Asset Allocation Quilt H1 2024

Source BoA, Bloomberg

This year was one in which the opinion on cash switched from it being the asset that wouldn’t give you a capital loss, to one that wouldn’t give you a capital gain, forcing allocators to, well, allocate.

If we take a snapshot from BoA’s returns ‘quilt’ for the first half of 2024 we see cash in sixth place overall so far, along with the rest of the fixed income assets, with commodities and Gold among the allocation winners. We see this as part of the emerging trend of substituting commodities and gold into portfolios in place of fixed income, which we see as being in a structural bear market akin to Japanese equities from 1990 - ie you can make money trading, but at best it is a sideways moving market.

As to the diversification trade - ie non US assets - we would generally be more nuanced, splitting out Europe and Japan from EAFE and China from Emerging markets for example, but the behaviour of a significant amount of investment capital allocation is done through the lens embodied in this quilt. As such, EAFE and MSCI EM are best seen as diversification trades and the flows that end up in the non US markets are thus a function of index weights rather than any fundamental or economic insights.

Mean reversions, but SPX once again the anomaly

There are some clear mean reversions - most obviously commodities, in third, from last in 2023, and Emerging Markets, which continue to claw back their losses from 2022 - most notably in China and Hong Kong. However, the stand out is, once again, the S&P 500, for while the 26% gain in 2023 took them back up to 3% or so above where they stood before the 18% 2022 sell off (that being the nature of investment maths), the further 15% rally this year has left the SPX overextended.

Except of course that on an equal weighted basis (SPW) the S&P500 is up only 5% year to date, having been up around 11% in 2023 , after falling around 13% in 2022. In fact, all very similar to the EAFE index. Those excess returns of SPX (weighted) over SPW (equal weighted) should thus be see as a reward for taking significant concentration risk.

The real issue is that risk management is actually creating new risk

The problem is that the so-called Magnificent 7 (M7) has morphed into the M3, which together have delivered 70% or more of the returns to the SPX year to date, as short-dated options traders, momentum traders and the accidental momentum traders otherwise known as ‘low risk’ index trackers are squeezed in to more and more concentrated positions. Excluding those and the US market has responded to the new, new normal in pretty much the same way as everywhere else. Include them and you are taking a very different set of risks - albeit ones that are not officially acknowledged or measured.

The US Market ex the M3 has behaved pretty much like the rest of the world markets over the last three years.

This remains the elephant in the room for most investors and an unspoken (or, more worryingly, unnoticed) issue for those linking the ‘health’ of the US stock market to that of the US economy. US Politicians like to point to their stock market as some sort of opinion poll on the economy and by extension their policies - although that is more the job of the bond market (in which case the opinion is less good), but because of the perceived wealth effect it does have an impact in the other direction, which is of course why incumbent politicians try and keep stocks high.

Thus we might summarise the first half to say that an allocation of cash to equities generally made sense, as well as to gold and commodities, the latter having a financial element to them as well as a modestly positive story on economic fundamentals. Bonds remain a ‘must have’ only if you are required to have them, while the distortions to the US benchmark index are now such that low risk investors are being forced to take increased concentration risk and stock specific risk.

Macro

Most Market summaries begin with a review of the macro variables, whether GDP was slightly higher or lower than expected, what US job numbers were, what happened to core CPI and so on, in effect all the variables that are supposed to drive interest rate policy, but in fact don’t. So we will limit that discussion to saying that during the first half of 2024, those that follow the high frequency US economic data began the year with wildly overblown expectations of a so called ‘pivot’ and 6 rate cuts from the Fed, before pivoting themselves to declare no rate cuts at all – with some even predicting/demanding rate increases, before ending the second quarter ‘optimistic’ once again of at least one cut this year.

Most macro comment is on the high frequency variables that supposedly affect Fed rate policy. Except they don’t.

The bond markets yo-yoed along with this noise, but the real story as far as we are concerned is that, regardless of what the Fed does or doesn’t do at the margin with short rates – they are moderately too high in our view to be considered ‘back to normal’ – US Treasuries remain in a bear market akin to the Japanese Equity market from 1990. It is entirely possible to make money from tactical trading, but unless convention requires you to hold them (which fortunately for the US government is true for most people) the long-term supply side issue overwhelms any other short-term positive for US bonds.

The strength of US Equity markets is a large part illusion and tells us little about the economy

As noted above, US Equities had a mildly positive first half if you look at the equal weighted index of the 500 largest companies, but continue to hit all time highs if you are a momentum chasing trader or an accidental momentum trading index tracker and concentrating your portfolio into just three stocks, none of whose earnings and thus share prices have much if anything to do with the GDP data so assiduously studied. Indeed, the reverse is probably true; the wealth effect from the capital gains in this narrow basket of stocks is probably more important to the US consumption figures than anything else right now.

