Market Commentary: April 2024

Written as of May 13, 2024.

Highlights this Month

• Navigating economic headwinds and inflation concerns
• Domestic Economic Indicators: The dichotomy of U.S. economic health and monetary policy
• Assessing the impact of geopolitical uncertainties on the markets
• Currency Power: The U.S. dollar’s global financial influence
• Investor sentiment and market projections amid uncertainty

Executive Summary

Global economic conditions make for a complex landscape influenced by resurgent inflation, geopolitical tensions, and shifting fiscal policies. Over the past month, the S&P 500 experienced a 4.2% decline, ending its five-month winning streak, signaling a cautious environment where traders are taking gains amid heightened market volatility. Similarly, other major indices like the S&P/TSX and most developed market equity indices faced downturns, underscoring a broader trend of risk aversion among investors.

Inflation has emerged as a central concern, particularly in the United States, where the Federal Reserve faces challenges in managing rising price levels without stifling economic growth. The Personal Consumption Expenditures Price Index (PCE), a key indicator watched by the Fed, showed a year-over-year increase of 2.8% in March, with signs pointing towards sustained price pressures. This scenario complicates the Fed's pathway to potentially lowering interest rates, especially as core inflation—driven by sectors like housing—remains persistent.

Geopolitical risks also loom large, with the U.S. maintaining a stable but cautious geopolitical risk score. The commentary notes the dynamic and potentially volatile nature of global and domestic events that could swiftly impact markets. Notably, tensions between the U.S. and China are highlighted as a significant factor that could shape future economic landscapes, with implications for global markets.

Financial conditions, while somewhat tightened, are not seen as restrictive. The Fed's rate hikes and a more hawkish outlook have influenced market expectations, which have adjusted from anticipating multiple rate cuts to foreseeing fewer adjustments. This recalibration reflects a broader skepticism about the effectiveness of monetary policy in a potentially less responsive economic cycle.

Furthermore, our commentary touches on the U.S. fiscal situation, which is approaching unsustainable levels with debt-to-GDP ratios expected to rise dramatically. Despite this, the U.S. Treasury and the Federal Reserve are employing strategies to manage short-term fiscal pressures, including adjusting the terms and pace of government bond issuance.

We maintain, the market's current state and the economic outlook are being shaped by a mix of enduring inflation, geopolitical strife, and strategic fiscal management, setting a cautious yet pivotal tone for future investment and policy decisions.

April in Review

After a 4.2% (USD, total return) decline, the S&P 500’s five month winning streak was snapped last month, with traders pruning positions and taking gains. The S&P/TSX also declined, falling 1.8% (CAD, total return), as did most developed market equity indices. In fact, most risk assets came under pressure in April, with Strategas observing there were few places for investors to hide, with only U.S. dollar, gold, and utility ETF’s delivering positive returns last month. Emerging market equities, and China in particular, were also positive.

Navigating Economic Headwinds and Inflation Concerns

For investors, it was a bit of a reality check. According to a recent JP Morgan survey, nearly half of the respondents highlighted resurgent inflation and higher interest rates with the Fed on hold as the biggest threats to risk markets. A third opted for geopolitical turmoil and U.S. elections. The PRS Group prepares an annual International Country Risk Composite Score with both geopolitical and economic risk components. While the geopolitical risk composite score for the U.S. remains relatively low and stable, global and domestic events have the potential to quickly change, with dramatic implications to global markets. Below, we look at how both economic and political issues are impacting markets, starting with inflation.

If we had to pick one factor behind the market weakness last month, it would be inflation. Prices are not deflating as expected and this is bringing into question the Federal Reserve’s ability to lower rates. For the second month in a row, the Fed’s favored Personal Consumption Expenditures Price Index (PCE) gained 0.3% versus the previous month and was +2.8% year over year in March. As recently highlighted by Bloomberg, U.S. inflation has accelerated on a short-term basis, with 3-month annualized Core PCE higher than both the 6 and 12-month annualize change. As a sign, further prices increases might be on their way, the ISM Manufacturers Prices Paid Index (the prices companies pay) increased to its highest level in two years at the end of April.

The main sticking point with Core PCE inflation remains services, especially housing. Given new tenant rent continues to move lower, many forecasters believe owner’s equivalent rent, which is used to calculate housing inflation in both the Consumer Price Index (CPI) and PCE Index, should continue to move lower. The Federal Reserve Bank of Dallas’ trimmed Mean PCE, which Bloomberg recently referred to as the “purists’ measure of inflation,” highlights how inflation is falling, but is still at levels last seen in 1991.

