Tactical Allocation Viewpoints - April 2024

The Macro Picture

Equity markets marched confidently higher in the first quarter of 2024.  However, as we start the second quarter some questions and doubts have arisen that have led to a pick-up in volatility.  First, expectations around the path of inflation and by extension interest rates in 2024 have shifted.  Second, an escalation in the conflict in the Middle East raises concern about more direct confrontation between major military powers. Last, uncertainty around the U.S. election outcomes in November may trigger market moves.  These events challenge investors’ fortitude, especially after such a strong rally from November 2023 through March 2024, during which global equity markets reached many new highs.

United States. Looking ahead, the range of possible scenarios has expanded relative to the first quarter, when a strong belief existed that we were in a period of predictable declines in inflation and a resilient economy with improving profit growth expectations.  The scenario we described as a “Teflon Economy,” where any possible concerns were brushed off, seemed an apt description of the first quarter – although we must admit that equity market participants drove equity prices to higher levels than even we anticipated.  As we look ahead from here, there are some alternate scenarios that may be growing in probability and that need to be appropriately considered when allocating investments.

1. Alternate Scenario 1: Declines in inflation stall, or even reverse, as economic activity continues to pick up both domestically and abroad. Alternatively, inflation could be is negatively impacted by a further expansion of military action and or protectionist policies.
2. Alternate Scenario 2: Considering the U.S. elections later this year, a few key issues could be most impactful depending on the results. These include tax policy, foreign relations (thinking both trade and military support), immigration, and the regulatory environment.  While easy enough to understand the differences, it is more difficult to predict the results of the election in advance.  Investment managers may be able to identify sector-specific opportunities that are more immune to whoever is elected, but it would be more difficult to predict the winners and losers without knowing the election results.

We are not anticipating a recession this year; however, we remain mindful of the challenges that prolonged restrictive monetary policy may pose to certain segments of the economy.  We need to evaluate not only which companies or sectors may be more desperate to see interest rates fall, but also what the potential ripple effects may be.  Small companies, commercial real estate, and lower-quality companies are all ones that are looking forward to lower interest rates.  Do they have a long enough runway or have their businesses improved enough with the strong U.S. economy to insulate them from higher borrowing costs?  How might the banks (and other lenders) be impacted if we see defaults pick up?  Are there enough liquidity reserves to cover potential losses?  For now, credit spreads remain quite tight, suggesting that there are no meaningful cracks in the foundation.

Europe and Asia. Developed markets in Europe and Japan, while not enjoying as robust economic growth as the U.S. are seeing steady improvement in economic fundamentals.  Inflation is less of a concern, with Europe likely closer to cutting rates than the U.S. at this point.  The Southern European economies are enjoying growth in both manufacturing and services sectors, while France and Germany, two of the largest economies in the E.U., are still struggling to get their manufacturing-focused economies back on track.  Japan does not have an inflation challenge per se, but rather is dealing with a monetary policy stance where they have only recently eliminated their long-running negative interest rate policies and yield curve control in a somewhat desperate effort to stimulate economic activity and inflation! Inexpensive currencies in Europe and Japan relative to the U.S. dollar should help their exporting businesses and make them attractive tourist destinations.  However, the biggest challenge remains, how will these economies with aging demographics be able to reignite more robust economic growth?

Ten years ago, the Chinese equity market looked like it was going to outgrow the MSCI Emerging Markets Equity Index as the introduction of A-shares into the consideration of China’s market size drove it to new highs.  Today, however, because of the domestic regulatory regime, poor trade relations with the U.S., and an anti-China investment movement resulting from concerns over the independence of Taiwan, the Chinese market capitalization has shrunk dramatically. Meanwhile, India has taken advantage of China’s struggles and its younger population to partner with global businesses to drive economic activity, carving a larger piece of the MSCI Index for itself.  These dynamics highlight how difficult it can be to invest in emerging markets, but also how active managers can be successful in such a diverse and volatile index.

Fixed Income. Return expectations for fixed income are more attractive, with rates having reset higher in recent weeks.  Geopolitical disruptions have not led to a flight to quality when it comes to investment grade fixed income in the U.S. despite increases in Gold and a stronger USD.  Likewise, credit spreads that typically react to concerns of greater risk have stayed quite tight while the Volatility Index (VIX) has jumped meaningfully.  The key questions remain focused on when inflation can be tamed and when restrictive monetary policy can be eased.  The divergences that we are currently witnessing may lead to more interesting relative opportunities.

The Micro (Bottom-up) Picture

Volatility creates opportunities for those who are prepared to act.  This recent bout of volatility may very well create some opportunities in the months ahead.  For the time being, we recommend rebalancing portfolios to take advantage of divergence in performance across asset classes.

We are attracted to the idea of a broadening out of the markets as valuation differentials remain wide across equities, and therefore remain underweight U.S. large cap equities. We continue to prefer equities outside of U.S. Large Cap Growth, which we find to be most overvalued.  That leads us to maintain our tilts in Large Cap and Developed Non-U.S. towards Value (and ideally quality, profitable companies, as favored by most active managers we use).  That mix should be 65%/35% in favor of quality/value.

Please contact your client advisor for the full Tactical Allocation Viewpoints report, which includes detail on Pathstone’s current recommended allocations by asset class and sub-class.