However, the fact that Microsoft has less than 2% of revenues from China and both Apple and Nvidia are cutting prices to compete there is a telling point about their Global reach and their ability to grow outside of the US ‘zone’. Meanwhile, the fact that the combined market capitalisation of the three largest stocks in the US market is close to that of the whole of the world’s second largest stock market – which is of course China - should give allocators some pause for thought.

Outside of the US, interest rates and energy prices are more important than stock prices

Outside the US, the wealth effect is far less significant, but the interest rate effect is, particularly in much of ‘the 5 eyes anglosphere’ where there is a large amount of floating rate mortgage debt whose cost has risen dramatically as the ‘independent’ central banks all assiduously followed the Fed, first down and then back up again. Parts of Europe – what used to be referred to as the PIIGS (Portugal, Italy, Ireland, Greece and Spain) also suffer from the floating interest rate issue – but the main reason behind the ECB cutting rates at the end of q2 (just after Canada) was the German economy, which is struggling with enforced de-industrialisation. The fact that this comes from a dramatic drop in competitiveness due to higher energy prices , something that is almost entirely self inflicted with the crazy mix of net zero policies and US inspired (but EU led) sanctions on cheap Russian energy, offers an immediate solution, but one that European politicians appear unable to take. In Germany’s case, a no-nuclear policy also makes them far more vulnerable than France to the fact that energy costs are now multiple times that of India and especially China.

‘Consensus Geo-Politics’ is facing popular resistance

In equity markets we always need to be careful not to confuse the country of listing with the origin of its earnings and many European multinationals earn much of their income from outside the Bloc or else, like Banks, they actually benefit from the higher rate regime. Nevertheless, the current US approach of demanding its ‘allies’ impose sanctions that sacrifice their own interests in pursuit of US geo-political aims on Russia and China is starting to bite – not only on competitiveness and earnings, but also increasingly with politics. The end of the second quarter saw a populist rejection of the status quo EU politicians at the national level, although of course the actual powerbase in the commission remains largely unaffected. However, the fact that it triggered President Macron of France to call a snap Election means that both the UK and France will begin the second half of the year with new governments and all eyes will inevitably then be on the US and Donald Trump - especially after the car crash debate for the Biden team.

The Donald rather than The Fed

For markets, the policy makers to watch will thus not be the Fed but populist politicians, most obviously Donald Trump, but also European sovereign leaders as they push back against the two key globalist policies of open borders and net zero. Trump has already said he will ‘drill baby drill’ and close the southern border and will likely continue a US policy of re-shoring and, in particular try and cut dependence on China.

There seems little prospect right now of any meaningful cut in US government expenditures - although if Donald Trump were to follow the suggestions of fellow populist Nigel Farage and adopt just three policies; scrap net zero and associated subsidies, impose a 5% haircut on all government departmental budgets and stop payment of interest on Central Bank deposits, policies which, when combined, Reform UK estimate could save GBP115bn a year, then, with the US economy about 10x the size of the UK, the numbers - and hence the impact on the deficit funding - would be extremely meaningful. Bond vigilantes to the rescue?

The biggest risk is a Trump Plaza Accord

Of course the US, as a large commodity producer and net energy exporter is currently benefitting rather than suffering from the sanctions it and its (unfortunate) allies are imposing on Russia. So too are the Chinese, who are picking up the cheap Russian gas and will continue to do so as the economically suicidal EU now intends to ban trans-shipments of Russian LNG to Asia. The Europeans may, ironically, benefit from the excess of LNG stuck in Europe, but sadly not for the British, who will also be likely to be given more of the Green Leap Forward as the chief instigator of the disastrous Climate change act is set to return as Environment in another early election.

The ‘surprise’ of a $ devaluation may already be being priced in

However, the real policy issue for markets may turn out to be the US$. If they can successfully reduce import dependence, the best policy to boost re-shoring and re-industrialisation would be to devalue the $ by 25% in a (Trump) Plaza Accord redux. Equally, while overseas investors would see a capital loss in their Bond and Equity holding, US investors wouldn’t see the same - indeed, the value of overseas earners would rise, while, ironically, US Bonds would no longer be seen as an asset to realise gains on for overseas investors now selling rather than buying fixed income.

It would certainly be messy - the travails of Japanese Banks like Norinchuken are already alarming some observers as they struggle to unwind their fixed income books - but we suspect that it would start to accelerate moves by allocators to buy Gold, Commodities and US$ diversification trades like EAFE and MSCI EM. In fact to do exactly what they appear to be doing already…Wisdom of crowds perhaps?

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