Written by Julian Howard, Lead Investment Director, Multi-Asset Solutions, GAM Investments
Global equities, measured by the MSCI All Country (AC) World Index, posted a robust +9.6% gain in local currency terms in the first quarter of 2024. The strongest regional gain came from Japan, benefitting from improving global growth, stronger corporate governance and normalising inflation and rates. The US made the strongest contribution to market progress, given its two thirds allocation within the MSCI AC World Index.
The S&P 500 was up +10.6% over the review period, with the Nasdaq 100 Technology Sector Index up +8.7%. Justifying continued gains in a rally dating back to October 2022 is challenging, with US interest rates standing at an elevated 5.25% and increasingly stretched valuations. By the end of the review period, the forward earnings yield on the S&P 500 was 4.6%, offering investors just 0.4% more yield than the 10-year US Treasury’s risk-free 4.2%.
How did stocks get to this point without a serious adjustment?
Not just technology enjoying the productivity party
In the US, both a steady rise in output per hour worked and strong consumption have created a ‘Goldilocks’ environment of improving economic growth without changing the stabilising course of inflation. Much of this is due to post-pandemic supply chain normalisation, but also a growing contribution from adoption of artificial intelligence (AI). Participation in the S&P 500’s gains now also extends beyond technology. Sectors such as industrials, energy and materials have all posted gains above 8% this year to end March. Hence, cyclical parts of the stock market, which more closely reflect the state of the real economy, were unworried about inflation or interest rates.
We are broadly ‘neutral’ to equities across our strategies given valuations, but not underweight either—since market resilience may yet surprise, plus we are not prepared to risk low participation in markets. Within equities, our starting point is low-cost, transparent exposure to global stocks, with a ‘barbell’ emphasis on US innovation on the one hand, and the structural growth opportunity offered by emerging markets and China on the other.
We do not equate today’s run-up in technology stocks with the dot-com bubble of the late 1990s. However, extended valuations and the rally’s duration since October 2022 make it important from a risk management perspective that the capital preservation sleeve of our portfolios performs consistently and reliably.
We continue to focus on short-dated government bills across the main currency classes, given the unbeatable risk-adjusted returns versus nearly all alternatives. A currency-hedged allocation to US Treasuries is additional ‘crash protection’ in the event of an extreme geopolitical or market event. Exposure to these two risk-free assets is complemented by allocations to insurance-linked securities, mortgage-backed securities, ultra short-dated investment grade bonds and subordinated financial bonds. In alternatives, we hold a single risk-managed convertible arbitrage fund. In tactical asset allocation, we continue to hold US Treasury Bills – partly as defence against a possible market correction, but also to keep powder dry for re-engaging in stocks in such an event’s aftermath.
Productivity will determine the outlook
If the productivity rebound peters out, as the tailwind of supply chain normalisation fades and AI adoption stalls, markets will surely turn their full attention back to that 5.25% Federal Funds Rate and the Federal Reserve’s apparent reluctance to quickly unwind it all in short order.
However, if productivity gains continue due to widespread AI take-up, the rally could persist. Economists have concerned themselves with the ‘productivity puzzle’ on both sides of the Atlantic following the global financial crisis (GFC), given its absence appears to have held back restoration of pre-GFC economic growth. Should the productivity puzzle be solved this year, it could create a set of near-perfect economic and market conditions, at least for the US.
High productivity would afford the US economy means of growth without undue inflation and the adverse consequence of higher interest rates. Stocks will benefit, not just because listed technology corporations will continue to supply and improve AI. Cyclically-sensitive sectors will also be able to grow, without butting up against higher inflation and rates.
As this plays out, investors need to contend with an unedifying conveyor belt of geopolitical risks. The Middle East remains volatile, US-China relations are poor and unlikely to improve post-November. Then there is November. A Trump win would bring tax cuts on the one hand, but higher fiscal deficits, tariffs, and policy ambiguity on the other. One consolation is that America’s exceptionalism allows recklessness and uncertainty to go unpunished. This is nowhere better exemplified than in its markets, which we think will remain focused on cold, hard fundamentals. The US offers an ironic haven from what could be a bumpy period in geopolitics. Beyond the noise, the prospect of a genuinely new economic era could be quietly unfolding.
