08 Apr 2024
With a favourable economic background of inflation cooling (albeit slowly) and the prospect of lower interest rates, global stock markets recorded their best first quarter performance in five years. Investor confidence grew that the US would achieve the elusive ‘soft landing’ as economic data, especially the jobs market, has remained robust even after the Fed’s rate tightening cycle. Some parts of the market have been buoyed with enthusiasm about the potential for artificial intelligence. The MSCI World Index gained around 7% in the first quarter and stocks outperformed bonds by the biggest margin in any quarter since 2020 as market expectations for rapid rate cuts dissipated with economic data remaining robust in most major economies. The American market has delivered gains on a consistent basis over the quarter, closing at a record high on 22 separate occasions. In the first few months of the year gains were very much skewed to perceived beneficiaries of AI with, for example, chip designer Nvidia adding more than $1tn in market value during the first three months of the year, equivalent to about one fifth of the total gains of global stock markets over that period. As the quarter progressed, the rally broadened with the laggards over the quarter interest rate sensitive sectors such as utilities and REITs as market expectations of six rate cuts moved much closer to the Fed’s forecasts of three cuts in 2024. While interest rate expectations have seen disappointment, on a more positive note, US equities are still forecast to deliver earnings growth of around 10% in 2024 and so there remains a relatively benign background to equity markets.
The year had started with a US tech driven rally, but during March, not only did other parts of the US market start to perform, but the rally broadened globally with, for example, the FTSE 100 in the UK and market indices in Germany, France, and Spain all outperforming the S&P 500 in that month. In the US, the so called Magnificent 7 have not been so magnificent in 2024, a point not picked up on by many investors. Tesla has seen its share price decline over the past 12 months with the stock coming under pressure from last summer driven by earnings downgrades. Apple too is one of the so called Magnificent 7 and is only up a negligible amount in the past 12 months versus a gain by the S&P 500 of over 25% and has seen downgrades to earnings expectations. The top performers among these names have been Nvidia, Meta, and Amazon and these stocks have all seen upgrades to earnings forecasts.
European markets, despite relatively muted short-term forecasts for earnings gains of roughly 4% in 2024, have seen investor sentiment improve, driven by a belief that the worst is now behind the region with the Continent switching from reliance on Russian energy sources to liquid LNG and the recessionary fears for the region overall have disappeared.
At the local currency level, Japan was the best performer over the quarter where, in yen terms, the Topix rose over 16%, although currency weakness reduced much of these gains for non-domestic investors. In Japan, market leadership has also been quite narrow with, in the first two months of the year, only one out of four companies in the Topix outperforming with the perceived beneficiaries of AI and exporters who benefit from the weaker currency leading market gains. Equities in Japan were encouraged by the wage growth data in the final part of the quarter with an increase of 3.5% in 2023, the largest in the past 30 years and a very positive outlook for wages in fiscal year 2024 with many companies now promising wage increases. Whereas previously in Japan, even during economic upswings, regular wages have been static, these have now been increasing, rather than just one-off increases in bonuses, which should give consumers the confidence to spend.
The latest Bank of America’s global fund manager’s survey shows two thirds of those polled no longer expect a US recession over the next 12 months, whereas at the start of 2023, only 10% of fund managers thought recession would be avoided. This change in sentiment on the profit outlook has been one of the key drivers of global equity markets over the last 12 months and during the first quarter of 2024. There is also now more optimism over the prospects for corporate profitability over the medium term.
The extent of ‘risk on’ appetite is perhaps demonstrated by the 60% rally in bitcoin whose total value is now above the gross domestic product of about 150 countries. All in all, the quarter was a positive one for risk assets. In recent periods, markets have moved earlier to discount the prospect of lower rates and a new economic cycle with the post-pandemic period showing investors will ‘front run’ the prospects of any economic rebound.
