Q4 OUTLOOK: "Clash of the Titans"

"Fortune is ally to the brave”

Zeus (Liam Neeson), 2010, Clash of the Titans produced by MGM

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What has happened?

Q3 2024 was another headline-filled quarter, with the main highlight being the Fed finally kicking off its rate-cutting cycle with a larger-than-expected 50 bps cut, despite resilient macroeconomic indicators. While the US may be experiencing slower growth than in 2023, it is robust and the job market remains historically tight. Chairman Powell appears to be on track to orchestrate the first successful soft-landing in modern financial history. In Asia, however, developments were more turbulent. Japanese markets were hit in August by a brutal strengthening of the yen as markets tested the Bank of Japan’s (“BoJ”) intentions and the widely known carry trade. Meanwhile, China presented what could be considered as its own “whatever it takes” moment, with authorities seemingly setting aside previous hesitations regarding aggressive economic stimulus. While we wait for further details and formal approval to be given by the Politburo, the unprecedented package is expected to surpass the scale of pandemic measures and is anticipated to include key initiatives such as real estate support and equity purchases by financial institutions. Finally, Europe’s post-pandemic recovery continues to be mixed. While inflation continues to decline, and is lower than in the US, economic growth continues to be lacklustre. Q3 2024 also saw the revision of France's deficit target into negative territory, which renewed tensions around sovereign debt across the region.

Global equity markets rallied further and returned +5.1% for Q3 2024, bringing YTD performance to an impressive +19.3%. Markets favoured an improving economic and inflation picture and the start of US rate-cuts, overlooking mixed mega-cap earnings and concerns over the Yen carry trade at the start of the quarter. They were given a boost into quarter-end on China’s new stimulus approach. This led China to lead regional equity performance, while the US and Europe also posted gains (Heng Seng Index: +21.7%; Shanghai Shenzhen CSI 300 Index: +17.9%; S&P 500 Index: +5.9%; STOXX Euro 50 Index: +2.4%). Japan again underperformed, posting a loss of -3.5% (Nikkei 225 Index). In terms of size-bias, mid/large-caps encouragingly outperformed mega-caps as the market broadened out (Russell 2000 Index: +9.3%; MSCI World Mid Cap Index: +10.1%; Bloomberg Magnificent 7 Total Return Index: +5.4%). Turning to fixed income, high yield (“HY”) rallied a respectable +5.5% (Bloomberg Barclays Global High Yield Total Return Index, USD Hedged) while investment-grade (“IG”) gained a decent +4.2% (Bloomberg Global Aggregate Index Total Return Index, USD Hedged). Gold jumped +13.2% over the quarter on improved inflation and interest rate expectations.

Our strategy performance

Our Tyrus Capital Global Convertible Strategy finished up +3.8% (SI USD Hedged) for the quarter, lagging the popular Refinitiv Global Convertible Focus IG (USD Hedged), largely due to the outperformance of energy (coal) plays which are heavily weighted within the index.

Our strategy's gains were primarily driven by the US and Asia, with substantial contributions from large IG Chinese companies (e.g., Alibaba and Ping An Insurance), which benefited significantly from Beijing’s new stimulus approach. Our high exposure to Japan was a detractor to performance following the major sell-off in early August; however, this impact was largely offset by our Asia ex. Japan exposure. In the US, performance was enhanced by movements in long-duration assets. We capitalised on this through investments in REITs, including those focused on renewable energy, while coal utilities, for clear reasons, remain outside the scope of our sustainable mandate.

