Second Quarter 2024 Investment Review

IN BRIEF

• Delayed start for Fed rate cuts.
• Other central banks started cutting rates in June.
• Treasury yield reflect market dynamics.
• Equity markets remain resilient and reached new highs in Q2.

Market Comment

At the start of the year, markets anticipated 175 basis points in interest rate cuts. However, expectations for Q2 rate cuts have been reduced due to U.S. economic resilience and sticky inflation. The March employment report showed strong performance with a notable beat in non-farm payroll data, lower unemployment, marking 29 months below 4%. March inflation data, including the CPI and the personal consumption expenditure deflator, also exceeded expectations. Instead of raising rates, the Federal Reserve (Fed) maintained current interest rates at the May FOMC meeting, allowing existing rates to gradually cool the economy. Fed Chair Jay Powell noted that inflation is taking longer than expected to reach the Fed’s target. Consequently, investors revised their expectations, recognizing that the Fed is unlikely to start the rate cut cycle before September. If inflation and job data remains strong through the summer the first-rate cut might be delayed until year end. 

In April, the 10-year U.S. Treasury yield rose by 40 basis points (bps), indicating markets were adapting to changing conditions, though it posed challenges for fixed income investors. The 10-year yield started at 4.3%, peaked at 4.7%, and increased by 80 bps year-to-date (YTD). In May, government bond yields fell as weaker inflation numbers triggered hopes for earlier rate cuts, reflecting data variability and market dynamics. The rate cut cycle is seen as postponed rather than cancelled. Fixed income markets broadly fell, with the Global Aggregate Index declining by 1.7% and recovered in May and June. This weakness also affected investment grade and, to a lesser extent, high yield. Other major markets’ 10-year yields were mostly unchanged, except Japan’s, which rose 20 bps to 1% for the first time in 11 years as the Bank of Japan (BOJ) gradually exits negative interest rates.

Despite bond market volatility, equity markets remained resilient. The S&P 500 saw a 5.5% correction in April but quickly recovered half of the lost ground, supported by steady corporate earnings growth, companies delivered a solid 7.9% year-over-year increase in Q1 EPS. S&P 500 earnings growth is now less reliant on the “Magnificent 7”, driven by information technology and communication services, while energy and financials detracted. In May and June, global equities rallied 6.4%, with US equities performing strongly, driven by earnings beat and favorable inflation data.

The first week of June saw central bank divergence, with several banks beginning their easing cycles while the Fed is expected to remain on hold. The Bank of Canada, European Central Bank, and Swiss National Bank each cut rates by 25 bps, citing improved inflation outlook.

The policy divergence has continued to support the U.S. dollar. The Japanese yen significantly underperformed, exceeding 161 against the dollar for the first time since 1986, driven by the BOJ’s reluctance to tighten monetary policy.

Looking ahead, investors will have to balance an increase in election-related uncertainties with moderating economic growth, inflation and potential rate cuts setting a positive stage for corporate earnings and equities.

Key portfolio activity over the quarter:

Activity this quarter was more muted as we had carried more extensive re-positioning during Q1.

There were essentially three main trades this quarter:

1. We reduced our overweight to US Investment grade fixed income and diversified into global exposures, including China. The rationale was driven by the strong economic momentum in the US, which reduces the chances of rate cuts, while Chinese growth remains weak – a better backdrop for fixed income.
2. Within European equities, we reduced broad passive European exposure and insurance, in favour of diversified financials. The rationale centred on the improving outlook for the European economy as well as the high shareholder returns, we are expecting from European banks. We expect the combination of dividends and share buy backs to be approaching double digit returns to shareholders. Given we think the banks will also be seeing earnings growth, we think the sector could further re-rate higher.
3. As we closed out the quarter, we saw volatility in European government bonds following French election uncertainty. We were overweight German bunds and took advantage of the increase in French yields, switching that overweight in German bunds into French government bonds.

Resultant high-level positioning

There were no changes to our high level asset class allocation. That means we remain overweight equities across profiles, expressed through the US geographically. Within fixed income, we retain a 4% overweight to high yield credit, spread evenly across the US and Europe.

We would therefore describe overall positioning as moderately pro-cyclical i.e. slightly overweight risk given what we think is a relatively robust global economic outlook combined with peak interest rates and a bias from central banks to reduce rates. That is a good backdrop for risk assets to continue performing.

At a sector level within equities, our largest overweight is to financials, globally, which was increased though the European trade mentioned before. The other two main overweights are to healthcare and AI related sectors, specifically information technology. Essentially we are overweight two secular growth thematics; AI and GLP1 weightloss drugs, the latter focused on Eli Lilly and Novo Nordisk. Because we are overweight equities there is little at a sector level that we are underweight but a slight bias to be underweight industrials as well as utilities.

Within fixed income, because of our overweight to equities and high yield, we are underweight Core bonds but with a preference for investment grade over sovereign bonds. To maintain duration in portfolios, we are overweight certain longer dated bonds to provide a hedge in portfolios against growth disappointing to the downside.

For portfolios with alternatives, we are in line with the long-term strategic weights for hedge funds but underweight within liquid alternatives, preferring to spread that underweight across a combination of fixed income and equity.

Returns

This has been a positive quarter for returns, driven by equities and to a lesser extent high yield credit. Geographically, the overweight to US equities has added value. At the sector level, return dispersion has increased due to the out-performance of technology related sectors; defensive sectors such as consumer staples have underperformed. As the quarter progressed with yields falling in June, having full duration has been beneficial versus holding cash. As we look at the half year outcome, returns have been above expectation in absolute terms, boosted by continued earnings growth and we are slightly ahead in relative terms.

Outlook

As above, both the prospect for falling interest rates over the coming year and healthy corporate earnings growth, we feel portfolios are well set to continue progress albeit we might well expect some consolidation in markets given such a strong start to the year. Inflation data and increased geopolitical risks (driven by forthcoming elections) remain the key risks to portfolios. Due to these risks, we are broadly diversified in our exposures and are avoiding highly directional positioning or over concentration on one theme. We remain of the view that for investors focused on long term, goals-based outcomes, this is a time to be fully invested versus cash.

DISCLAIMERS

For illustrative purposes only. Estimates, forecasts and comparisons are as of the dates stated in the material.

Indices are not investment products and may not be considered for investment.

Past performance is not a guarantee of future returns and investors may get back less than the amount invested.