Investment Institute
Viewpoint CIO

Risk beats peak cash

  • 23 February 2024 (7 min read)

Stock markets are hitting all-time highs. And why not? Interest rates don’t look to be going any higher and there is no recession on the cards, least of all in the US. Credit spreads tell us the bulk of the business sector has resilient balance sheets. Profit margins are also benefitting from lower commodity prices but most of all there is another technology revolution underway. Why else would spending on high powered semiconductors needed to run artificial intelligence (AI) models be growing so much? A soft landing, stable-to-lower interest rates, positive GDP growth and an absence of systemic credit issues all support buoyant equity markets. And at the centre of it all is the concept of US exceptionalism, allowing its most connected economic allies in Europe and Japan to also benefit. It’s a bull market and it’s risk on.

Delayed cuts, but no hike 

Market pricing for where the US Federal Reserve’s (Fed) key policy rate will be at the end of 2024 has risen from 3.65% on 12 January to 4.45% on 22 February. That is quite a revision, implying three fewer cuts in interest rates than expected six weeks ago. In the wake of the stronger-than-expected January reports on employment and consumer prices, there were even some voices suggesting the Fed would need to hike rates. Talk is cheap, and so is the cost of a bet on rates rising. According to Bloomberg, the premium required for an option to bet that three-month interest rates would be higher than the current level implied by a Fed Funds Rate of 5.5%, by June, is around 0.03%.  Betting that rates will be lower would cost 0.48%. The market does not believe rates are going higher but if you want a cheap bet, there it is.

Being boring  

We have got used to the Fed, and other central banks, putting a lot of emphasis on their communications strategy in recent years. As ex-Bank of England Governor Mervyn King once said, monetary policy should be boring - there should be no shocks. If the feeling among Fed policymakers was that the fight against inflation was being lost, then by now some of the commentary and wording in official communications would be pointing to that. But it is not. The Fed assumes it will cut rates this year. Even in the minutes from its most recent policy committee meeting, the tone was more about the timing of rate cuts rather than whether they were going to happen at all. If there was a sudden rate hike with no warning, markets would go into meltdown.

Instead, the Fed has steered market expectations towards expecting fewer rate cuts this year, albeit a little further down the road. Any investor following the US macro data flow would agree this was totally justified. But unless the Fed says otherwise, rates shouldn’t be a threat to investing in credit and equities. Cash returns might remain above 5% in the US and close to 4% in Europe, but most equities are smashing that so far.

Credit resilience 

In the same set of minutes, the Fed commented on credit conditions in the US economy. To me, these are important because the public, liquid corporate bond market is a preferred investment sector for where we are in the cycle. To quote the Fed: “The credit quality of non-financial firms borrowing in the corporate bond and leveraged loan markets remained sound overall.” It did refer to rising credit card and auto loans delinquencies and the fact that the commercial real estate market was subject to an ongoing tightening of lending standards and price declines. The picture illustrates that higher interest rates have barely affected large, high-quality corporate borrowers with significant holdings of cash on their balance sheets. But they have had some impact on lower-income consumer borrowers and the more interest rate-sensitive business models in the real estate sector. However, this has been limited so far.

Drag on earnings for regional banks 

Weakness in the commercial real estate market is nothing new. Declining office occupancy rates and the rise in online shopping has hit rental cash flow and the asset valuations of office and retail developments. Rising financing costs have further eroded net cash flow for developers and risk hitting covenants on loan-to-value metrics for some borrowers that may need to raise more financing. These concerns have played out in the regional bank space where commercial real estate loans represent – in aggregate – almost 30% of bank assets. The bank sub-index of the Russell 2000 equity index has underperformed the overall market by 18% over the last year (and underperformed the S&P 500 by 38%). In the bond market, however, the real estate sub-sector of the US Corporate Bond index has continued to perform quite well. The aggregate yield to worst is currently at 5.6% compared to 5.45% for the market overall, with spreads about 20 basis points wider. Being marginally shorter in duration than the market average, the real estate corporate bond sector has slightly outperformed the market over the last 12 months.

