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Q1 SUMMARY

• Despite uncertainty surrounding potential Fed rate cuts, economic strength and diminishing recession fears led to the best Q1 U.S. market performance since 2019, with the S&P 500 up 10.6%.

• The endless rate cuts that everyone assumed would start in March got postponed as January inflation numbers came in hotter than expected.

• Despite this, the S&P 500 and Nasdaq continued their relentless march to all-time highs.

• The A.I. hype train kept much of the party going, but crucially, other sectors stepped in to pick up the slack (Energy, Financials). as some of the MAG 7 names showed signs of weakness (Apple, Alphabet, Tesla).

• Inflation figures in February also came in hotter than expected (but marginally).

• Since then, the market has traded laterally as market participants pause for breath. This is understandable given the S&P 500 is up 21% over the last 5 month.

• Elsewhere, Fixed Income performance in Q1 was mixed, with gains in Leveraged Loans and High Yields and declines in Treasuries, Investment Grade and Corporates.

Asset Class Performance: Q1 2024

Sector Breakdown

MY VIEW

Yes, economic conditions are positive, but everyone is aware of that, and we sit at all-time highs as a result. But what takes us higher from here?

When positive expectations get too high and everyone decides to sit on one side of the boat, I start to worry. 

With that said, the sheer volume of capital in the system leads me to believe that this positive performance can be maintained over the longer term, even if there is some period of consolidation to contend with along the way.

MORE EXCESS

It’s undeniable that there are pockets of excess in the market. There always is.

Recent speculation in crypto, NFTs, gambling, options and day trading is reminiscent of the 2021 meme stock days.

But when we look at the market as a whole, the story is a little different.

Yes, we have seen the Nasdaq 100 jump 60% since 2023 and Nvidia has increase by 500% in the same timeframe. These numbers, in isolation, look excessive, but when you account for the fact the Nasdaq’s recent run comes off the back of a 35% drawdown and Nvidia is now trading at a cheaper multiple relative to its 2019 price, things start to make a lot more sense.

Context is key.

Let’s not be naïve, the stock market can’t continue to grow at the current rate forever and some future returns have been pulled forward in recent months, but that doesn’t mean we are destined for a major pullback.

The labour market continues to show resilience, consumers remains strong and are coming from a very strong financial positions and corporate finances are healthy. Until we see a material change in this data, the longer term outlook remains positive, and any pullbacks should be viewed as buying opportunities.

THE WEALTH EFFECT

There are endless data points out there, so it is crucial to focus on the most relevant information.

For us, labour statistics and household net worth remain two of the most crucial indicators of economic strength.

At the most basic levels, the vast majority of people are employed, still have excess savings relative to pre-pandemic levels and have seen their assets increase in value substantially since the pandemic.

The median, inflation-adjusted net worth for the typical U.S. household grew 37% to $192,900 from 2019 to 2022, the highest on record – fuelled by higher home prices, investment account balances, and the pandemic-era stimulus payments.

This wealth effect will ensure consumer spending remains robust, which in turn, ensures corporate earnings remain strong. And as we all know, earnings drive stock market returns over the long run.

UNEMPLOYMENT RATE

Despite the recent interest rate hiking cycle, unemployment remains near its lowest level in 50 years.

 Wage growth has declined somewhat but still sits above inflation, ensuring positive real wage growth.

‘Slowly slowing’ is the goldilocks scenario here, so this remains a positive for markets.

HOUSEHOLD NET WORTH

For me, the below chart is arguably one of the most important charts there is at the moment. It helps explain where much of the recent market strength is coming from.

Despite higher interest rates and the highest inflation in over 40 years, the stock market marched on. Here’s why.

According to the Fed’s latest report, household assets stand at $176.7 trillion (blue line), far exceeding their liabilities of $20.5 trillion (white line).

That puts household net worth at a staggering $156 Trillion.

Household Net Worth Hits All Time High

Yes, there is wealth inequality, and the situation is not the same for everyone. Still, the reality is, American households have more wealth than they ever had before, even after adjusting for inflation.

Disposable household income continues to rise.

The Household debt service ratio has ticked up as a result of higher interest rates but remains historically low at 9.8% of disposal personal income.

Household Debt as a % of Disposable Income

When jobs are plentiful and real wages are still growing faster than inflation, real incomes continue to grow.

So, while everything around us seems to be getting unjustifiably more expensive, many have been able to more than offset these higher prices with gains elsewhere. (Although it may not always feel like it.)