While the Fed will be keeping a close eye on housing inflation, what happens with wage growth is likely where the real decision will be made. The Fed wants the job market to cool, but not so much that it drives the U.S. economy into recession. According to Bloomberg, the Employment Cost Index in Q1 indicates the job market is still too hot, though falling job vacancies could be a leading indicator for a rising unemployment rate and falling wage growth. According to Goldman Sachs, the U.S. labor market is already back in balance, with the jobs-workers gap recently falling to Goldmans equilibrium level of 2 million.

Conflicting data leaves the Fed with some tough decisions. The last Fed dot plot indicates the Fed expects to cut overnight rates three times, or 75 basis point, in 2024. The Market has gone from expecting up to seven cuts earlier in the year, to just one by the end of April. According to Bloomberg Economics, the Fed has recently turned more hawkish, but the transmission mechanism between rates and demand might be weaker this cycle such that the U.S. economy might be less sensitive to higher rates. Or it could be the impact of higher rates works with a lag and a slowdown is just sluggish to transpire. According to the San Fransico Fed, markets have become more sensitive to inflation, with financial conditions tightening in line with inflation surprises. Not all sectors are impacted equally, with the San Fransico Fed highlighting transport and financial services as the most responsive to higher rates.

While current financial conditions may have tightened somewhat at the margin, they still don’t appear particularly tight. It is true the Fed raised rates very quickly and appears to have a more hawkish bias of late, the Fed’s dovish pivot late last year helped turn financial conditions easier, with both a healthy stock rally and tight credit spreads the main contributors. According to Goldman Sachs, only higher long-term rates and, to a lesser degree, a stronger dollar, have had a tightening influence on U.S. financial conditions. Party on Garth!

In fact, a theory gaining some support, as reported recently by Bloomberg, is how higher rates could actually be helping spark economic growth rather than control it. Households have already locked in lower mortgage rates, as have many U.S. nonfinancial corporations, but higher short-term rates mean households and companies are earning more on the bank balances and savings. To quote one convert in a recent Bloomberg article, “the reality is people have more money.” Same for companies. Many large U.S. tech firms have large cash holdings, and according to Jefferies’ Greed & Fear, U.S. non-financial corporate net interest payments have been plummeting.

Domestic Economic Indicators: the dichotomy of U.S. economic health and monetary policy

So if U.S. households and corporations are the winners, who is the loser? The U.S. government. Uncle Sam didn’t lock in lower rates and continues to borrow at record levels. According to the Wall Street Journal, the U.S. Government is expected to sell another $386 billion of debt in May, leaving many to wonder who will buy all these bonds. In the first three months of 2024, the U.S. sold a record $7.2 trillion, building on the $23 trillion issued last year. Such huge supply hitting the market should weigh on prices, driving bond yields higher, but Treasury Secretary Janet Yellen and the Fed have a few tricks up their sleeves to soften the blow. Rather than issue longer term coupon debt, the U.S. Treasury has opted to sell more Bills (T-Bill have maturities of one year or less). Yes, short-term yields are higher, but demand for short-term bills is greater, and Yellen can delay issuing longer-term in hopes rates come down in the future.

Historically, the Treasury prefers to keep Bills at less than 20% of debt outstanding versus the current 23% and rising. The Fed is also doing its part, recently announcing it would taper its monthly quantitative tightening (QT) treasury purchases from the current $60 billion a month down to $25 billion, reducing the pace in which the Fed shrinks its balance sheet. Because the Fed creates liquidity when it buys bonds, any slowdown in unwinding the quantitative easing (QE) purchases also helps increase liquidity. Also helping drive market liquidity higher is the Treasury’s General Account (TGA), which it uses to pay the government’s bills. Tax revenue drives the TGA higher with bond issuance making up any short falls. With the TGA currently flush, Yellen can now draw down the TGA and avoid issuing new debt. The TGA, the Fed’s Balance Sheet, and future bill issuance are all in position to help liquidity going forward. According to Strategas, April was the low point for liquidity and likely contributed to April’s poor returns. Going forward, liquidity should become a tailwind for asset returns.

Also working in the market’s favor is the economy and corporate earnings. According to the Wall Street Journal’s April survey, only 29% of economists see a recession in the next 12 months. Reflecting this economic optimism, Strategas recently observed forecasts for S&P 500 earnings have been rock steady at 11% for this year, and +14% for 2025. Rates could continue to move higher, but as pointed out by BMO Capital Markets, if higher rates are due to a stronger economy, stocks actually do better when rates rise.

Not everyone agrees with this bullish view on the U.S. economy; however, Rosenberg Research’s recession probability tracker, which includes the slope of the yield curve, financial conditions and global interest rates, is still uncomfortably high at 50% recession odds in the next 12 months. Rosenberg also points out the Sahm Rule is close to flashing red given the U.S. unemployment rate is closing in on a 0.5% increase, and the ISM Composite PMI (purchasing manager’s index), a measure of production, recently moved into contraction territory.

