PWA quarterly – on new winners and laggards and an earthquake at Harvard’s

One “big one” is left in this global election year… but how will the presidential elections in the US affect markets? Or will China dominate the scene with its current huge stimuli? Is value investing back again after a decade of only growth stocks performing well?

In our current newsletter we try to answer these questions in order to navigate the next months wisely.

The first cut is the steepest

Economic Review and Equities

The global economy continues to grow below the historical average and has stopped recovering in 2024.

Global equities rallied in the third quarter despite bouts of volatility, based on better macro data that rekindled economic optimism especially towards the end of the quarter. China's announcement of new stimulus measures and long-awaited interest rate cuts in the US supported both equity and bond markets. The quarter also saw two assassination attempts on former President Trump. The withdrawal of current POTUS Biden from the presidential race in July and his endorsement of Vice President Kamala Harris also fueled speculation, especially as for the first time the nomination was made without the usual primaries. Nevertheless, equities managed to eke out a nice gain for the quarter.

Europe and Switzerland – good value

Markets were volatile during the quarter as investors waited for better economic data to give central banks more room to maneuver. As incoming numbers were mixed and political factors also played a role (U.S. presidential election, assassination attempts, Paris Olympics, elections in France and the U.K., etc.), markets moved mostly sideways with increased volatility. Macro data for Germany was weak and EU inflation only came down towards the end of Q3, allowing the ECB to cut 25bp in September. However, PMI numbers for the Eurozone were weak at 48.9, still pointing to a contraction in the economy. The strongest sectors were real estate, utilities and healthcare, while IT and energy suffered as investors began to refocus on value due to the uncertain economic outlook. Still, European equities performed better than the US market – for the first time in many quarters.

USA – the laggard; for once

US markets started the third quarter well, but as in Europe, mixed macroeconomic data led to a sector rotation away from growth and towards value. Utilities and real estate were the top performers, followed by financials, while IT was only marginally higher. The expected rate cut in July, which did not materialize, as well as weak employment data caused nervousness. This led to particularly high volatility in August, which was then dampened by better macro data in the second half of the quarter. As the fears of a damaged economy due to the late action of the FED receded, additional support came from corporate earnings and the interest rate cut in September (50bps), the markets recovered and eked out a positive performance for the whole quarter. Of course, the presidential race also began to affect sentiment, especially with Biden dropping out in favor of his running mate Kamala Harris.

Asia & EM – better than the rest

Emerging markets and Asia posted gains in Q3, with a similar sectoral picture to developed markets: AI-related concerns and an IT sell-off made Taiwan, South Korea and India the losers in Q3, while Thailand, Hong Kong and China posted solid gains, helped by the stimulus measures (interest rate cuts, fiscal support) introduced in China. Japan had a remarkable quarter: after hitting a new all-time high in July, the market corrected sharply, with the Nikkei suffering its biggest one-day drop ever on August 5, losing 12.4%. This even surpassed the Black Monday correction of 1987! However, as corporate earnings were solid and macro data showed progress, stocks rebounded by over 10% the next day. The yen was also very volatile, suggesting that speculative activity was not a small part of what happened. The worst performing market was Turkey, where the local currency depreciated and outflows from foreign money hurt.

Bonds – lead the pack in Q3

The third quarter saw the start of the cycle of interest rate cuts in the major economies. This lead to a very strong quarter for bonds, the best for ages. The Fed cut 50bps and the ECB 25bps, as did the SNB (again), all in September. Only the BoE was earlier, cutting 25bps in August following the landslide election victory of Labour. As a result, yields also fell, with the US 2yr yield falling 111bps, leading to a steeper yield curve. Within corporate bonds, US investment grade (IG) bonds performed strongly, while global high yield still outperformed global IG. Convertibles provided solid downside protection and participated well in the rally in equities.

Alternative investments

Commodities started the quarter weak as the macro-outlook remained bleak. Industrial metals, energy and agriculture almost all fell in July and August, with only precious metals, coffee and cocoa in agriculture and zinc and aluminum recovering in August. Overall, the index fell in the third quarter, with energy being the weakest due to concerns of lower global growth. However, with the positive end to the quarter from a macro perspective, Agriculture, Industrial Metals and Livestock were able to gain slightly for the full third quarter. Only precious metals gained significantly, with gold solidly higher.

Interestingly, the real estate market, as covered by REITS (Real Estate Investment Trusts, being real-estate owning companies) was the best performing asset class of the quarter, while digital assets as a whole were negative, despite Bitcoin being positive.

Our Investments and Actions

Due to seasonal expectations, we had underweighted equities, taking risk out of the portfolios. Fortunately, the overweight in bonds largely offset this. Our new CAT bond investment performed well. However, as long as the hurricane season is still raging, this could be a buying opportunity. Fortunately, yields remain attractive.

Navigating the 4th quarter

Inflation is under control, sentiment is fine. Is that all there is to say? Can we expect another year-end rally after a strong Q3? The FED rate cuts are fully priced in, even if the first cut in the US was twice as large as usual. We see no further support for the markets here, while earnings are starting to disappoint.

