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Investment landscape
In the first quarter of 2024, global equity markets reached record levels, propelled higher by a general perception of ‘resilient economic data’.
Just so that readers do not misjudge us for so-called ‘permanent bears’, let us stress right away that a new high, in itself, is not necessarily a cause for concern, or a foreshadowing of an imminent market collapse. As a case in point, over the past 50 years, the S&P 500 achieved new highs for 26% of the time, so it’s perhaps a lot more common than one might think.
Rather, what is crucial is to assess the reasons why global equity markets have reached new highs. Does it reflect the strong underlying fundamentals of the world economy, and how that may translate into the earnings growth potential of corporations, in which case such market levels may be justified? Or is it driven by misleading or misinterpreted economic data, as well as fear of missing out, that is increasingly fueling a sense of complacency by market participants regarding risk perception?
Let us consider some of the recent economic data that has been either cheered on or ignored by investors.
In the U.S., real
gross domestic product (GDP) for the fourth quarter of 2023 surprised on the upside, increasing at an annual rate of 3.4%. So far, so good. But looking at the data more closely, one might observe that this was mainly driven by government spending, nonresidential business investments, as well as consumer spending.
Government spending increased 4.6% year-on-year (yoy), which wouldn’t necessarily be problematic, if it wasn’t for the fact that the federal budget deficit totaled $2.0 trillion in fiscal 2023, representing about 7.4% of GDP, larger than any fiscal year in history when the U.S. was not at war, in recession, or facing another major emergency.
There isn’t much to complain about regarding business investments (up 3.7% yoy), apart that it mostly relates to investments in intangibles rather than real productive assets. But then we turn to consumer spending, which increased by 3.3% yoy. This too would not be worrisome, if not for the fact that a large portion of this spending appears to have been financed by further debt accumulation on the part of households, including credit card debt, which increased by $50 billion in 4Q23 to $1.13 trillion.
What we are trying to highlight here should be rather self-evident. Such economic indicators can be ambiguous at best, and investors would be prudent to recognize that on the surface, they tell us very little about real economic conditions, let alone future economic or investment prospects.
Another such example relates to employment statistics, which is also concerning because of the widening gap between what the establishment nonfarm payroll data is telling us (that the labor market is still very strong) and what the household survey of employment is conveying (that companies are steadily laying off workers).
Finally, we can point to inflation figures, which are of course a key determinant of central banks’ policy decisions regarding interest rates, given that it is key to their mandate. In our 4Q23 commentary, we voiced our caution regarding the consensus view at the time that the fight against inflation was over and done with, which would pave the way for a significant number of interest rate cuts in 2024. Rather, we suggested that we may be experiencing a temporary phase of disinflation in an overall longer-term period of structural inflation.
Both the January and February U.S. CPI prints proved ‘stickier’ than expected, and the March report to be released this week might even show a slight re-acceleration of the headline CPI, which will likely raise even more concerns about inflation being solidly entrenched. On the back of these developments, investors have had to reassess their expectations regarding the likely number of interest rate cuts this year, from 6 or 7 cuts (of 25 basis points each) in January to fewer than 3 as of today. Some market observers go as far as arguing that there might not be any interest rate cuts in 2024, as highlighted by a recent Barron’s article.
Financial markets
In this context, global equities posted strong returns, with the MSCI World up 9% during the first quarter (gross return, in USD). This was especially true in the U.S., where the S&P 500 rose 10.6%, outperforming most of its peers, driven yet again by the exorbitant performance of the ‘magnificent seven’ stocks. However, the best performing market of the quarter was Japan once again, with the TOPIX up 18.1% in 1Q24, despite the BoJ’s announcement to end its negative interest rate policy and yield curve control. Overall, European equities continued to lag the U.S. and Japan, while emerging market equities significantly underperformed their developed market peers, with the MSCI EM Index returning 2.4%, as investors remained concerned about China’s growth prospects.
While equity investors cheered supposedly strong economic data, for fixed income investors it was a more challenging quarter. Stickier inflation prints, ‘resilient’ economic activity, and the Fed back-pedaling somewhat on its dovish December tone combined to drive negative returns for bonds. Overall, the Bloomberg Global Aggregate Index fell -2.1% last quarter as yields increased.
Finally, looking at investors’ risk perception, there are clear signs of complacency, with one notable exception. On the one hand, many markets appear increasingly priced for perfection, as high valuation levels would indicate. Concentration levels are also high, and still rising throughout the first quarter of 2024, despite greater market breath. Volatility remains low, with the VIX averaging around 14 over the period. Investors’ use of margin debt is on the rise once again. Looking at corporate credit, U.S. and EU high-yield spreads have continued to decline, and currently stand at 3.2% and 3.6% respectively. As such, the level of insurance against default that investors demand for junk bonds is rapidly moving back towards all-time lows. These are but some of the signposts that might give some indications about risk perception.
On the other hand, physical gold, traditionally a risk-off asset, begs to differ with the notion that all market participants are increasingly complacent. Throughout the first quarter of 2024, the performance of the yellow metal likely surprised many investors, nearly matching the performance of the S&P 500. The breakdown of the long-standing relationship between gold and real interest rates remains a puzzlement to many, who struggle to recognize that while gold does indeed not possess a yield, it offers many other advantages, as we’ve described in detail in numerous prior writings.
The yellow metal, which we consider as the ultimate reserve asset, given it scarcity, permanence, and the fact that it carries no counterparty risk, appreciated steadily throughout the start of the year, and then sharply starting in March. It is not entirely clear what prompted this move precipitously higher at this particular moment in time, apart from the long-standing usual suspects: high debt levels and budget deficits, monetary policies that remain far from highly restrictive, growing worries about inflation, and rising geopolitical tensions. Perhaps more significantly, robust buying from a number of central banks such as the China’s continued unabated, as has been the case ever since the sanctioning of Russian reserve assets at the start of the invasion of Ukraine. Interestingly, the rally in gold appears to have occurred without much enthusiasm from the investment community, as measured by gold ETF flows which have declined marginally year-to-date, whereas inflows in the newly-launched crypto ETFs have surged.
Conclusion
In conclusion, it is with a sense of humility that we say again, as we’ve stated many times in the past, that the crystal ball is foggy at best. We do not know what will happen in the near term. But that doesn’t necessarily mean that our chosen pathway to strive for resilient wealth creation is any less clear. In a world of monetary abundance, we want to mainly focus on owning scarce and productive assets, focusing on ‘quality’ businesses trading at reasonable prices, oftentimes found in fairly mundane places. We also want to maintain some level of optionality by holding liquid reserves, predominantly in the form of physical gold.