Betting against the U.S. economy has been the “pain trade” for traders, especially those swinging for the fences by adding duration (longer-terms) to their fixed income portfolio. According to Factset, investors poured billions into the iShares 20+ Year Treasury Bond ETF, only to see losses of nearly 10% so far in 2024. According to Goldman Sachs, the degree to which traders have repriced future fed funds and the number of cuts expected in 2024 indicates 10-year rates could increase even more. As recently pointed out by Bloomberg, however, higher-yields also provide investors with a certain degree of safety. In mid-2020, a mere eight basis point increase in 10-year yields would have been enough to wipe out an entire year’s worth of interest income versus 60 basis point today.

It's possible 10-year yields could increase 50 or 60 basis points and test the 5% level. Afterall, 10-year yields hit a 16-year peak of 5% only last October. According to Bloomberg’s Big Money poll of professional investors, however, only 13% see 10-year yields at 5% or more a year from now, and with the U.S. Treasury carefully monitoring liquidity, any big increase in yields before the 2024 Presidential election will be closely monitored. The real concern is longer-term. According to the Congressional Budget Office, the U.S. is on an unsustainable fiscal trajectory, with debt-to-GDP on track to grow from 100% of GDP today to 116% by 2023. Use market-implied rates and debt to GDP rises to 123% by 2032. Bloomberg Economics agrees. Of the one million simulations Bloomberg ran on the outlook for U.S. debt, 88% showed borrowing on an unsustainable path.

Strategas believes the golden era of fiscal policy is behind us and austerity is only a matter of time. They believe the inflection point is when interest costs hit 14% of tax revenue, at point breached last July. With interest costs currently at 17% of tax revenue, Strategas believes the bond market will start getting restless and spending programs will come under pressure next year. This is where we pick up the discussion on geopolitical risks, because spending cuts will be tough under the current geopolitical conditions. The International Monetary Fund (IMF) recently highlighted the U.S. and China as two major economies where large fiscal deficits are concerning. It’s not the only place the World’s two largest economies are competing.

Assessing the Impact of Geopolitical Uncertainties on the Markets

Much attention is focused on the war in Ukraine and the Middle East, and rightfully so, but for financial markets a brewing cold war between the U.S. and China is what is likely to shape markets and economies longer-term. A recent article in the Economist stated a global contest between the U.S. and China to recruit supporters is underway, and China is doing a better job than one might expect, especially in the developing world. According to Strategas, the median approval rating of China is higher than that of the U.S. in Africa, and the Financial Times points out ASEAN (Southrast Asian) countries would be more likely to align themselves with China, if forced. For its part, China now exports more to the developing dorld than it does to the U.S., E.U., and Japan.

U.S. Treasury Secretary Janet Yellen recently called out China for building up excess capacity in strategically important industries like electric vehicle, battery, and solar. China has historically been accused of using subsidies to give Chinese producers a competitive advantage over global rivals, and the recent ramp up in loans to the manufacturing sector is evidence China is doubling down on the strategy. According to a recent WSJ article, China has the capacity to produce 40 million electric vehicles (EVs) a year, even though they sell only 22 million domestically. Not surprisingly, China has quickly become the acknowledged leader in EVs, and the World’s largest exporter of cars, with the China Passenger Car Association estimating China sold 5.26 million cars overseas last year. A weak Yuan has helped drive Chinese prices even lower, making Chinese excess capacity a real geopolitical threat going forward.

The U.S. and E.U. are likely to respond with protectionist measure of their own, like tariffs and subsidies. Biden’s already passed the CHIPS and Science Act and the Inflation Protection Act in 2022; both provide subsidies meant to help fund domestic manufacturing. China’s focus on the developing world is likely due to the recognition the developed world sees China as a threat that needs to be managed. China’s decision to emphasize exports and investment in manufacturing in this geopolitical environment could also be exposing a weakness of the China growth story rather than a strength. According to a recent WSJ article, Chinese manufacturing capacity utilization in Q1 2024 plummeted to 73.8%, with automobile manufacturing utilization rates falling below 65%. China should be rebalancing its economy away from its reliance on investment and manufacturing and towards consumption. The fact that Chinese President Xi Jinping has been unable or unwilling to do so could be seen as a growing weakness rather than a strength for China.

Investors appear to be voting with their feet, with Chinese stock indices trailing the S&P 500 over the past few years and direct foreign investment into China hitting a 23-year low last year. The mood inside China doesn’t appear to be any better, with consumer confidence well below historical levels and increased public demonstrations focused on labor and real estate issues.

Currency Power: The U.S. dollar’s global financial influence

In the world of economic and public opinion, perhaps currency remains the final arbiter. While its share of allocated foreign currency reserves has slipped over the years, the U.S. dollar’s status as the World’s reserve currency remains unchallenged. The dollar remains king across most regions. Only in Europe is the majority of trade invoiced in a currency other than the dollar. China is working hard to gain more share, but its efforts have achieved only marginal gains.

