UBP House View - September 2024

Over the past 15 months, most asset classes have put in positive performances. However, we’ve entered a transitional phase marked by rising volatility, political risks, and market dissonance. To navigate this shifting landscape, we have reduced our global equity exposure and increased our conviction on hedge funds, as alternative investments are well-positioned to capitalise on current market uncertainties.

Key Takeaways

Editorial

Market optimism signals caution

Despite recent spikes in volatility, equity markets and tight spreads indicate confidence in a strong US economy, whereas long-term rates signal a looming recession. This dichotomy is underscored by the prevailing optimism on earnings growth, which seems overly ambitious given the macroeconomic backdrop. Although we are not in recession, economic conditions are far from robust.

Over the past fifteen months, most asset classes – excluding those in China – have performed positively. However, we acknowledge that we have moved into a grey area of rising volatility, political uncertainty, and market dissonance. In light of this, successfully navigating the coming months of transition until we get more visibility on the outcome of the US presidential election will be crucial.

Even without acute threats on the horizon, we are proactively reducing short-term risks and positioning ourselves accordingly; as a result, we have become more cautious about equities. In mid-August, we adjusted our overall global equity exposure to lock in profits – without focusing on specific sectors or regions – from the increased positions taken in May 2023. Simultaneously, we have reduced our conviction rating on US equities from 4/5 to 3/5. Looking to fixed income, we remain slightly cautious on interest rate risks during the US elections, notably on 10-year Treasury bonds.

To effectively navigate this transitional phase and recognising that alternative investments are well- positioned to capitalise on market uncertainties, we raised our conviction on hedge funds from 3/5 to 4/5 as of the middle of August.

Strategy

Managing risk in equities in view of the fed’s upcoming rate cut

With futures markets once again anticipating a high probability of rate cuts by the US Federal Reserve beginning in September, investors became excited over the summer that history will repeat itself and US equity markets would deliver the average 11% returns that US equities have delivered since the early 1950s. However, looking back over those nearly 75 years, the context of Fed rate cuts matters.

First, the starting valuation of Fed rate cuts is important. Using data from Prof. Robert Shiller, when the Fed cuts rates and valuations are in excess of 20x earnings (as they are currently), returns average flat to negative on a 3- to 12-month horizon. The only episode that saw 12-month returns above the historical average was the 1998 rate cut following the Russia/LTCM crisis, where the summer of 1999 saw the early stages of the turn-of-the-century tech bubble.

Second, looking at aggregate US corporate profits from the Bureau of Economic Analysis, during recessionary periods, corporate profits have, unsurprisingly, on average declined prior to a rate-cutting cycle. This has led to a more than 10% rebound in corporate profits once the Fed begins cutting.

In retrospect, when no recession was unfolding, as determined by the National Bureau of Economic Research, corporate profits have historically grown strongly into the first rate cut (as they are forecast to do in 2024). More importantly, following the first rate cut, the corporate profit “recovery” has averaged a modest 3%.

Therefore, with US equities trading at elevated valuations, equity investors are increasingly relying on a meaningful earnings upgrade cycle to already elevated expectations on corporate profit growth looking into 2025 in order to drive their returns looking ahead. However, using history as our guide, we expect the absence of a meaningful rate-cut-induced earnings recovery cycle to make this catalyst for the next leg of equity returns unlikely as we move into year-end.

As a result, investors can focus on high-quality, high-visibility earnings streams in order to sidestep potential downgrades to corporate earnings expectations in the months ahead. In addition, we see opportunities for investors to rotate towards hedge funds which can take advantage of the increased two-way risks facing investors as earnings expectations moderate in the market going into year-end.

For more detailed insight, download the full UBP House View.