Turbulence ahead

It will take more than a year for the rate cut stimulus to have a positive impact on markets, and even longer for it to be reflected in corporate earnings. Vanguard Asset Management also says that AI will not save the day yet because the impact on earnings is not broad enough. Therefore, the drivers of the markets are elsewhere.

The current geopolitical environment does not make the system any safer. After so many elections this year with no major impact on the markets, we are left with one "big one". But as we have said in previous quarterlies, we don't expect the US election to move markets significantly, no matter who wins. Rhetoric and policy are two different things.

In conclusion, we are relatively neutral in our risk positioning as the mixed signals do not give a clear direction.

Over a longer time horizon of a few years, the expected return difference between low-risk and higher-risk portfolios becomes less significant. Risk is not well rewarded in a global portfolio.

Currencies and Bonds

YTD, the USD is flat against other currencies such as the notoriously strong CHF. As interest rate differentials narrow, the USD could weaken further. We have a higher-than-usual position in cash, ready to invest in either bonds or equities in the event of a market setback.

There is currently an oversupply of government bonds, therefore, we remain underweight. Our latest investment in this asset class is a rules-based approach that successfully switches between government and corporate (credit) bonds, while managing duration (the average maturity of bonds) between short and long. We continue to like emerging market bonds (attractive risk-adjusted returns) and high yield, although the latter is becoming quite expensive. If a recession hits the (US) economy hard, this asset class will take a dive. However, it usually bounces back very nicely, currently supported by high yields.

Alternatives – Stability –

We are cautious on private credit, while we still like our selection in fully liquid senior loans.

Equities – broadening markets help

In recent years, markets have been driven by just a few large stocks, especially in the US. The largest 5 stocks of the S&P500 make up for 27% of the index. Additionally, only one third of the stocks outperformed the index itself over the past two years. Yes, these few companies have also grown their earnings very nicely. But can the Magnificent 7 grow their earnings to return to fair value within 3 years? Vanguard doubt it, as they would have to grow earnings by 40% p.a., see above.

Expected S&P500 Earnings Growth; Magnificent Seven versus S&P493 2023-2026

However, from the third quarter onwards, market performance is (finally) being driven by a broader range of companies, following expectations as shown in the graph below. This broadening will help:

?a) smaller and mid-cap companies

?b) value-oriented investments

?c) actively managed funds.

We expect generally higher volatility which translates into: the ride will become more bumpy going forwards.

USA – turbulent landing

Labour market data is likely to rekindle recession fears in the coming months as more people enter the labour market. Inflation is unlikely to be a major drag on the economy, while large caps are defying traditional valuations. As a result, most managers' longer-term outlook for US equities is well below that of the rest of the world. However, the FED will remain accommodative if the economy needs an extra push. An alarming signal for us would be if Mr. Trump, if re-elected, defied the established norm of an independent FED. Since its independence is not protected by law, what would stop him from using the FED to achieve his goals? At its core, political stability relies on independent institutions, the rule of law, and a functioning economy.

A clearly worrying signal comes from an unexpected corner: This year, only 95% of Harvard students found jobs immediately after graduation. Never in history has this rate been so low. It is perhaps a better indicator of economic sentiment than many technical indicators.

Europe and Switzerland – growth only in smaller companies

Germany, the former engine of the European economy, is weakening further. New orders, an important leading indicator, are falling again. In contrast to the US, Europe's largest companies are not really growing, while capitalization is falling relative to the rest of the world. We prefer small and mid-caps because there are some real gems here and a third of their revenues come from emerging markets. We have found a great new high-conviction investment for our clients. Additionally, we are still slightly overweight Switzerland again.

Asia and Emerging Markets – China plus one

Japan has seen a strong rebound in GDP growth. This is due to corporate governance reforms that have forced companies to use capital much more efficiently and focus more on shareholder value. This has incentivized Private equity firms to once again invest in the country. Additionally, high corporate capital expenditure (CAPEX) combined with low inflation will continue to support prices.

Will China's mega-stimulus package have an impact on the country or even the global economy? We have seen an initial boost. However, we believe that investing in a few emerging markets with compound annual growth rates is more promising than investing in the general EM space, which has been flat for the past 10 years. Why not pragmatically follow companies that are strategically reducing their dependence on China by adding manufacturing facilities outside of China, such as in Vietnam or India? This is called a "China plus one" strategy.

A weaker USD usually supports EM equities.

Thematics – Value is trending

Our investment in cybersecurity has not lived up to our expectations. We all know how important it is, but companies don't seem to be moving with the story. We are going to invest into a more defensive and value related theme that we call critical infrastructure. The power grid is a bottleneck with interesting investment options. Without it, no matter what source of electricity is chosen, the economy and even society will become dysfunctional. The world's demand for electricity is growing and growing, as in your household and ours...

Alternatives – Classic

Even after a good run, we still see some (limited) upside for gold and other precious metals.? Oil will continue to trend lower despite the conflicts in the Middle East - unless a full-blown conflict develops directly involving Iran. The reason for this is weak demand from China.

Positioning our portfolios

Here is the chart showing our view on asset classes for the 4th quarter of 2024.

We wish you a clear and calm autumn.

Philip and your PWA Team