As long as China restricts capital flows and manages its currency, it is unlikely to replace the dollar. It’s also doubtful China would agree to run persistent trade and current accounts deficits, like the U.S., which would be required in the role of the World’s reserve currency. If not China, then who? The biggest argument for the U.S. remaining the World’s reserve currency is the lack of an alternative, but the U.S. risks becoming too complacent as competitors continue to chip away on the Greenback’s dominance. The U.S. has become reliant on the steady flow of capital into U.S. dollar assets, with Strategas recently pointing out how the U.S. runs a massive current account deficit with the combined U.S. trade and budget deficit trailing only India and Italy.

According to Apollo, however, foreign governments, particularly China, have recently been selling Treasuries, which could become problematic as higher U.S. budget deficits means more U.S. government bond’s looking for a home. According to financial historian Niall Fergusson, any great power that spends more on debt service than defense, will not stay great for long. Fergusson believes the U.S. should hit this point next year, when net interest is expected to comprise 3.1% of GDP versus only 3.0% for defense spending. In order to be the World’s reserve currency, it is generally accepted that you have to have the World’s strongest military. The U.S. does have the World’s strongest military, but the margin of its supremacy is narrowing. Being the World’s super power is expensive, and becoming more so every day.

The recent increase in the price of gold provides an interesting view on the current competition between the U.S. and China. The recent surge in gold is perplexing to western traders given gold historically trades inversely to real interest rates. Because gold doesn’t pay a dividend or interest rate, there is an opportunity cost to owning gold, namely the real rate of short-term money. As inflation has fallen (while nominal rates have been largely unchanged), real rates have recently gone up. In this environment, we would expect gold to fall in value, but it has done the opposite. This price action makes more sense once we look more closely at the capital flows and realize gold was being influenced by the eastern, not western investors.

While North American and European Gold ETF holdings have indeed been falling, holdings in China have increased. While this serves as a valuable reminder that markets are now global, perhaps even more important is understanding who in China is buying, and why. The Chinese central bank is buying and is in the process of increasing the percentage of its FX Reserves in gold at the expense of U.S. dollar bonds. Perhaps they are worried about future sanctions, or maybe they are concerned about the U.S. fiscal situation? Either way, it’s a sign China is positioning away from the U.S. dollar, and this can’t be good for future demand for U.S. debt. Chinese investors are also buying gold, however, as is evident by the increase in demand for Chinese gold ETF’s. Remember, gold doesn’t pay interest or a dividend, so Chinese retail investors choosing to buy gold is hardly a vote of confidence in the Chinese economy.

We can’t claim not to have a dog in this fight. America is (for now at least) a democracy where rule of law reigns. Democracy and Capitalism certainly has its flaws, but over the long-term, has proven itself as an efficient allocator of capital. Left to choose, people and capital continue to flow to America, and productivity growth shows America knows what to do with it. According to the IMF, from 2000-2019, the allocative efficiency of the U.S. added 0.81% to growth in productivity, the highest of the 20 advanced and emerging economies studied. China’s allocative efficiency detracted 1.05% a year. Some believe America takes the World’s brightest and gives them the capital needed to prosper.

Investor Sentiment and Market Projections Amid Uncertainty

According to Barron’s recent Big Money Poll, 53% of institutional investors have a bullish outlook for stocks over the next year. We can’t disagree. Yes, interest rates are high, and the Fed may lag in cutting them, but this is only because the economy is strong. Sure, some cracks are beginning to show, but the employment market still looks tight and ample liquidity is available to keep the market happy. As constantly pointed out by Strategas, it’s when the Fed starts to cut rates that investors need to start worrying. In the 12 months after the first-rate cuts, Strategas points out earnings have historically fallen about 10%. Eventually, the Fed will cut rates. Maybe not in July, maybe not even in 2024. When they do, bond yields will likely fall. Given the US fiscal situation, however, they might not fall as much as expected, and they might not stay down as long.

As Barclays research recently highlighted, it’s been dangerous to stay out of stocks over the past 20-years as they have provided superior real returns versus bonds and cash. The last two decades have been an incredibly favorable environment for stocks, and as Bridgewater points out, investors haven’t needed to diversify over the last 10 years given equities have provided relatively attractive risk adjusted returns. This might not be the case for the next 10-20 years. Geopolitics will likely result in higher inflation and rates longer-term. Given where stock valuations are presently, some adjustment downwards could be expected. A recent chart produced by Strategas showed how S&P 500 P/E rates averaged 13.8 times pre-Berlin Wall versus 19.4 times after. It feels like we are going back to a pre-Berlin Wall environment.