Weekly market update - Should we fear the correction?

He is best known for ‘Ockham’s razor’, a philosophical theorem. “Entia non sunt multiplicanda praeter necessitatem”, which translates as "Entities must Snot be multiplied beyond necessity", or simply put “the simplest explanation is usually the best one”.

Ockham’s razor will come in handy, as we try to interpret the rout in risk assets during the last three weeks. Both bonds and equities have been losing ground since early April, during an episode which was reminiscent of the QE era, when assets were more correlated.

Global stocks, which have been consistently rallying since the end of October and gaining as much as +26%, are finally correcting, by about -5% from their highs. Global bonds are also down -2.2% in April and -3.5% for the year. The us Dollar, a global safety asset, is rallying, gaining +2% against Pound Sterling and +1.2% against the Euro in April alone.

There have been a number of narratives that may explain this move, however no particular one seems to fit the bill.

Let’s explore them one by one.

1. It’s not the geopolitics: While things in the Middle East have certainly been heating up, we have not seen a major escalation of hostilities in the past week. The price of oil has remained relatively stable, and certainly well below levels which could conceivably cause a third inflation wave.

2. It’s not the Fed: The primary culprit could be the Fed keeping rates 'higher for longer'. After a series of strong US inflation and employment data, Fed officials came out en masse in the last couple of weeks and more or less confirmed that we should not expect many rate cuts this year, if any. Michelle Bowman, a board member and a hawk, even wondered whether the Fed had under-tightened, or a rate hike is warranted. Former Treasury Secretary and perennial Fed Chair candidate Larry Summers has raised the possibility of rate hikes as well.

However, the argument doesn’t stand up to serious scrutiny. The simple fact remains that US large-caps are +2.5% higher than they were in mid-January, when bond markets were pricing in 7x cuts. Throughout the period, equity markets ignored sticky inflation and bond markets repricing fewer rate cuts and just kept going. There’s no particular catalyst that we see which could conceivably just make equity investors more rate-aware.

3. It’s not growth: Economic growth lifts earnings growth, in theory at least. Just last week, the IMF published its bi-annual World Economic Outlook, in which it raised 2024 global growth prospects from 3.1% to 3.2%, with the US significantly upgraded from 2.1% to 2.7% by year’s end. While Europe and the UK were slightly downgraded (0.8% and 0.5% growth respectively, 0.1% below January’s estimates), their outlooks haven’t worsened significantly.

Despite key indicators flashing red, the developed world hasn’t experienced a recession. The US 2y-10y yield curve has remained inverted for 470 straight days, by far surpassing the previous record of 423 days in 1980. It is also the deepest inversion in the last 50 years, reaching 1%. Even the present number, 0.4%, by comparison milder, represents the trough in many previous episodes. The fact that we don’t have a recession is a reflection of two issues. One is that the central bank may have actually under-tightened, or, simpler, the US which has been fiscally expanding, has spent the money wisely enough to spur growth. At any rate, growth concerns are possibly not behind the latest equity setback.

4. It’s not earnings: According to Factset, of the 14% of US large-cap companies which have so far announced earnings, 74% have beat net income expectations. Arguably, a smaller 58% beat for top-line earnings and a 0.5% is nothing to write home about, but certainly not the catalyst to cause a correction.

5. It’s not valuations: This might come as a surprise, but equities were not that expensive in early April. Yes, US equities were trading at a 19% premium over their long-term average at the time, but a 21.5x forward price-to-earnings is hardly 'irrational exuberance'. Meanwhile, the rest of the world, including Europe, was trading at a discount. The 496 US large-cap companies that are not the Magnificent 7, are trading at 18.5x forward earnings, very near to the long-term average.

Having exhausted both events and fundamentals (monetary policy, growth, earnings, valuations) we can now turn to technical reasons. After all, the market has been dominated by algorithmic trading in the past few years.

6. It’s - probably - not the ‘algos’: Algorithms tend to follow patterns. And while they would enhance a move (say a -2% drop becoming a -5% drop or a +10% rally becoming a +20% rally) they would need something to instigate a move large enough to follow. Lacking a specific catalyst, they would usually turn to seasonal trends. Yet here again we hit a roadblock. April is not usually a bad month for equities. And May (when old traders advised to 'sell and go away') is actually one of the best months in the year. I do have some reservations about this call, to be sure. Any one black box is mysterious enough, so a market of black boxes is pure enigma. And while we can’t see any clear trend emerging, we can’t help but notice that the last three major moves happened exactly at month’s end (a drop after end July 2023, a rally after end October 2023 and now again a drop after end March 2024).

