“The latest US consumer and producer price data suggest that inflation progress is stalling”

Macro

As we reflect on the first quarter of 2024, it becomes evident that investors have been navigating a landscape marked by dynamic shifts in economic indicators, policy expectations, and technological advancements.

Long-term inflation expectations have remained above the Federal Reserve’s 2% target. Although the market initially priced in a lower 10-year breakeven inflation rate of about 2.15% towards the end of 2023, recent sideways fluctuations suggest cautious anticipation for clearer data regarding inflation trends.

The implied interest rate for 2024, as reflected by Fed fund futures, has shifted to 0.25bps below the Fed’s median projection. This marks a notable change from the 0.785bps observed at the beginning of 2024. Market sentiment now suggests a probability of over 50% for the first 25bps cut occurring in June this year, signalling a shift in interest rate expectations.

In line with our investment call in January, certain style factors have continued to drive excess returns in the market. Notably, advancements in generative AI have provided significant momentum to semiconductor and semiconductor equipment sub-sectors. Additionally, companies exhibiting high earnings growth, strong margins, and low leverage have consistently outperformed, reflecting the importance of fundamental strength in today’s market landscape.

Given expectations of higher interest rates persisting, we advocate for close monitoring of earnings while maintaining exposure to quality style factors. Large-cap quality US equities are particularly favoured over the broader market, as we anticipate that robust businesses capable of producing consistent results will effectively navigate the challenges posed by a higher cost of capital.

Amidst increasing speculation regarding tighter export controls on US chips, especially in the event of a potential political shift, diversifying into Japan’s advanced chipmaking equipment manufacturers presents a prudent strategy. Japanese semiconductor production equipment companies may gain relevance in China, offering a strategic diversification opportunity. However, we remain mindful of potential pullbacks in valuation should global demand for semiconductors wane.

For investors prioritising downside protection and willing to accommodate illiquidity premiums, multi-strategy hedge funds emerge as an attractive option. Notably, the hedge fund index has demonstrated a maximum drawdown of -7.27% between January 2021 to March 2024, significantly outperforming the -24.8% drawdown observed in the SPX Index during the same period.

In conclusion, it is imperative to remain agile and adaptable in the coming quarters with a heightened appreciation to mitigate risks effectively.

Fixed Income Strategy

The latest US consumer and producer price data suggest that inflation progress is stalling, or possibly even reversing. Since FOMC members are seeking “greater confidence” that inflation is on a sustainable downtrend to justify cutting rates, markets are more sensitive to a potentially hawkish outcome at the upcoming FOMC meeting. Current market pricing involves 3 rate cuts in 2024. If the summary of economic projections shows the number of cuts moves to fewer than 3, this could be a meaningful driver of Treasury yields. Moreover, while the BoJ is late to policy rate normalization and this should have marginal impact on the USD bond market, it is also the last remaining bastion of negative interest rate policy, which has helped to anchor yields globally. We are inclined to trim duration of bond portfolios.

US Consumer, Producer Prices Accelerate at Start of 2024

Source: Bloomberg Finance L.P.

Continued noise around US commercial real estate (CRE) exposures and in particular Office-backed CRE loans is increasing debate around the risk posed by European Office exposures to European banks. The challenges faced by the European Office segment are somewhat similar to those in the US (i.e. financing costs, vacancy rates, property values), however CRE overall accounts for less than 9% of European bank loan books, of which 2 ppt comprises Offices. Hence, CRE exposure is unlikely to pressure large banks’ balance sheets. That said, CRE potential stress is mostly prevalent within smaller, specialist CRE lenders. These banks’ spreads will likely remain elevated with investors preferring large and diversified banks. We are inclined to position in major European banks that continue to offer a material spread pickup over US and Asian peers.

Macau gaming operators have reported 4Q23 results showing gross gaming revenue (GGR) grew 11% quarter-on-quarter and EBITDA grew 8% quarter-on-quarter, capping 4 consecutive quarters of growth in 2023 and taking GGR and EBITDA to 75% and 81% of 2019 levels respectively. In line with typical seasonality, February GGR was sequentially lower at MOP 18.5 billion, 70% of the pre-COVID level vs 78%/81% in January/December, likely dragged by sharper-than-expected slowdown post the Lunar New Year holidays. March month-to-date GGR at MOP 610 million per day, representing 3% decline month-on-month, is in line with historical sequential decline of 4% vs February. This suggests the recovery trend remains intact. Should operators maintain moderate capital expenditure and dividend policies, the sector is expected to generate free cash flow, which potentially can be used for deleveraging including bond buybacks. We are inclined to maintain positions in Macau gaming operators.

Macau GGR Recovery Trend Intact

Source: Bloomberg Finance L.P.

Listed Equities

The recent U.S. inflation report revealed higher-than-anticipated figures, casting uncertainty over the possibility of interest rate cuts by the Federal Reserve this year. Although the February CPI report showed a slight increase in inflation, the underlying components indicate a positive downward trend. Overall, the report aligns with market expectations, but we believe the Fed will await more convincing evidence of inflation slowing down before cutting rates. The Fed is cautious about reducing rates too soon, as it could overstimulate the economy and lead to inflation staying above its 2% target or even accelerating further.

Sticky Inflation suggests path to further disinflation remains bumpy

The higher-than-expected PPI print of 1.6% vs 1.1% YoY consensus, combined with the steady inflation CPI print of 3.2% vs 3.1% YoY consensus, suggest that the path to further disinflation may be bumpy. Despite the high inflation reading and high price levels, which generally affect low-income consumers, recent confidence measurements show optimism across lower-income households. Therefore, we remain cautiously optimistic about the US market.

Confidence Stronger for Lower-Income Households

Regarding the Japanese equity growth story, last month the Japanese government announced provisional figures showing a surprise slip into technical recession due to sluggish domestic demand and private consumption. However, the revised figures of 0.4% compared to-0.4% YoY may boost expectations that the Bank of Japan will end its unconventional policy of negative interest rates, introduced nearly a decade ago. Although the BoJ may hesitate to raise rates too hastily, we expect this scenario to play out by the second half of the year.

Source: LSEG Datastream; Japan’s Cabinet Office | Reuters, March 11, 2024

Source: LSEG Datastream; Japan’s Cabinet Office | Reuters, March 11, 2024

Private consumption, which accounts for approximately 60% of Japan’s economy, fell by 0.3% in Q4 last year, slightly worse than the initial estimate of 0.2%. Supporting the growth of Japanese equities, Japan’s largest trade union, “Rengo,” along with prominent companies like Toyota, Panasonic, Nippon Steel, and Nissan, announced a 5.85% pay wage increase, the highest in over three decades. This year, we expect wage inflation to replace cost-push inflation at the macro level, supporting the overall consumer sector.

In addition to cost-push inflation, we see further support from rising consumer sentiment in Japan, which ticked up 3% to 39.1 points in February. We believe Japanese corporate restructuring continues to play an important role in Japan’s growth story, with higher dividend yields and record corporate buybacks expected this year.

In conclusion, Japan remains a strong market for the year. We are inclined to buy the dips when opportunities arise.