Wolves, Smarter Than The Last Bear

What Will Allow This Rally To Continue?

The Fed Put And What Triggers It

In January, we discussed how the economy skipped the most predicted recession and shared why we were positive for 2024. In that analysis, we discussed how the historical data for similar economic periods highlighted an overall positive environment, allowing us to add to our longs in early November 2023.

We also highlighted that we think 2024 will be an overall positive year for risk assets but with higher volatility and that the key to a positive outcome was the potential for reducing real interest rates.

Since then, three things have happened that have us taking a tighter risk stance this year; 10-year rates have moved up, inflation reaccelerated (only one data point), and equity valuations in some sectors have expanded aggressively. Initial claims have also increased marginally, but the key positive remains a robust labour market and strong company earnings.

Why do higher rates and higher valuations concern us? The same reason there was a deep correction in 2022 - when the market fears rising rates, it will begin to reprice the value of assets to reflect the changing cost of capital. Hence, if inflation continues to rise, the market will reprice rates and equity valuations.

Importantly, inflation did rise, and 10-year rates did move up about 10% from 3.86% at the start of 2024 to 4.26% as of 26 February. The underlying data seems to support reducing inflation, which remains the expectation of most investment houses. However, should we get another surprise, the further rally in rates could potentially cause a correction in equity markets.

Alternatively, inflation could continue its path down and drive valuations up further, sparking the next phase of the rally. It is this dependence on a single data point’s outcome that concerns us. It reflects the notion that from a valuation perspective, we are very tight and that growth needs to bear the burden of driving longer-term returns from here on out if rates do not come down.

While a strong labour market and a free-spending government remain the positive tailwinds for growth, the high cost of capital will also reduce the ability to spur growth organically.

Do we think a recession is likely to occur in 2024? No, we do not see it as a high-probability outcome in the data (does not mean no-probability). As discussed in our previous update, the high level of rates currently gives the Central banks room to stimulate the economy and support asset prices when we are at a full employment economy.

Why are we keeping our risk restriction tight even as we remain strategically positive? As stated, we are at tight valuations and have multiple forces driving and putting the brakes on growth. Therefore, to begin a new phase of the rally, we need rates to reduce so that the drag on growth and asset valuations reduces. However, to get this, we need central banks to remove tight monetary policies, and that will likely only come with a lower inflation print.

To get a lower inflation print, we need further weakness in the economy. At such high valuations and expectations for growth, neither is this economic weakness priced in, nor is the potential for higher rates priced in if growth continues to accelerate.

Therefore, before we get to the next stage of the rally, be it driven by growth or lower rates, there needs to be a repricing of expectations and, hence, asset prices.

There is an old parable in markets that corrections hit when the last Bear gives up. The parabolic move since November in equity markets and the growing disregard for the concerns that drove expectations in 2023 could signal the coming of the correction, just like the wolves came when no one believed “the boy who cried wolf”.

To be clear, we do expect inflation to moderate, real rates to reduce, and the economy to continue to grow, albeit at a slower pace over the medium term. This should lead to strong asset price growth over time. The caution is only for the transition phase, and hence, we are looking for opportunities in undervalued segments of the market where we can control our risk, as there are many strong tailwinds for the global economy still.

Importantly, with rates this high, we have the Fed put in play, and hence, we will be a buyer of market corrections this year. Our views aside, no one has a crystal ball – therefore, we remain invested at tight risk restrictions and in areas we find value.

Positioning For 2024: A Positive Tilt With Tight Risk Controls

The Fed’s Put Is Back

As shared above, we are strategically positive, but are cutting risk on a tactical basis. To test our view, we looked at 716 past 6-month economic periods and found 20 periods reflecting a resemblance to today’s conditions of reducing CPI, increasing initial claims, rising earnings per share, rising yields, and rising real yields.

The aggregate data in chart 1 above shows a strong positive skew for 6 months out (75% positive vs 68% for the total data set) on the number of positive outcomes but a negative skew 3 months out (63% vs 68%). It also reflects a small average range of return outcomes.

The largest drawdown occurred in the period beginning in the middle of 1981 when real yields were high and inflation began to spike again, pushing central banks to raise rates further. This finally reversed with large market gains when inflation began to come down in earnest in the middle of 1982, and the Fed began cutting rates aggressively.

This period of volatility occurred because the Fed cut too early and by too much. Given the actions of the Fed today, we see their prudence as a good sign of economic management. We expect them to wait till there is a meaningful decline in inflation to the 2% target before cutting rates.

As such, we do think they will avoid the pitfalls of 1981, but in waiting for the data to show some economic slack, long-duration assets must price in slower Fed cuts or a much deeper economic weakness. The middle ground in the medium term everyone is hoping for, and that seems to be priced in (soft landing) may cause a revival in inflation and result in a market correction, as shown in 1,981.

Disclaimer

This publication is intended only to provide information to the general public and is not to be taken as financial advice or an offer or solicitation to buy or sell (any securities or otherwise).? The information set out in this publication is based on information obtained from sources believed to be reliable, but we (which collectively refers to Golden Equator Capital Pte. Ltd., its associated corporations, affiliates and their respective directors and employees) do not make any representation or warranty as to its accuracy, completeness or correctness.?Any valuations, opinions, estimates, forecasts, ratings or risk assessments herein constitutes a judgment as of the date of this publication, and there can be no assurance that future results or events will be consistent with any such valuations, opinions, estimates, forecasts, ratings or risk assessments.?Notwithstanding the above, we retain our right to change the information in this publication without notice.?We accept no liability whatsoever for any direct, indirect and/or consequential loss arising from any use of and/or reliance upon this publication, which has not been reviewed or authorised by any regulatory authority in Singapore or elsewhere. Golden Equator Capital Pte. Ltd. is licensed, supervised and regulated in Singapore by the Monetary Authority of Singapore, and accordingly this publication is intended for use in Singapore and not intended for distribution or use by any person in any jurisdiction or country where the distribution or use of this publication or any material herein is restricted and would not be permitted by law or regulation.