7. It’s not the futures market: Up until a few weeks ago, while leverage was unusually high, net positioning for US large-caps was a significant short. In the past few days, positions have moved to exactly neutral. A short-squeeze is usually beneficial for prices, and by no means explains a downward movement.

8. It’s not the debt: A point of concern from the IMF’s latest report was that the US had issued too much debt, which is not sustainable and may risk unbalancing global growth. In a separate report, they also said that concentration in the bond market is a concern, with 50% of the US 2y Treasuries futures markets held by fewer than eight traders. It makes sense, especially after years of central bank buying which has crowded out many bond trading desks, that the market is thin. Combined, these two pieces of information could spell trouble for the bond market. However, the nature of bond risks is non-linear. Markets tend to react violently after a specific event, say a default, but do not linearly price in rising risk. As for the debt levels? Equity markets have long learned to live with it, especially if it comes from the world’s biggest economy which also holds the global reserve currency.

So the simplest explanation is that, lacking a major catalyst, nothing has changed in the past few months. Despite the recent action, equity and bond markets are looking at different things. Bonds are slowly and painfully climbing back from the absurd position at year end that the Fed would cut 7x times. It has yet to price in any rate hikes. Our base case position remains that the US central bank will begin cutting at some point later in the year.

As for equities? A simple look at the graph tells a story of the Mag 7 leading the fall. Lacking a clear catalyst, we should assume that it is mostly profit-taking from positions that have rallied significantly over the past few months. Mean reversion is part and parcel of regular investing life.

Should investors be concerned? For the time being, they are not. A net long position in US large-cap futures markets suggests that traders are buying the dip.

The rally may not have had strong legs, but, seemingly, neither does this correction.

George Lagarias – Chief Economist

Market update

Markets fell last week as the prospect of delayed rate cuts by the US Federal Reserve continued to dampen investor enthusiasm. A stronger than expected US retail sales report, in which sales increased by twice the expected figure, set the tone on Monday. US stocks and Treasuries fell after the report, as strong consumer spending was seen as a sign that the Fed may keep rates high. Later in the week, misses in key earnings metrics from the Dutch semiconductor company ASML, as well as concerns over rising geopolitical tensions, weighed on sentiment.

In all, global stocks fell by -2.7% over the week. US stocks fell more than the global average, by -3.0%, while UK and EU stocks fared better, falling by about half a percent each. Emerging market and Japanese stocks fell by just under -3% each.  

Bond yields increased in the UK and US. The US 10-year Treasury yield rose by 8 basis points to 4.64%, spiking after the release of US retail sales data and housing data. The UK 10-year Gilt yield rose by 4 basis points as UK inflation declined by less than expected.

Gold continued its rally, rising by +2.2%, while oil fell by -2.1% over the week.

Macro news

US retail sales rose by 0.7% in March, more than twice the expected figure of 0.3%. Figures for February were also revised higher, from 0.6% to 0.9%. ‘Control group’ sales, a subset of sales which are used to calculate GDP, were also particularly strong, rising by 1.1%. The figures suggest that the US consumer remains resilient and may serve to delay the timing of rate cuts by the Fed.

UK retail sales, on the other hand, were flat over March, missing market expectations of a 0.3% rise. A rise in sales was seen in petrol stations, furniture shops and clothing store, but these were offset by declines in food and department store sales. 

UK headline inflation eased to 3.2% year-on-year in March, from down from 3.4% in February, helped by a slowdown in food price growth. The headline figure was slightly higher than consensus estimates of 3.1%. Core inflation, which excludes the more volatile elements of inflation, also fell to 4.2%, from 4.5% in February.

The week ahead

Advance estimates of US GDP growth in the first quarter of 2024 will be coming out on Thursday; this will be closely watched by investors as it will help to determine the Federal Reserve’s schedule for rate cuts. Tech earnings will also be in focus, as major US names such as Tesla, Meta, Microsoft, Apple, Intel and Alphabet are set to report earnings this week. Core PCE, the Federal Reserve’s preferred gauge of inflation, will also be released on Thursday.