Broker Check
BCIS Reflection – March 2024 – Beware the Tides of March

BCIS Reflection – March 2024 – Beware the Tides of March

April 11, 2024

The “more than projected” Federal Reserve rate cut tide continued going out during March and accelerated in the early days of April on the back of hot inflation and jobs data. Fed Funds futures now indicate less than a 60 percent probability of a rate cut in June (down from an approximate probability of 70 percent at the beginning of the month) and reflect approximately 60 basis points or 0.60% in rate cuts by the end of the year (down from 125 basis points at the beginning of the year). The current expectations are broadly in line with the Federal Reserve’s FOMC members’ expectations of three cuts (75 basis points) by the end of 2024. Fed: 1, Market: 0

Despite the increases in the Federal Funds rate, financial conditions as measured by the NFCI and shown below, remain relatively loose which, in addition to the stronger economic data, helps alleviate the need for an immediate rate cut by the Fed. A negative NFCI number indicates easier access to credit, lower borrowing costs, or a more risk-tolerant investment environment.

Stocks have taken “high for longer” rates in stride. The following asset class heatmap shows the returns to various asset classes starting with year-to-date on the left. Notable is the shift in asset class returns over the month of March.

Despite the change in rate expectations, equity markets posted decent returns for the month – led by large value and small/mid-caps, which, at this juncture, are somewhat reliant on a change in Fed policy:

For the second month in a row, information tech and communications services did not lead the market. Whereas last month consumer discretionary led sector returns, March saw value sectors energy and utilities lead. The increased breadth of leadership is healthy for the market and should help offset any weakness in technology and related sectors.

This increase in leadership breadth can also be shown below in the returns for the month in the S&P 500 equal weighted index versus the S&P 500 market capitalization weighted index (where tech related companies rule the roost.

Fixed income produced largely positive results for the month, with spread sectors (corporate bonds and MBS) leading.

Fixed income was helped by a drop in US Treasury rates, with longer rates dropping more than shorter rates (a “bull flattening”).

Spreads tightened during the month, with investment grade credit and high yield credit tightening 6 and 13 basis points respectively. Mortgage-backed securities and the overall Bloomberg US Aggregate Index tightened 2 basis points each. Credit continues to have a strong bid as investors are buying the yield (carry) despite the tighter spreads. Tight credit spreads are normally a good sign for the US economy.

The chart below shows the yield-to-worst of the investment-grade credit, MBS, and high-yield credit indices. With MBS and investment-grade credit near decade highs, it is (somewhat) easy to see the attraction of these assets.

Municipal bonds saw rates increase across the curve as well, making them more attractive on a taxable equivalent basis.

While municipal yields are (significantly) off their highs, they remain above their 10-year average.  That said, municipal yields as a percentage of Treasury yields (using the 10yr as an example, please note scale truncated due to the COVID spike), are near their 10-year lows, reducing the attractiveness of the sector – again, municipals are more about yield than relative attractiveness.

Summary

Whilst we believe that the market falling in line with rate cut reality is, ultimately, good for the pricing of risk, we realize that this acceptance puts the equity burden squarely on corporate earnings growth. Thus far earnings have been keeping pace, allowing equities to maintain (for the most part) their current elevated valuations. The resilience of the US economy in the face of significant rate hikes continues to attract capital and support growth. We are, of course, concerned that there will be an inevitable slowdown in earnings estimates and remain concerned that the profitability (or lack thereof) in many companies in the index will create headwinds for the market later this year.

In the face of this, however, value and small cap companies performed well in April, but higher for longer is a headwind for these equity factors and could limit the relative performance. We still cannot find that catalyst for international developed markets (inexpensive is not cheap) to rebound and remain cautious on rate-sensitive emerging markets.

Within fixed income, we continue to like the spread sectors for their carry, with the realization that the risk premium (spread) is tight and reflects continued demand rather than macro fundamentals. Mortgage-backed securities (where we are overweight) performed well during the month and we believe they are still attractive despite the spread tightening. Ultimately, we are braced for a bumpy ride as the tide continues to go out.




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