— Akira Kurosawa
“In a mad world, only the mad ones are sane.”
‘Consolidation’ was one watchword for markets coming into the new year after 2023’s year-end rally saw risk assets race higher. (The S&P 500 climbed +15.8% from its October low by the ebbing of the year.) And so it was when January trading commenced. On no real news beyond the turning of a calendar page, the upward momentum frayed and the S&P 500 registered its first weekly decline in ten (-1.5%). Other indices followed suit.
But markets did not linger long over this moment of retrenchment. Instead, the real story of January has been one of momentum renewed – at least for certain, familiar parts of the market.
As we go to press – and admittedly January has a couple of trading days and a Fed meeting to see out yet – the S&P 500 is up +2.7% month (and year) to date. The techy NASDAQ is at +3.3%. Indeed, the S&P 500 has this week climbed to successive all-time-highs (surpassing the previous record struck in January 2022). If this was a correction, it was the merest nod at rectitude.
But this latest rally has not treated all equity segments equally. Although the late-2023 rally saw gains broaden out, a now familiar bifurcation returned to markets in January. The small band of ‘Magnificent Seven’ Big Tech stocks is up +4.5% YTD, comfortably ahead of the full S&P 500 – and that is despite a -26.5% slide in Tesla amid a worsening earnings outlook. NVIDIA, in contrast, has rocketed +27.9% YTD. In fact, if the Magnificent Seven were a stock market all to themselves, it would be the second biggest market in the world by market cap, behind only the US!
Other parts of the equities universe were less lucky. Confirming the parting of the ways between US mega-caps and the rest, US small-cap stocks have retreated in January (the Russell 2000 is down -2.5%) while some European indices have also struggled: the FTSE 100 has slipped -2.6% and the CAC 40 fallen -0.9%. (Other major European indices are, however, lightly positive on the year, including the DAX and the SMI.) Underscoring the narrowness of January’s moves, the equally weighted version of the S&P 500 is in fact slightly down on the year, at -0.2%.
January’s renewed momentum is predicated on the Goldilocks outcome of a soft-landing for inflation we have discussed in previous notes. The month’s macroeconomic data offered little to either confirm or confound this outlook with any confidence. CPI surprised slightly to the upside, PPI came in below expectations. Labour market prints point to continued tightness (though if you strain your eyes there are possible signs of weakness to be found – for instance, the still-low unemployment rate was helped by more than 600,000 registered as leaving the labour force). The Q4 GDP growth number certainly suggests the US economy is in rude health; it beat all expectations at +3.3% annualised.
Our concern is that at this point that picture-perfect landing appears fully priced into certain assets – and many equity valuations may be stretched. The risk is therefore that over-confidently priced markets may react badly to any data undermining the golden narrative – and that risk is real given a complex, finely balanced macroeconomic outlook. We therefore prefer to maintain our selective approach to equity risk – including a focus on those parts of the market less touched by recent run-ups. This includes a presence in value and SMID-cap stocks, where low multiples offer some protection from anticipated deterioration of business conditions.
January’s risk-on mood has also touched corporate credit markets, pulling spreads tighter. US Investment Grade traded at a 130-basis point premium to sovereigns at the end of October but by this week the spread had narrowed to less than 100 bps – the tightest in more than two years. Other credit sectors have traced the same path, with the tightening even more pronounced in US and European High Yield, erasing a quarter of the premium available to investors in higher-risk credits.
Spreads are now below their 10-year averages – and looking just at the indices, the lack of compensation for additional (credit) risk calls into question the appeal of this part of the fixed income universe – especially given that expected deterioration in business conditions. And indeed, we do favour the high risk-adjusted returns available in sovereign bonds right now. Nonetheless, many corporates’ fundamentals entered this hiking cycle in a position of historic strength, shielding them from the worst eventualities, even as rates have ramped up. We therefore continue to enjoy selectively picking up quality corporate issuances still offering near-cycle-high yields. As in equities, selectivity is key.
At first glance, one major index that has been on a tear is Japan’s Nikkei 225. The Tokyo barometer is up +8.3% YTD – well ahead of the developed market pack (and even the Magnificent Seven – we’ll count that as a one up for Kurosawa’s original). This comes on top of a +28.2% ascent in 2023.
Looks can be a bit deceiving though: currency effects are playing a sizeable role here. Strip them away by denominating in USD and this year’s gains are a somewhat more circumspect +3.3%. The wide rates differential caused by the Bank of Japan’s commitment to ultra-dovish policy, even as all other major central banks soared with the hawks, has hammered the Yen, which at its lowest had depreciated -28.2% versus the dollar since the Fed began hiking.
But this forex dimension does not mean that what is going on in Japanese stocks is not worthy of investors’ attention – indeed, it might make it more so.
Japanese equity valuations have long been depressed, especially on a price-to-book (P/B) basis. By 2023, fully half of all companies listed on the Tokyo Stock Exchange (TSE) had P/Bs below 1 – i.e. their market value was lower than their net assets! This stems from bloated balance sheets (often with large cash holdings), encouraged by a corporate culture with historically little emphasis on shareholder value creation and the efficient use of capital (including a taboo on unsolicited takeovers). That is starting to change. The TSE has launched a punchy drive to get companies to better use shareholder capital – or return it. Companies that fail to submit and deliver on value-creation plans (measured by P/B appreciation) risk delisting.
Policymakers’ efforts to shift the governance culture are starting to bear fruit. Buybacks and unsolicited takeover bids (aimed at driving value creation in target firms, seizing control from leaderships that are perhaps asleep at the wheel) are trending up, while competition-suppressing cross-shareholdings are trending down. This has provided one spur to the rally since early 2023. A brightening macroeconomic outlook has also helped. Japan’s growth recovery from COVID-era restrictions is proving robust and – most importantly – inflation is up. While today’s CPI print came in below expectations, services CPI measures suggest imported inflation is bedding in domestically. Expectations are growing for monetary policy normalisation this year – perhaps as soon as the April Bank of Japan meeting.
A new doubling in Japanese savers’ tax-free investment allowance should create a powerful new bid on Japanese stocks, on top of renewed global interest (Japanese savers have a vast pool of savings but very low rates of equity investment compared to other jurisdictions). This encourages a positive outlook on Japanese equities. Indeed, the Nikkei 225 is climbing towards its 1989 all-time-high – before the bubble burst in 1990. If it can breach this psychologically important barrier and turn a 35 year page, it could unlock further momentum (though we admit this will probably be cold comfort to the unfortunates who bought in at the top all those years ago). For USD investors investing on an unhedged basis whilst the Yen remains depressed, currency appreciation driven by possible monetary normalisation later in the year could add to the appeal of Japanese stocks.
Japanese equities have disappointed before – but now there are enough signs that this time it just might be different.
It is nice to have got the new year off to a bright start – but again we have to have a wary eye on the narrowness of the recent rally. We certainly do like the idea of a soft landing and are heartened by the indications of continued economic vibrancy – in the US at least – even as inflation appears to continue its descent. The problem is that almost everybody likes this idea. As a result, a soft landing appears almost fully priced in, raising the risk that markets could be disappointed by future data – and react accordingly. With that in mind, it is hard to look beyond the attractive risk-adjusted returns of government bonds and a selective approach to equity and credit risk, with an eye also on toning up duration exposure.
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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