Our Views

Main focus: Fed pivot and US resilience welcomes in the last act of stagflation. The Fed finally pivoted and did so with gusto, opening with a 50 bps rate-cut despite the continued economic strength in the US, highlighted by headlining GDP and employment. In terms of a soft-landing scenario, we now have a clear indication of a dovish shift in monetary policy – the “Fed put” has returned. This shift is critical, because interest rate policy now has the potential to act as a tailwind rather than a headwind for markets. Fund flows also favour risk assets, as mid-single-digit returns in money markets begin to lose appeal relative to fixed income and equity expectations. The outlook for fiscal policy remains more uncertain, particularly beyond 2025, given that we are coming from extremely elevated support levels of the pandemic. In the short-term, however, as the US approaches an election where neither candidate is associated with fiscal restraint, upward pressure on spending appears likely. Although equities could benefit from this spending, this set-up could place additional pressure on fixed income (especially at these high valuations), where vulnerabilities are evident. While a Kamala Harris win feels more status quo from the incumbent Biden administration, Donald Trump succeeding at the polls would likely result in a more corporate and domestically focused agenda, which would potentially favour cyclical and mid-cap sectors. However, we know that campaign promises often hold little weight, making it essential to interpret what the fiscal stance will look like in the months ahead.

In Europe, we have some degree of monetary and fiscal clarity. The ECB is expected to continue to cut rates, albeit likely at a slower pace than desired – in line with its characteristically cautious approach. Inflation seems to be under control, as does Eurozone stability (for the moment at least), however, fiscal stimulus within the Euro area will be limited and therefore perhaps the bigger drag. France’s new deficit number is a sad reminder of the huge amount of structural reform that is needed at a time where fiscal space is fairly limited in the face of a lethargic end consumer. We should expect a prolonged period of muddling through, likely over the next 6 to 9 months, with additional headline risk related to tariffs if Donald Trump returns to the White House.

In Asia, economic cycles remain distinctly different from those in the US and Europe. Japan, though more aligned economically, diverges significantly on policy. Investor interest in the region remains strong due to yield differentials and local valuations; however, risks are heightened by the potential for a more hawkish stance from the BoJ and the new government, coupled with the threat of currency strength impacting corporate earnings. At a minimum, the Fed’s policy pivot has placed a floor under JPY depreciation. In China, where investors have faced significant challenges over the past two years, we now appear to finally have a more optimistic outlook. A marked shift in their approach to stimulus and achieving their growth targets signals a potential turning point, akin to a form of quantitative easing, with stock market support exceeding the usual “national team” interventions being a telling sign. This could serve as a wake-up call for foreign investors holding structural underweights in the world’s second-largest economy, particularly as it remains one of the most undervalued markets globally, even after the September rally

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?

Many market participants appear concerned today, even though the US is on track to achieve a soft-landing, economic growth is holding strong, inflation is trending down, and interest rates are being cut. This is because both equities and bonds sit at, or close to, multi-year highs in price and/or multiples terms, noting some exceptions such as Chinese and European equities. Meanwhile, choosing to sit in cash as an alternative will be less rewarding as interest rates normalise in the US and Europe and inflation trends down. For asset allocators, it turns out a recession would have been easier to handle given it has a clearer playbook to follow. Given this backdrop, we like convertible bonds (“CB”) for several reasons:

? CBs are cheap: While stating the obvious, CBs trade at a discount, especially in Asia. This is noteworthy when other asset classes are expensive.

? Equity alternative – the short-to-medium-term mid-cap play: We do not know if Donald Trump will win or if he will provide the mid-cap bonanza many expect him to but, what is clear, is that mid/large-cap earnings are expected to play catch up with larger-caps. Regardless of who enters the White House in this volatile environment exacerbated by high valuations, CBs are an astute way to play that catch up without having to compromise on balance sheet quality

? Fixed income alternative: As mentioned above, neither US contender is likely to be fiscally conservative, noting a Trump win in particular would create inflation pressure again. The recent volatility in the longer-end of the yield curve presents a significant challenge, as neither of these impulses are welcomed by duration-sensitive fixed income. From a credit perspective, the fact that corporate bond spreads remain historically tight compared to sovereign bonds makes us unenthusiastic about credit at this stage in the cycle. Overall, this leads us to favour the equity factor at present. In this context, CBs, especially those with an IG bias, such as our strategy, are appealing due to their asymmetric behaviour and current volatility levels which are comparable to bonds. They also offer better liquidity, the same seniority, reduced duration, and some equity participation. Unless you are considering a switch to gold, it may be tactically advantageous to capitalise on short-term gains from this shift in the short end of the curve, given the uncertainty around long-term prospects.

On this thought, we wish you a very enjoyable end of the year!

Best wishes,

D. Regnier and Team