It is something to watch if the Fed is keeping interest rates on hold for longer than thought a few weeks ago. Listed regional banks reported an aggregate -30% earnings growth rate for the fourth quarter (Q4) of 2023 while the S&P 500 banking sector’s earnings per share were down 11%. Liquidity conditions are getting tighter, with the Fed closing its Bank Term Funding Program, and bank reserves falling. Further stresses within the regional bank sector are possible as rates remain high. However, for now, these risks do not constitute a reason to be negative about corporate credit or the broader equity market. With bond yields higher year to date, there continues to be income opportunities in credit, and there is the prospect of bonds rallying hard if the equity bull market reverses on bad economic news.

This view extends to high yield, which continues to have the structural attractiveness of delivering equity-like total returns but with much less volatility. The annualised total return for the US high yield market over the last 10 years has been 6.4%. The US Russell 2000 small cap equity index had a total annualised return of 7.6%. However, the annualised volatility of monthly returns for high yield was just 3.8% compared to 20% for small cap equities.

Lots of credit opportunities 

It is not all about US credit though. European investment grade has slightly outperformed the US market year to date, and relative to the underlying government bond market, sterling credit has beaten both. Leveraged loans, emerging market debt, Asian high yield and asset-backed securities have all delivered positive returns so far. As long as cash rates remain high and the so-called soft landing scenario is in place, these assets should continue to perform well and provide returns above cash because of the attractive embedded credit spread.

Sky is the limit 

Arguably, this week has not been about credit at all, but about Nvidia. The US semiconductor manufacturer reported Q4 earnings on 21 February. The announcement was much anticipated, with those believing we are in a tech-stock bubble looking for evidence of such in the data. These was none. Revenues were reported at above $22bn after beating $18bn in Q3. This revenue is driven by the US technology and the broader corporate sector spending on AI and greater data management power. On an annualised basis, the revenue of this one company is equivalent to almost 5% of the total amount spent by American companies on information processing equipment in 2023 (taking data from the National Accounts). Current estimates suggest revenue will top $100bn this calendar year – it was $27bn for calendar year 2022. 

Productivity boost 

Whether investors think the stock represents fair value now – according to Bloomberg its price-to-earnings ratio is 29 times 12-month forward earnings – is a matter of belief in whether growth can be sustained going forward. In comparison, using Bloomberg price-to-earnings ratios, it is a little cheaper than Microsoft and slightly dearer than Apple. The more critical point from a macro perspective is it tells us that technology is driving the US economy and stock market earnings, and the result will be higher productivity and growth. The AXA IM Investment Institute will be publishing a series of papers on the broad theme of US exceptionalism later this spring but suffice to say whether it is a diversified credit portfolio or a high earnings growth stock fund, the US is the place to look. We will obviously consider the risks – the policy and economic implications of different outcomes to the US election being a key one, but also the ongoing threat of financial weakness coming from the risk of keeping interest rates too high. But there is much more, including how the US story creates opportunities for impact investors in the field of biodiversity and climate change to seek listed companies that are using technology to make a real difference. Rapid technological change and the scalability afforded by deep financing options are enriching the US equity markets as a source of opportunities for impact investing.

The Eurozone and UK economies have already landed. The US is still growing - and growing faster than anticipated. This year will see a much better balance of real growth (2.0% is our forecast now) and inflation than was the case in the last couple of years. While there are political and financial risks, and investors need to get used to interest rates being in the 4% to 5%, rather than 0% to 1% range of the last decade, the current macro backdrop for investing in the US looks good. Financial assets are not cheap, but cash-flow generation is strong and that should sustain valuations. If technology boosts productivity, then real returns will be higher which should also mean higher real interest rates, as I have touched on recently. But productivity also means higher income growth, shifting the supply curve to the right and lifting all boats.

Modernising the world 

In my first job after graduating, I had to hand-draft economic reports, send them to the typing pool, wait for the typed version, edit it, and then get it proofread and edited again by someone more senior. It took days. Word processing software and personal computers changed all that and the typing pool disappeared. On the data side we had a monthly tape delivered with updated International Monetary Fund economic data which had to be uploaded onto a mainframe computer overnight, before we analysts could access the data on a terminal. Now I can download the same data into an Excel model and produce a presentation with updated charts in a matter of minutes. Soon, the process will not even need someone like me - AI will do it, as it will perform the bulk of report writing, data management, client communication and administrative portfolio management duties. Life is changing quickly, and that makes it harder to keep economic models credible and forecasting meaningful. Thank goodness because otherwise investing would not be as much fun or, hopefully, rewarding. Do not fight modernisation, especially in the investment world!

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 22 February 2024). Past performance should not be seen as a guide to future returns.

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