“Remain cautious of the potential for shifting expectations if US inflation data surpasses forecasts”

Marco

Looking at the Fed Fund Futures, markets are currently pricing in the possibility of the first 25bps US rate cut to occur in July. While this aligns with our base case, we remain cautious of the potential for shifting expectations if US inflation data surpasses forecasts.

In a scenario where financial conditions tighten sharply due to a prolonged period of higher rates, credit markets could experience further strain. Conversely, if the anticipated July rate cut materialises, long-term investors may miss the chance to lock in near-peak yields as bond traders adjust to inflation expectations.

On a portfolio level, we tactically favour bonds over equities, given bonds’ potential to offer higher total risk-adjusted returns through capital gains as yields decline. According to UBS’ forecasts, the anticipated rate cut would yield a notable total return for UST 10-year bonds relative to its current yield-to-worst (YTW). Despite cash having the highest YTW at approximately 5%, investors might miss out on potential capital gains if they do not secure current yields at longer durations. On that note, we prefer high-quality bond segments which are likely to rally in the event of a hard landing. Our strategy involves a barbell approach to bond duration until the first US rate cut is more certain.

In the private asset funds space, senior private credit funds continue to outperform in a higher-for-longer environment with returns of 11.20% in 2023 and 3.70% in Q4 2023 respectively. This outperformance is attributed to private credit’s typical linkage to floating rates, such as SOFR, making them less sensitive to interest rate fluctuations compared to fixed-rate bonds. For long-term investors, private credit is expected to outperform public loans in a higher-for-longer scenario due to yield premiums. However, fund manager selection remains crucial, and we prefer semi-liquid funds over close-ended funds with long lock-up periods.

Equities

US equities have now rebounded back and above to its previous high level in March. The pullback in April was the first real pullback for the market in 2024. Now the question is, where do we see the market is going from now. First, we expect increased volatility. Through the probabilities in CME FedWatch tool, it seems that the market is not highly convicted on its expectation, for instance, there’s just only a 50-50% chance for the rate cut to happen in September. Therefore, we’d anticipate more bumps along the way as we advance as fresh economic data are getting release that influence Fed’ decision and market sentiment.

Additionally, the largest intra year decline for the past 40 years, so for this year YTD, the largest draw back has only been 5%. But for the last 40 years, there has been only 4 years with a smaller pullback than that number. As we think with the uncertainties in Fed policy, as well as upcoming election, and geopolitical tension, all introduce uncertainties to the market and volatility to the downside, so we doubt that the 5% dip in April will not end up to be the only 5+% drawdown in 2024. Hence, we think there is likely some correction ahead.

Meanwhile, robust earnings is what led us to be believe will provide good support for the equity market in the medium-long run for the equities. We are now at the end of Q1 earnings season and US companies have delivered a robust Q1 earnings, 78% of them have reported actual EPS above estimates, and this number is above the 5-year average of 77% and above the 10-year average of 74%. In addition, the S&P500 earnings growth for Q1, the actual YoY earnings growth rate is solid at 5.9%, with a positive surprise of 2.5%. The strong growth rate in fact is the highest YoY earnings growth rate reported by the index since two years ago Q2 2022.

Looking ahead to the full year forecast of 2024 and 2025, for the S&P500, year 2024 is expected to be growing at a solid and healthy rate of 11.3%, and the number was revised up higher than previous estimate of 10.7%, indicating market optimism and support. The full year 2025 guidance for S&P500 also been revised up 0.7% from 13.5% to 14.2%, and that double digit growth is robust leading to a continuation of healthy trend in earnings growth across sections and overall.

Overall, we think there will likely be a correction in 2024 but we think the correction be more of a healthy or temporary correction and rather than a prolonged sell-off with robust earnings and earnings growth supporting the US stock market.