Readers will have noticed a more cautionary tone from us last month, and the best way to describe our view is that we have taken our foot off the accelerator but that our foot is not on the brake.
After US equities (S&P500) ran 28 per cent from their low in October last year to their peak in March this year, it is healthy for markets to take a pause and pull back 5-10 per cent. We do stress however that we remain optimistic towards risk-based assets and in particular global equities for the remainder of 2024 and into 2025.
As economic growth remained stronger than expected, the fall in inflation began to stall and the timing of interest rate cuts was pushed out, we exited bonds in late March/early April and put this cash to work in high yielding cash alternatives, with little to no exposure to duration.
The monthly Bank of America fund manager survey in April confirmed our view that caution was necessary for the immediate term. This is a survey of 224 asset managers with combined funds under management of US$638 billion.
It was the most bullish survey since January 2022 with equity allocations at their highest level in 27 months and cash levels down over one month from 4.4 per cent to 4.2 per cent. Historically, cash levels below 4.0 per cent have been an indicator that equities are becoming over bought.
The debate is now whether the economy is set for “no landing” or a “soft landing,” as inflation remains sticky in the immediate term and interest rate cuts have been delayed. It is interesting how the market has shifted from worrying about growth to now worrying about too much growth and its impact on inflation.
In April, Capital Economics in London revised their rate cut expectations for the US this year from four to two, as inflation proved stickier and economic growth stronger than anticipated however, Capital Economics is looking at an acceleration in interest rate cuts in the US in 2025 and a range for the US Fed funds rate of 3.5 – 3.75 per cent (presently 5.25 – 5.5 per cent).
For Australia, Capital Economics expects the Reserve Bank of Australia will lift interest rates by 0.25 percentage points to 4.60 per cent in early May when it meets next week.
Underlying inflation is overshooting the RBA’s current forecast, and services inflation is also proving to be persistent. Australia is an outlier now whilst other developed market economies are looking at rate cuts.
The bottom line in Australia is that the government has failed to get wage price inflation under control and its policies at a fiscal level underpin inflation as opposed to assisting in driving inflation lower.
Readers have queried our underweight to Australian equities that we neutralised in March. As the chart above from Capital Economics highlights, the Australian market is not cheap. The sector composition of the index has and will contribute headwinds (which is why it has underperformed by approximately 10 per cent over the last twelve months). The above chart neutralises sector weightings globally and shows Australia on a valuation basis to be on par with the US market (the US is a far higher growth market), and more expensive than the rest of the world ex the US.
Despite delays in the US and Australia it is possible that the European Central Bank (ECB) and the Bank of England could commence rate cuts as early as June.
One of the reasons we took our foot off the accelerator is that not only have equities had a strong run, but also risks have elevated. The oil price above USD90 a barrel has concerned us with respect to implications short term for inflation and, whilst geopolitics seldom has a long-term effect, it can dramatically increase volatility in the short term therefore the elevation of the conflict in the Middle East needs to be monitored.
The exit of our bond positions was on the basis that these risks skewed towards higher bond yields than we originally expected, and our original base case for bonds being in portfolios had reversed.
The current pullback in markets is healthy and may well continue in the short term, but our medium-term optimism for risk-based assets remains for the rest of 2024 and into 2025. The debate around the timing of rate cuts is valid but cuts will come eventually. The benefits from the adoption of AI (Artificial Intelligence) in many economies, particularly the US, together with resilient economic growth, will provide a tailwind.
Capital Economics have a target for the US S&P500 of 5,500 by the end of 2024 and 6,500 by the end of 2025 against the existing levels as of writing of 5,100.
We have talked many times about the importance of diversifying amongst and within asset classes. The other aspect is the importance of asset allocation.
Our asset allocation as we enter May is:
Since COVID our tactical changes have resulted in a lot of changes in portfolios, and these tactical shifts have been a key driver of portfolio returns above the blended benchmarks.
We do not see this changing, and the importance of tactical asset allocation will be important to both protecting and driving returns.
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