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BCIS Reflection – April 2024 -  Waiting For Rate Cuts with Arms Wide Open

BCIS Reflection – April 2024 - Waiting For Rate Cuts with Arms Wide Open

May 15, 2024

April was a difficult month in the markets as risk was re-priced to reflect higher for longer rates; US Treasury yields increased while spreads (marginally) widened. Within financial assets, only emerging markets produced positive returns. We do not believe this is setting the stage for weaker near-term markets but was a healthy response to a change in the market’s interest rate and economic forecast. That said, there is plenty of risk to go around which does not appear to be baked in the cake, amongst which are geopolitical risk (two active conflicts and others percolating), global elections (64 elections globally covering 49% of the world population), divergent central banks (not all economies are created equal), and, should we forget to mention it, the inflationary impact of all of the above. In other words, the tails are getting fatter and the midpoint lower. Markets will welcome rate cuts with arms wide open, but we may be stuck in a higher for longer world.

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The Long View

While the Fed has reminded us that current policy is restrictive, it is important to recognize that the effects of this “restrictive policy” have not necessarily worked their way into the market and this same policy will be (somewhat) dampened by the reduction in the amount of balance sheet runoff (less supply for the market to absorb). No, the easing of the tightening does not offset the high(er) Federal Funds rate but helps financial conditions.

Despite the increases in the Federal Funds rate, financial conditions as measured by the National Financial Conditions Index (NFCI) and shown below, remain relatively loose which should 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. As it takes approximately 12 months for rate hikes to flow through the system (after the “pause”), this would imply that financial conditions should begin to tighten. If, however, they do not – credit is still available and, changes to capital requirements aside, do not appear to be shifting to a more restrictive stance with the possible exception of commercial real estate – the impact of rate cuts will be a period of easy money yet again. This has been driving equities higher lately.

Despite the availability of credit and easy financial conditions, equities responded negatively during the month to the higher for longer rate outlook and repriced accordingly. 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 April. The more “rate sensitive classes such as real estate, small cap equities, and value equities underperformed, while emerging markets continued their three-month streak of outperformance.

What is interesting is the positive returns in emerging market equities during a period of US Dollar strength. These returns, as with almost all financial asset returns, continue to be driven by expectations of a rate cut by the Federal Reserve (EM currencies rallied after hitting a near-term low last month). As the chart below shows, there is a negative correlation between emerging market equities and the US Dollar (USD axis inverted):

Equities

As stated earlier, the change in expectations led to a repricing of financial assets – led by large value and small/mid-caps, which, at this juncture, are somewhat reliant on a change in Fed policy:

The only sector generating a positive return for the month was the utilities sector, which is more defensive in nature. The energy sector gave back some of last month’s gains, but on a year-to-date performance basis energy continues to be one of the stronger sectors. Real estate continues to be a laggard due to its sensitivity to interest rates and the performance of some of its sub-sectors.

Looking at REITs a little more, as they are a favorite of income investors, we can see the relationship with interest rates:

In addition to rates, there has been a marked valuation change due to weakness in commercial real estate and declining metrics within the REIT space:

That being said, REITs are attractive for income investors (and potentially total return given the repricing) and should stabilize as the CRE troubles work through the system and rates stabilize.

Fixed Income

Fixed income produced negative results across asset classes during April due to the repricing of Federal Reserve rate expectations. Fixed income was helped by a drop in US Treasury rates, with longer rates dropping more than shorter rates (a “bull flattening”).

Investment grade credit spreads tightened three basis points (“bps”) during the month while high yield credit spreads widened marginally by 2bps. Mortgage-backed securities and the overall Bloomberg US Aggregate Index widened by 7bps and 2bps, respectively. Mortgages (26 percent of the US Aggregate Index) continue to lag the broader market as rate volatility was present, but Fed clarity was not – keeping banks, foreign accounts, and many larger investors on the sidelines.  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 and the financial condition of the corporate issuers. We are somewhat cautious on credit at these spreads but believe investment grade issuers (and higher rated high yield issuers) are in solid financial shape and defaults should remain low.

Despite its underperformance, we still like (and are overweight) MBS due to the relative cheapness of the sector and the liklihood of spread tightening as Fed clarity develops.

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 absolute yields 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 has almost completed its repricing to the current Fed reality (there are still some optimists out there that have been resisting), this only eliminates one of the systemic risks present in the system – or should I say, in the system’s orbit. Equity performance will now be driven by other input, including fundamental factors (earnings growth for one), geopolitical factors (which influence global trade and can have significant regional impact), and domestic political factors (election, regulatory policy, and trade restrictions, just to name a few) - many of which are “known unknowns”. 

Credit will be influenced by many of the same inputs. Interestingly, the volatility index for the S&P 500 (VIX or Chicago Board Options Exchange Volatility Index) is approaching its 5-year lows signaling smooth sailing.  The resilience of the US economy in the face of significant rate hikes continues to attract capital and support growth – as does easy financial conditions, which typically lag Fed policy moves.

Interestingly, value outperformed growth in April while small-cap stocks underperformed large-cap stocks, but higher for longer remains a headwind for these equity factors and could limit the relative performance. Despite the potential for the European Central Bank to ease policy rates before the US and the outperformance of the EAFE markets during the month, we still cannot find that catalyst for international developed markets which gives these markets sustainable outperformance (from a tactical perspective). Emerging markets look interesting from a macro perspective, but more in local currency as dollar strength is a headwind (which affects one on their exit from local currency).

Within fixed income, we continue to (cautiously) 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.

Investors have been waiting for rate cuts, and when the Fed decides its time, all markets will welcome it with arms wide open.

Welcome to this place, I'll show you everything

With arms wide open, now everything has changed



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