Q1 OUTLOOK: "Money, Get Back"
“Money, get back. I’m alright, Jack, keep your hands off my stack””
Money, song by Roger Waters, from the album The Dark Side of the Moon by the Pink Floyd, 1973
What has happened?
We are getting back to normal with a pivot finally in sight for 2024. Inflation in the West fell back under the 4% mark and the prospect of a more normal baseline now seems in reach. This led the Fed to keep rates unchanged, soften its tone, and shift the dot plot significantly lower. In the US, we saw a solid macroeconomic quarter from a hard data perspective as GDP (Q3 2024: +4.9% QoQ), spending, and labour markets impressed again. Forward-looking indicators (which are biased by soft confidence data) remained depressed, but there are also signs of improvement here too.
In Europe, economic growth stagnated yet again as Q3 2023 GDP remained at -0.1% QoQ (Germany also -0.1% QoQ) and PMIs stayed in the contraction zone, noting the situation is made worse by the combination of Europe’s manufacturing bias, energy supply issues, and the slowdown in China. The region continued to deleverage at a faster pace than the US as lending to businesses and households was unchanged or contracting, which especially translated into lower activity in the real estate sector. The ECB held rates and continued with a slightly hawkish rhetoric despite the fundamental backdrop.
In Asia, China’s macroeconomic picture stayed mixed despite the People’s Bank of China (“PBoC”) remaining accommodative in its approach with further incremental stimulus (still no shock-and-awe package). Growth underperformed (Q4 2023 GDP growth slowed to +1.0% QoQ from +1.5% QoQ prior), a theme reflected in the deflationary CPI and PPI inflation prints. In Japan, Q3 2023 GDP (-2.9% annualised QoQ) temporarily pulled back – this was somewhat expected but was slightly worse due to weaker private consumption and inventories. The Bank of Japan (“BoJ”) looked decidedly confused for most of Q4 2023 in its forward guidance, noting that it did at least outline inflation and wage targets that would need to be reached before an exit from negative rate policy is implemented.
Global markets saw one of the most impressive year-end rallies in recent memory as equities returned +9.7% (MSCI ACWI Index, USD hedged) for Q4 2023. This took 2023 performance to an impressive (albeit mega-cap-driven) +22.7%. All regions rallied this quarter, led again by the US (S&P 500 Index: +11.5%) with Europe (EUROSTOXX 50 Index: +8.7%), Asia ex. Japan (MSCI As Index: +8.0%), and Japan (Nikkei 225 Index: +5.2%) also each posting encouraging performance. Unfortunately, China and Hong Kong continued to be a drag on global markets (Shanghai Shenzhen CSI 300 Index: -7.0%; Hang Seng Index: -3.9%). For the first time in five quarters, mid-caps (Russell 2000 Index: +14.0%) did slightly better than the Magnificent 7 (Bloomberg Magnificent 7 Total Return Index: +12.6%).
Our strategy performance
Our Tyrus Capital Global Convertible Strategy finished up +3.4% (SI USD Hedged) for the quarter and +4.5% for the year. While we (a) posted positive performance, and (b) were ahead of the convertible bond ("CB") indices for most of the quarter, our participation in the year-end rally was hampered by our more defensive profile and strong ESG bias , noting sustainable convertible bonds were down -3.5% on average for the year. This nevertheless does not change our commitment to sustainable investing, noting we expect some of the underlying reasons for the detractors (e.g., overcapacity and interest rate increases) to correct in 2024.
Our summary view
Main focus: Soft landing and money flow. Inflation pulling back sharply (with a path to a sub-2.5% trend level in core PCE inflation visible by the end of 2024) has finally given the Fed and other central banks the impetus to forecast interest rate cuts for 2024. The US still leads the way in terms of the inflation cycle and remains the outperformer in terms of surprisingly strong growth. We must not simply forget about lags (as referred to in our last Strategy Report), because these will continue to drive data that will shape the trajectory of economic activity and monetary policy. Significant concerns exist as to whether serious economic scarring from the pandemic and elevated inflation levels have yet to hit. Although excess savings were considerably larger than first thought (to the tune of somewhere between USD 400bn to USD 1.2trn), these savings will eventually run out and the wealth effect will feel some downward pressure. The question of whether financial conditions have bottomed out, making them a tailwind rather than a headwind, is still debatable. How these twin lag effects feed into the economy and the Fed’s rate trajectory will be paramount for investment strategy in 2024. When it comes to the pivot itself, we still believe that the Fed will continue to focus on bringing inflation down to target. The Fed’s step change in the dot plot, its dovish voting move, and its softening of overall language this quarter (which this time implied that a weakening labour market was no longer a condition for rate cuts) together made for good reading against the backdrop of core PCE inflation settling back down to a path towards normality. With lower rates comes an improved outlook for the debt refinancing calendar (both the huge government debt and more manageable corporate debt), but this can still present event risk, especially for smaller and lower-quality names. This vastly increased interest expense can also really drag on earnings, especially when margins are tight. Looking to markets, and hinted in the title of this report, in 2024, fund flows should give a significant tailwind to risk assets given the amassing of cash into money markets over the last year, which we feel should now start to switch back. It would appear more compelling to jump headlong into risky assets, but this still requires some selectivity given the macroeconomic and geopolitical environment. There is little room for error given equities are still very expensive (particularly the headline US indices) and credit spreads are tight, noting that 2024 is an election year and a plethora of geopolitical risks exist that could create turbulence. There is always the outside risk of a no landing of course, but as a probability, we see this as an outlier to this year’s outlook. Assuming that is not the case, IG bonds with their higher coupons and positive exposure to duration make more sense, while we prefer the small/mid-caps within equities as they offer better valuations and far more upside in terms of earnings rebound, especially if our more comfortable soft-landing scenario is confirmed in the coming quarters.