The US Federal Reserve left rates unchanged at their recent March meeting. The US economy has continued to expand at a solid pace with fourth quarter GDP coming in at around 3.2%. For 2023, GDP expanded by 3.1% bolstered by strong consumer demand and improving supply conditions. The housing sector was a weak spot, largely reflecting high mortgage rates, with activity weakening. There has also been some dampening of business fixed investment. Each end quarter, the FOMC meeting releases an updated Summary of Economic Projections (SEP) and the most recent numbers published late March showed participants on average (median) slightly revising up their core PCE inflation numbers for this year, but more notably increasing growth projections for 2024 and 2025 with, as a result, a slower pace of rate cuts now expected. The most recent data suggests that inflation is slowing but that it is, in the words of Chair Jay Powell, ‘A bumpy road’ and the return to a sustainable 2% inflation rate may take a little longer than the Committee had expected at the back end of last year. Monetary policy remains restrictive, putting downward pressure on economic activity and inflation but the labour market has remained more buoyant than expected and the Fed expect unemployment to stay around the 4% level, even as economic activity has slowed. As discussed in the last Global Outlook, US economic growth appeared to re-accelerate at the back end of 2023 and entered 2024 with the economy growing above trend with, in particular, the labour market remaining relatively buoyant as payroll job gains averaged 265,000 over the past three months. Even though the unemployment rate edged up, it remains at historically low levels of 3.9%.
Strong job gains have been accompanied by an increase in the supply of workers and Powell seemed encouraged by the continued supply chain improvements occurring in the US, both in terms of manufacturing and the labour force. The participation rate among individuals aged 25-54 years has improved and strong immigration has helped ease labour market tensions. The Fed’s preferred inflation measure is the PCE and looking at both total and core data, inflation is falling back, but is not yet anywhere close to the 2% level. January inflation data was stronger than the market expected, although some commentators believe that this may have been due to firms putting through annual price increases in that month, or in other words, there would be a need for seasonal adjustment of inflation data in January. The Fed continues to believe that longer-term inflation expectations remain well anchored and the median projection in the SEP for total PCE inflation falls to 2.4% this year, 2.2% in 2025 and 2% in 2026.
The press conference saw Chair Powell reiterate that the Fed believed the policy rate was at its peak for this tightening cycle and at some stage this year, rate cuts would be appropriate. However, there is uncertainty in the economic outlook in both directions and the Fed would be prepared to maintain current levels of interest rates if necessary. The Committee believes it is not yet appropriate to reduce the target Fed fund’s rate until there is greater confidence that inflation is moving sustainably down towards 2%. The strength of the labour market, when viewed in context of the dual mandate at the Federal Reserve, means the Committee is not under pressure to cut rates prematurely. The SEP shows the median of interest rate forecast by the individual Committee members but not a debated decision or plan, with participants believing that rates will still be above 3% at the end of 2026, above the longer-term projections.
Powell, at the press conference, stated that the Fed remained confident that inflation would move down to the 2% target but stressed this was ‘Over time’. The Fed expect housing services inflation to fall back. The message from the Fed was that with the economy growing and the labour market strong and with inflation coming down, although not perhaps as rapidly as expected, the question of rate cuts can be approached carefully. The Fed do not believe that rates will go back to the pre-pandemic post GFC world in terms of lows and that the days of zero long-term real rates are over. Powell stated that a strong labour market was not necessarily a concern if it was a result of supply side improvements. In 2023, hiring was strong, and inflation came down quickly. In other words, a growing labour force can result in a virtuous circle with more people working and as a result higher levels of aggregate spending in the economy. For rate cuts to occur, the Fed will need clearer evidence that inflation is moving down sustainably towards their 2% goal but at the press conference, there was confidence that rates have peaked. The strength of the US economy allows the Fed to be patient as they are aware that cutting rates and then being forced to raise them again quickly would have a very negative impact on the economic outlook.
Chair Jay Powell projects the consensus views of the Committee at the post Federal Reserve meeting press conference and board members make various speeches and comments reflecting their own individual views. Christopher Waller, often regarded as one of the more hawkish members on rates on the Committee, recently spoke at the Economic Club of New York. Waller stated that the resilience of the US economy in the fourth quarter and inflation data in January and February reinforced his personal view that there was no rush to cut rates. In his speech he argued that the strength of the US economy and resilience of the labour market meant the risks of waiting to ease policy were relatively low and smaller than the risk of acting too soon and squandering progress on inflation. Waller expects first quarter GDP growth in real terms to come in at around the 2% level or just above. Spending on goods has moderated but services spending continues to grow. He commented that jobs growth remains robust and a slight tick up in the unemployment rate may be driven by an outsize rise in the number of 16-24 year olds counted as unemployed which tends to be a volatile data point. A positive is that the number of people quitting their jobs has fallen below the levels just before the pandemic, which suggests there is less pressure on firms to raise compensation packages to attract workers. Waller believes overall wage and benefit packages are showing signs of moderating but remain a little elevated. There remain 1.4 jobs for each person looking, down from the 2022 peak of 2:1.
