Third Quarter 2024 Investment Review

IN BRIEF

• Fed launched its first easing cycle since the pandemic by cutting 50 basis points.
• ECB & BOE cut by 25 basis points while BOJ hiked.
• Market environment rapidly changed triggered by softening US labor market and unwinding carry trade.
• Negative corelation between bonds and equities re-emerged.

Market Comment

The past three months have been characterized by a dynamic and uncertain environment. The Federal Reserve's (Fed's) focus has shifted to the softening labor market, raising fears of a sharper U.S. economic slowdown, and triggering a global sell-off in risk assets.

On the central banks and policy rates front, expectations of rate cuts from the Federal Reserve and the European Central Bank (ECB) have dominated market sentiment. Futures markets have been actively pricing in these anticipated rate cuts, with discussions centered around whether the Fed will cut by 25 or 50 basis points. The Fed ultimately lowered the policy rate by 50 basis points to a target of 5.00%. 

This move marks the start of the Fed's first easing cycle since the onset of the pandemic in March 2020. Fed Chairman Jerome Powell described it as a policy "recalibration,1” aiming to pre-empt any weakening of the US economy and labor market after more than a year of holding rates at their highest level since 2001. The Bank of England and the ECB also cut rates by 25 basis points during the quarter. In contrast, the Bank of Japan surprised the market by raising rates, triggering an unwinding of the U.S. dollar-Japanese yen carry trade, resulting in a stronger yen and provoking a sell-off of Japanese equities.

Economic data from the US and Europe has been mixed this quarter. Inflation has generally been on a downtrend with some persistent areas, while growth shows signs of slowing. A consistent theme has been the softening of labor markets, with a 0.2 percentage point uptick in unemployment rates, reaching 4.3% in July, mostly due to slowing job gains rather than job losses. Beyond the labor market data, the manufacturing purchasing managers index (PMI) and ISM surveys pointed to softness in the sector. Additionally, there are signs of slowing consumption, with increased price sensitivity among consumers and rising delinquencies on credit cards and auto loans.

US political developments have been marked by several surprising turn of events, contributing to an atmosphere of uncertainty and volatility in the markets as investors closely monitor the potential implications of policy changes and election outcomes.

Political developments, slowing economic growth, and uncertainty in monetary policy have triggered heightened market volatility. Investors have been navigating a tug-of-war between fear and greed. In July, there was a significant rotation from mega-cap stocks to small-cap stocks. Unlike in 2022, the negative correlation between stocks and bonds was evident in early August when a sharp correction in global risk assets was partially offset by an increase in government bond prices. Safe-haven assets like US Treasuries, the US dollar, and the Japanese yen saw increased demand amid geopolitical tensions and growth scare narratives. Strong US earnings growth, close to 10% year-over-year, provided some stability to equity markets, mitigating more pronounced sell-offs.

Key portfolio activity over the quarter:

With higher volatility in markets, we were active in portfolios.

We came into Q3 with a 2% overweight to equities, funded from core fixed income. As the equity markets continued to rally driven by the AI theme, portfolios drifted even further overweight equities. Therefore in mid July, we decided to take profits on the equity drift and additionally reduce the tactical overweight back to neutral on the grounds of valuation. That essentially meant that we sold 3-3.5% of equities, predominantly from the US. Of the proceeds, 2% was invested in high yield bonds (split evenly across the US and Europe) with the balance going into core fixed income.

The market environment rapidly changed triggered by a weak US jobs report followed by a ‘risk-off’ unwind of the Yen carry trade – investors had borrowed cheaply in Yen to fund leverage. As the Yen strengthened, investors paid down leverage causing risk assets to fall.

In a matter of weeks, our portfolios had drifted underweight equities. Given there was no fundamental change to our constructive outlook, we bought back equities in early August after the volatility and funded this by taking profits from the Core fixed income that we had bought in July.

In September, we made some more minor equity sector allocation changes and bought US consumer staples for their defensive characteristics and growth outlook, principally funded from the minimum volatility factor ETF.

The final trade of the quarter was a small shift into UK gilts funded from US treasuries, following underperformance and the delay in rate cuts from the Bank of England. We think that represents a long term opportunity as we don’t see the UK economy offering strong growth rates and therefore rates ultimately falling.

Resultant high-level positioning

We closed out the quarter being in line our long term strategic allocation to bonds and equities; that represented a reduction in equity risk of 2%. This was funded from US equities, so we are now also broadly in line geographic exposures; we like the growth characteristics of the US market, while international equities are valued more in line with a lower growth outlook.

The key positioning difference we have in portfolios results from our fixed income exposure. We are 6% overweight high yield; this sub-asset class looks relatively highly valued by historic standards but the absolute yield of around 7% is attractive and we don’t expect a meaningful pick up in default risk. This is funded from Core investment grade bonds. Combining the two sub sectors, we have average duration (essentially the maturity of the bonds) of around 6.7 years. This is a critical component of our portfolio construction in that we have equities and high yield that will benefit from our central case of the world returning to trend growth (from above trend growth), while the duration of the Core fixed income helps us hedge portfolios should growth disappoint to the downside.

At the sector level, our largest overweight is now to consumer staples, followed by financials and Information technology. Underweights relate to more cyclical sectors like industrials and consumer discretionary.

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

Another positive quarter for risk asset returns but a change in the mix. Core bonds have positively contributed as we have seen a fundamental turn in the outlook from one where the tail risk to portfolios was elevated inflation, to one where that tail risk has moved to a declining growth and inflation outlook. Our relatively long duration for Core bonds helped drive absolute returns and our overweight to high yield continues to perform well. The overweight to US equities helped drive relative returns. The sector mix was less of a driver this quarter but at the margin, the overweight to financials contributed positively.

Outlook

Markets have run hard this year, especially equities but this has been supported by earnings growth – currently running at around 11% in the US. While US equity multiples look full in the short term, they are supported by the declining interest rate backdrop. A notable characteristic of Q3 was that negative correlation between bonds and equities re-emerged, which helps smooth volatility. We think this characteristic will continue as policy rates and indeed projected rates remain above our expectation of where long term neutral rates are (the Fed estimates a neutral rate of around 2.9%). We remain of the view that with declining interest rates, risk assets will continue to out-perform cash returns. Short term volatility should be expected though, thinking about US election risk, geopolitical events as well as variable economic data as global growth slows.

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.

We are not recommending the use of benchmarks as a tool for performance analysis purposes.  The benchmarks used in this report are for your reference only.