Regionally: The US will be the focus of our equity allocation, but trading on such expensive multiples means some finessing is needed in terms of sector and stock selection. We still favour GARP and quality plays but see a place for more cyclical names if the Goldilocks economy persists and some of the negative manufacturing headwinds subside. A major question for all active managers will be when will small/mid-caps start to play catch-up with the mega-caps. Historically, they typically outperform in a rebound, but also have more to lose if lagged effects on earnings and refinancing ability do end up catching up with us. Both earnings and refinancing pressure are likely to show themselves in smaller caps, but the impact seems less scary now that a US recession is off the table and we have a pivot. Europe appears to be aligned in terms of inflation impulse and therefore interest rate policy, but it still differs wildly in terms of economic growth – the manufacturing recession especially impeding the region as well as looming European elections. Asia is torn by China’s economic woes and historical valuation discount. However, Japan still looks very interesting as it stands to benefit from inflation, its sensitivity to US growth, and the efficiency drive in the corporate sector.
领英推荐
All the rest: While it appears we are through the worst of the combined pandemic and stagflation impulses, the pandemic and stagflation latent, risks still exist, and we should keep an eye on the lagged effects we mentioned above. The geopolitical unrest in the Middle East and Ukraine and the knock-on effect that this can have on energy, food, and supply chains in general should not be ignored. In Asia, we feel it is difficult for China to turn the ship around in the short-term with their current approach and investor sentiment. As mentioned, Japan looks very attractive, but it has all to lose as it has done many times in the past – let us hope the BoJ can keep its resolve!
How are we positioned?
Taking the above views into account, the question turns to how these events affect our five investment themes, portfolio positioning, and trading strategy looking forward.
Where does this leave convertibles?
Despite overwhelming expectations, 2023 was the year that a forecasted US recession failed to materialise (forecasts arguably misled by errors in data). This is naturally a source of humility as we project ourselves into 2024.
For us, 2024 is going to be first and foremost a year of asset reallocation: With the pivot in sight and a record level of inflows in money markets during the last 2 years, we expect cash to get progressively back into risky assets in the coming months. Our view is that asset allocators will use this opportunity to simplify their strategies. While the last decade of low interest rates pushed them more into financial engineering, less liquidity, lower credit quality in search of yield, etc., we expect the 2024 dynamic to be much simpler and begin with plain bonds! Granted, spreads are not at their most attractive, but the reality is that bonds saw a lot of outflows in 2022 and 2023 after the move into cash. Now that we have the prospect of a pivot, a solid mid-single-digit coupon, and the resurfacing of a negative correlation benefit between bonds and equities, bonds become a much more obvious choice. Why bother going into private or illiquid assets in those circumstances!
Does this leave some spare time to get back to convertible bonds? Yes! When it comes to long-term allocators (e.g. pension funds, life insurance), convertibles have always been part of their satellite bond holding, but that same low-yielding environment had squeezed the asset class in favour of illiquid or subordinated alternatives offering larger coupons. We see the impressive revival in convertible bond new issuances in 2023 as testament that the supply, including IG issuers, is back. One data point as an example: as of the end of 2023, the yield on the Barclays EuroAgg (in Euros) is 2.87% vs. 2.46% for our CB fund when adjusted back into Euros. Sure, the durations are different, but not bad for a headline figure! If we are being frank, the demand has been slower to react partly due to the fact allocators focus on the bigger problems first (e.g., troublesome REITs that can no longer be redeemed) as well as regulatory changes (e.g., the challenge to find a CB fund fitting their ESG framework).
Another key trigger that should not be ignored has to be the equity factor: 2023 saw the entire market driven by the continued outperformance of a very small subset of 7 stocks, leaving active managers or those who simply do not have them in their investment universe in the dust. With now trillions in market capitalisation and hefty valuations, the question turns to whether these outperformers will continue to prevail, or will their smaller peers play catch-up or even outperform as they have done historically? Looking back in time, the end of the monetary policy cycle was typically met with a rebound led by these smaller companies, noting this conveniently happens to be the typical convertible bond issuer. With no refinancing risk in sight and more upside in earnings growth, convertible bonds could be a controlled way to dip back into the equity factor while maintaining some downside protection, particularly if you focus on healthier balance sheets and a built-in volatility dampener.
On this thought, prepare for what already looks to be another interesting year ahead. Best of luck!
Best wishes,
D. Regnier