Reflections of the CIO...

A very strong performance from risk assets in March brought the first quarter of 2024 to a positive end, a feat which was all the more impressive given simultaneously weak government bond markets and mixed economic news, particularly on inflation. The foundations for this ‘risk rally’ were built upon the ongoing resilience of developed economies, which, in general, have absorbed high levels of interest rates without too much visible difficulty. The steady descent of inflation from last year’s peaks has also continued, adding to an increasing mood of optimism.

Even when this optimism was tested mid-month, when inflation numbers hit a sticky patch, the central bank response to the issue was very mild and supportive of the prevailing positive mood. The US Federal Reserve, for example, kept with its view that the longer term trajectory to lower, ‘target’ inflation levels was still very much intact, despite shorter term trends being decidedly mixed. This narrative was taken by most investors to mean that interest rate cuts would still be arriving in the second half of the year, a prospect which powered both last month’s strong rally and the general uptrend of the last two quarters.

However, not all assets participated in this uptrend, nor did investors entirely buy into the Fed’s view of ever falling inflation. Government bond markets, for example, have been sluggish all year as investors dialled back on wildly optimistic assumptions on the scale of future interest rate cuts. Expectations are now about half as much as they were in January for the most important US market, a large reset to a more realistic level and much more in line with Fed guidance.

In addition, the underlying picture of market performance in March is more nuanced than strong headline numbers imply. US equities continue to dominate global indices, with a tiny group of large technology companies continuing to provide most, if not all, of the gains. This narrowness of equity market leadership is the same even if we look at medium and smaller company indices and requires some careful thinking about, as it has rarely proved to be a healthy indicator for future returns. The gold price was also very strong in March, suggesting that there might be some wider investor unease about lingering inflation risks.

The tricky part of assessing market direction from here is that many of the longer term issues – such as weak government balance sheets – feel as if they are ‘out of sight and out of mind’, such is the strength of the prevailing positive mood. However, we suspect it wouldn’t take too much of a change in circumstances before this particular issue returns to the front pages. This point was illustrated, literally, in late March by a front page headline in the Financial Times, telling a story about how the US debt market, cornerstone of the global financial system, could soon face its own ‘Liz Truss’ moment of panic. The story was published just as equity markets were delivering their strongest returns for five years.

From a top down perspective, we think that the next few quarters will see markets wrestling with the implications of several conflicting themes, some positive, some more negative. For example, the process of cutting interest rates whilst economies are resilient and inflation is still not at target, clearly risks re-igniting the inflation/interest rate cycle all over again. Energy prices are also picking up as the general level of geopolitical tension remains high, increasing the chances that any one adverse event could quickly escalate. More constructively, the steady ‘drip, drip’ approach of Chinese policy makers to their domestic economic issues may now just be gaining enough mass and momentum to make an impact, turning what was a headwind to global risk sentiment back into a tail wind. The upcoming earnings season is also key, as we will find out if overall growth in profits is enough to justify the upwards moves we have seen over the last six months.

As these issues come to the fore, we would expect a more muted market performance than that enjoyed year to date. We think that the environment will become more volatile, as investors try to sort out real underlying trends from headline noise. In the end, our view remains that the peak in the interest rate cycle will ultimately be a powerful enough force to overcome other risks and the outlook for the year remains solid. We were happy to ‘make hay’ in a quarter and month when the sun shone and, hopefully without stretching the analogy too far, we would expect to be able to do so again, after a pause for consolidating what has already been reaped.