Real incomes continue to grow & that’s positive for the economy

The average household net worth increased by a staggering 7.9% in 4Q23 alone.

Elsewhere, we see evidence that the excess Covid savings are dwindling slower than many expected.

The levels of cash held at banks are unlike anything we’ve ever seen. And while it’s rolled over a bit, there is still way more money just sitting in checking accounts doing nothing.

And this is not just the wealthy either. Deposit accounts for the bottom 50% have climbed substantial.

I could go on, but I fear I may have over done it with the charts already.

You get the picture.

A tonne of capital has been building up in the system over the last 4 years. Cash balances are high. Stock prices are high. Home equity has never been higher. Yields are at the highest levels they’ve been in well over a decade. Investors, savers and consumers are all in good shape.

All this helps explain the resiliency of the US consumer. (which is important given that consumer spending accounts for 70% of US economic activity)

According to BEA data, personal consumption expenditures increased 0.8% month-over-month in February to a record annual rate of $19.19 trillion.

THE ELEPHANT IN THE ROOM

It’s tough to write a piece about all the excess capital in the system without touching on where all this capital has come from.

In short, since the pandemic, the U S. fiscal policy has been ‘aggressively loose’. (government spending loads more money than they are making)

Whether-or-not a system stimulated by aggressive budget deficits is a viable long term solution is a discussion for another day (it’s obviously not). But it is the position we are currently in.

Like it or not, political incentives tend to skew towards the ‘kick the can down the road’ approach so I believe it will remain the approach of choice for the foreseeable. Short term solutions for long term problems and all that.

Rightly or wrongly, this aggressive fiscal approach will lead to asset price appreciation over time, with the exception of rate sensitive sectors with particularly high Debt to Asset ratios. (not all asset are created equal in a higher-for-longer interest rate market so choose wisely)

We can only play the game right in front of our face. People love to talk through ‘optimal scenario’s’ when discussing what SHOULD happen in the economy. I’m more concerned with the rules of the game we are ACTUALLY playing and profiting from that.

In short, there is permanently more money in the system now and money circulates. This money will continue to support consumer spending, which in turn supports earnings, and earnings drive the stock market over the long run.  

* There are more market-specific reasons to remain positive, namely recent market breadth and a positive pick-up in earnings, but I will go into more detail on this data in a separate note.

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OF COURSE, IT’S NOT ALL GOOD NEWS

The market is up 16 of the last 20 weeks since the October 2023 lows and the S&P 500 index is up 21%. This reflects a clear pull forward of future returns, especially when you look at where these returns are coming from.

The bulk of the equity performance so far this year and the past 18 months has been driven by multiple expansion. Globally, 12-month forward earnings are up only 7% from the lows, in contrast to a 28% upward move in P/E. The current U.S. forward P/E multiple of 21.4x is up 6% year-to-date, up 20% since October 2023, and up 30% from the October 2022 lows.

In short, the major downside of raging bull markets is that everything becomes more expensive and repeating the same feat becomes increasingly difficult as we move forward.

As you can see from the below, valuations have gone from relatively cheap to relatively expensive in the space of 18 months.

S&P 500 Valuation and Earnings Measures

But do new all-time-highs mean the market is due for a pullback?

No. The reality is, markets can remain ‘overbought’ for long periods, so timing the exact moment of any pullback is very difficult.

Nobody wants to see markets fall, but in my view, some consolidation would be reasonable and even healthy after such a strong stretch.

I have been in the ‘inflation will be sticky from here’ camp for some time and for me the market is yet to truly factor in the higher-for-longer predicament. This eventual realisation remains the most likely cause for a pullback in my view.

Crucially however, any downturn is unlikely to turn into economic calamity given the financial health of the consumers and corporates.

SUMMARY

It would be naive to assume a recession is completely off the table, but with consumers in such a strong position financially it’s far from my base case.

Similarly, corporations remain strong as they locked in low interest rates on their debt in recent years. Even as the threat of higher debt servicing looms, their ability to sustain their elevated prices gives corporations' room to absorb higher costs. Never underestimate U.S. corporate's ability to protect their profit margins

At this point, much of the good news is now baked into the price, and we will need a strong positive catalyst to maintain the pace of the current run. A correction over the medium term is likely given the recent rally, but in my view, this should be seen as a buying opportunity into a longer-term upward trend.

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