long-term weightings, as US equity markets have gained approximately three times that of our domestic equity market on a rolling three month and twelve-month basis. Firm language from the US Federal Reserve Chairman Jerome Powell reassuring markets of interest rate cuts has buoyed sentiment, as has the strong performance of AI darlings in Nvidia and Meta, up approximately 90% and 45% respectively over calendar quarter one.
It is not uncommon for news outlets to spread fear around valuations as markets push through all-time highs, so it is important to remove any anchoring bias in your decision making and include information on earnings growth, policy/liquidity conditions and momentum/sentiment signals when assessing market direction.
Fixed Income and Diversified Credit
We began and ended the quarter with a Neutral weighting to Fixed Income. With no changes to monetary policy in the US, Europe or Australia during the quarter, bond markets were relatively subdued, trading in fairly tight ranges. Any movement in yields was mainly driven by comments by central banks, hinting at when they may commence easing monetary policy. Concerns about the amount of bond issuance required in the US also remain but so far, the market has absorbed the new supply reasonably well.
As the quarter comes to an end, we are removing our exposure to bond duration in client portfolios. A recession is now less likely to occur and, whilst we are still expecting interest rate cuts to occur in the US around mid-year, and later this year in Australia, it will be shorter dated bond maturities which are likely to benefit most from this. Long dated bonds will no doubt also benefit but any gains will be limited by a more muted inflation outlook. In short, we believe the risk/reward payoff is no longer attractive enough to maintain the allocation to bond duration.
As part of our Strategic Asset Allocation review, we increased our long-term weighting to Diversified Credit. We continue to avoid global high yield credit, favoring private corporate loans, senior secured asset backed loans and active strategies that can invest across the credit spectrum.
Property
Listed property REITs added to their strong end of 2023 returns during quarter one 2024, handsomely outperforming the broader Australian Equity Market. Listed property REITs generally have a strong correlation with direct property returns, with listed markets providing a leading indicator for unlisted markets. We are however cautious of extrapolating the strong REIT performance into unlisted property markets due to the heavy concentration of Goodman Group (at over 35% of the index) and more funds management type names in Charter Hall. These businesses have a high level of property development and equity market linked revenue streams imbedded within them, with Goodman Group also being linked to the AI data center theme, meaning they are less reflective of the broader unlisted property market.
We continue to cautiously assess unlisted property deals as they come to market, and we are pleased to see transaction activity lift during 2024. We anticipate forced sales by large property groups will be required to meet redemption requests during 2024, and for this to potentially signal a bottom for commercial property markets later this year.
We remain Neutral Property as we enter quarter two 2024.
Alternative Assets
As outlined in our January insight we are conscious of the proliferation of private market strategies. Many managers and strategies previously reserved for institutional investors have broadened their distribution to wholesale and retail investors. Whilst this offers great opportunity, we believe investors must remain very sensitive to three key factors:
- Illiquidity – investors should receive a return premium for locking away their capital. Strategies offering partial liquidity or a ‘liquidity sleeve’ should be treated as illiquid, this is how they will perform in times of stress.
- Valuations – investors must be conscious of their entry price, just because an asset is being offered for investment does not mean it is being offered at a fair market price.
- Leverage – The refinancing of debt that was fixed at very low rates will be a challenge for many investors in private assets.
Investors need only look at the private real estate market, particularly in the United States, where leveraged commercial real estate assets have seen significant downward equity revaluations. In some cases these assets were contained within liquid funds, more recent investors sharing the pain with those that had invested through the cycle.
The Initial Public Offering (IPO) market has remained dormant, however the successful NYSE listing of Reddit has lead to hopes of a revival in the US market. This has lead private equity managers to seek alternative sources of liquidity such as secondaries or continuation funds. We have continued to assess a large number of Private Equity strategies and remain confident in returns from this asset class, however we believe manager selection will become increasingly important.
Over the quarter we continued to see anecdotal evidence of trouble in direct lending to the property sector. We remain very cautious, investing only in senior secured loans particularly when backed by development projects. We also invest with managers where we are confident in their ability to ‘work out’ a troubled loan to protect investor capital.
Summary
Interest rate cuts on the back of falling inflation and productivity improvements from the development of AI are catalysts for better than expected economic growth and continued earnings momentum.
Markets are due to pause and consolidate; however we remain optimistic for portfolios across the remainder of 2024.
We enter the second quarter with the following tactical asset allocation positioning:
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