— Heraclitus
“If you do not expect the unexpected, you will not recognise it when it arrives.”
Much as we anticipated in our March note, markets have made a rocky start to the second quarter, as Q1’s generous rally was knocked back by shifting sentiment this month. Some correction from a rally mostly driven by multiple expansion is not an entirely unwelcome reality check for investors, given the extent to which we still see global macroeconomic risks skewed to the downside – a view not shifted by another month’s worth of economic data.
Much as we anticipated in our March note, markets have made a rocky start to the second quarter, as Q1’s generous rally was knocked back by shifting sentiment this month.
Interesting conjunctions and unusual patterns currently abound in markets. Assets that more commonly move in opposition have begun to chime with greater synchronicity. Gold has unhooked from US real rates. The dollar, equities and gold have all climbed together. Correlation of bonds and equities has moved to a positive level last seen in the previous century. April’s macroeconomic data, meanwhile, showed global economic divergence opening up – and exposed market expectations for macroeconomic trajectories in flux. US growth – and inflation – look increasingly out of step with other major economies, adding strains to the global economic and financial system. It certainly makes for a stimulating (if challenging) environment for policymakers and investors alike.
Geopolitical risk seemed to loom large over markets in April. Or rather, it did so repeatedly, amidst Israel and Iran’s rally of reciprocal strikes. Both antagonists’ preference to bide their time before making considered responses – rather than riskier knee-jerk reactions – ensured that fear of escalation was merely a recurring pattern for April markets, not a constant feature. Nonetheless, this was enough to repeatedly send volatility spiking up and risk assets down, while contributing to a steady bid on haven assets. After an extended dormant phase, the VIX Volatility Index sprang up above 19 points, its highest since last October. As investors awaited Iran’s response to the Damascus consulate strike, the S&P 500 endured its worst day since January, dropping -1.5% on Friday 12th April. On the same day, the shiny shelter of gold hit a new all-time nominal high above $2,400/oz intraday. And this being the Middle East, Brent crude moved above $90/barrel during the same week, for the first time since last October.
While Tehran has crossed what may yet prove a costly Rubicon in launching the first ever attacks directly from Iranian territory onto Israel, the immediate threat of wider escalation has receded, and markets have largely looked elsewhere, especially as the month has progressed.
Indeed, for all the dramatic peril of a possible wider war in the Middle East, it was ultimately more prosaic macroeconomics that most shaped markets in April.
Centre-stage was the latest US economic data. These further eroded confidence in an inflation soft landing and the imminent start of rate cuts. March’s CPI number came in hotter than expected, with a +3.5% YoY headline reading and +3.8% core. Both numbers had been forecast to be 10bps cooler. Last week’s GDP Deflator and Personal Consumption Expenditure inflation measures further undermined the idea that inflation was coming into land on the Fed’s 2% target. Employment and retail sales data also came in strong. In recent months, we have not expected cuts to come until the second half of the year. The latest data certainly suggest that there is little immediate justification for the Fed to start cutting rates in the near future.
In the wake of these data prints, markets spent April reshaping around a ‘higher-for-longer’ narrative. The already dramatic YTD repricing of interest rate expectations went even further. Markets began the year pricing a first cut in March and expecting the Fed to rack up more than six 25bp cuts by December. By the start of April, this had shifted to a July start and under three cuts by December. As we go to press, higher-for-longer’s April ascendancy means markets are not fully pricing a cut until December itself – never mind multiple reductions by then.
As we go to press, higher-for-longer’s April ascendancy means markets are not fully pricing a cut until December.
Such a sharp re-evaluation for the key variable of interest rates naturally hit risk assets. The third week of April was the S&P 500’s worst since Silicon Valley Bank’s demise last March (-3.1%). For the Nasdaq 100 (-5.4%), you have to go back to November 2022 for a week as bad. The indices fell three weeks in a row. All major DM equity indices bar the UK’s FTSE 100 joined to head firmly into the red for the month. Fixed income, too, sold off. The US 10Y and 2Y yields last week both reached YTD highs, above 4.7% and 5%, respectively, for the first time since October. The Bloomberg Global Aggregate bond index has retreated -1.6% MTD. While still tight, high yield credit spreads have finally twitched wider.
The prospects of US rates staying around their decadal highs for longer than was expected a month ago keeps the relative appeal of fixed income clear, particularly towards the nearer end of still-inverted sovereign curves. All-in yields are high and hard to beat. April’s move wider for (high yield) credit spreads does not fundamentally change our view on credit: there is relative value to be had compared to equities, especially in European high yield. But, ultimately, index-level spreads are still too tight to encourage a wholesale move towards credit. Instead, the main takeaway from April’s push towards higher-for-longer is that there is no urgency to add duration until data more clearly open a path for the Fed to start cutting. Nor have April’s developments radically changed our views on equities. The correction in the first three weeks of the month walked valuations back somewhat from levels we flagged as uncomfortable in our last note. Last week brought a counterblast, as corporate fundamentals came to the fore with earnings season. Almost half of S&P 500 constituents have reported; more than 170 will do so this week. On the whole, the picture remains one of earnings resilience – the standout being strong reports from Microsoft and Alphabet, causing the stocks to climb. AI-related demand was a key driver for both reports, giving the AI theme (which we have long favoured) another boost. Improving earnings, therefore, takes some pressure off the denominator end of the price-to-earnings ratio. But we nonetheless still see risk ahead for those earnings as the year progresses, suggesting an eye on valuations remains advisable.
On the whole, the picture remains one of earnings resilience – the standout being strong reports from Microsoft and Alphabet, causing the stocks to climb.
For us, the most important – and interesting – dynamic currently at play is the growing divergence between the US and the rest. The dollar has been gaining on its peers all year; the dollar index is up +4.2% YTD, with one point of that added in April. The prospect of US rates remaining higher for longer means more demand for relatively high-yielding US securities and thus more demand for the dollar. This keeps the pressure on other currencies – and economies and central banks – via interest rate differentials. The People’s Bank of China can ill afford to loosen policy too liberally to perk up the country’s still struggling economy, as the yuan’s value dwindles against the greenback and encourage capital flight. The Bank of Japan may have finally moved to tighten policy but US yields risk outpacing it higher; the yen yesterday briefly crashed through the ¥160/$1 mark (in thinner holiday trading), complicating the arm-wrestle with inflation. Today’s European inflation data seem to confirm that price pressures are easing more steadily than in the US – and that the ECB will move to cut in June. But if they move too far away from the Fed, they could see the euro head to parity with the dollar.
For all the voguish talk of multipolarity in recent years and of relative US decline, the fact remains that the world’s economies still exist to a considerable degree in the US’ backyard. (China’s economy may approximate the American economy’s scale, and its factory-of-the-world status strengthens its global influence, but its comparatively closed capital markets ensure that influence is far eclipsed by that of the US.) The world’s central banks will, therefore, be constrained by what Powell and his crew choose to do in the months ahead. Many will feel unable to support their economies with the softer monetary policy that they otherwise would – with potentially significant implications for growth. In this evolving context of complex divergence, we see particular opportunities for global macro hedge funds – of both the discretionary and systematic stripe, and favour portfolios with the diversification they can bring.
The fact remains that the world’s economies still exist to a considerable degree in the US’ backyard.
If you have any questions about the themes discussed in this article, please do not hesitate to get in contact with us: info@bedrockgroup.ch
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