In summary, it seems reasonable to conclude that the US has continued to outperform expectations with growth in the labour market more robust than has occurred historically at a time of significant monetary policy tightening. Manufacturing had been one weak spot, but in March the sector expanded for the first time in a year and a half, as companies increased production and demand rebounded. The ISM survey rose to 50.3 from 47.8 in February, well ahead of consensus expectations. A figure above 50 indicates that the sector is expanding, and it is the first data point showing this since September 2022.
Within other parts of the developed world, Europe has shown signs of shrugging off the worst of the cost-of-living crisis where consumers were hard hit in 2022 and again last year from higher global energy prices which saw consumer confidence drop as household spending power came under pressure. European economies did not benefit from the huge fiscal stimulus put to work in the US such as the Inflation Reduction Act but over time at least some of the €750bn recovery fund money should be spent. Within Europe the manufacturing heavy economies like Germany have suffered from households globally accumulating ‘too much stuff’ in the immediate aftermath of the pandemic. Europe has now seen two relatively mild winters in succession with gas prices falling quickly and this has reduced headline inflation numbers, helping disposable income. The labour market in Europe remains relatively strong and wages are now growing in real terms.
There are signs that the UK is now past the worst of its economic difficulties, although uncertainty will remain until the election outcome is known.
Of the major developed economies, Japan has recorded the worst headline GDP data but beneath this, wage growth is at its most positive levels for decades and the overall labour market remains strong. Of the major economies, the only real weak spot is China and even here, the most recent data shows improvement.
Overall, the global economy looks likely to avoid recession in 2024 and this is providing a supportive backdrop for corporate earnings. Inflation has been slower to moderate than optimists hoped, but markets have been able to look forward and anticipate rate cuts in the future which provided a supportive backdrop during Q1.
Interest rates and rate expectations have always been important drivers of short-term moves in equity markets. Over most 12-month periods it is changes in valuation levels, driven by rate expectations, especially at the longer end of the curve, that drive equity market direction rather than corporate earnings (with the exception being recessionary periods). Post the Fed meeting in March, some members of the FOMC have suggested in speeches that rates are unlikely to be cut as quickly as expected at the start of the year and Loretta Mester, president of the Cleveland Federal Reserve, stated she had raised her estimate of the longer-run Federal fund’s rate from 2.5% to 3%. (This may well have been incorporated in the most recent dot plot chart in the March SEP as the positions of individuals are not disclosed).
After inflation had surged to a multi-decade high in 2022, sparking 525bp of rate hikes, markets wobbled despite no actual recession as the valuation of equities came under pressure. Both nominal and inflation linked bond yields rose and the significant rally in Q4 2023 was driven by the markets perception in early November that rates for the cycle had peaked. The most recent price data for January and February show inflation has edged up and markets are now questioning whether the equilibrium interest rate or R-star will rise from current expectations. The last few weeks have seen markets re-price rate expectation, although it should be noted that these can fluctuate wildly, quarter by quarter, with at the start of the year the market believing the Fed would be cutting rates 6x in 2024. The ongoing resilience of the US economy, especially the labour market, means there is little pressure on central banks globally to cut interest rates. In the US, the economy has been boosted by continued high government spending which is unlikely to alter in an election year and rapid developments in artificial intelligence.
During the first quarter, although inflation rates in the US, and other developed economies have fallen, there has been a slower than expected decline in core inflation numbers. In other words, the delta of change in inflation statistics has worsened. US core inflation numbers over a three-month period have shown signs of a pickup, although some of this may reflect the January effect of companies raising prices once a year.
The developed economy where rates moved in an opposite direction is Japan. The BoJ ended negative interest rates in March but did so stressing accommodative financial conditions would persist. The yen has weakened significantly during the first quarter.
Inflation data in Europe has been more benign than in the US. In March, German inflation fell more than forecast with, for example, consumer prices in Germany rising 2.3% over the 12 months. European countries have benefitted from falling energy and food costs and slower goods inflation. The German economy has lagged southern European states such as Spain, Italy, Portugal, and Greece with its greater reliance on manufacturing rather than tourism. France, Italy, and Spain have also recorded lower than expected inflation rates which gives the ECB scope to start cutting rates ahead of the US with this possibility reflected in the weaker Euro versus the US currency. The ECB are unlikely to move ahead of June and will continue to monitor wage pressures which have shown some signs of abating.
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