Weekly Market Update: Would you stand in a bull ring? It comes down to your benchmark

Mr. Martinez will probably never stand for the 'Teacher of the Year' award. I’d be horrified to even fathom the sort of weird science experiments and mortal dangers he exposed his students to after his little stunt went viral.  

But he did illustrate a principle: doing nothing is a choice as strategic as any other.  

Not to put too fine a point on it, but most of the market feels like Mr Martinez’s students. With equities up +26% since the end of November, the question is whether to run with the bulls (overweight risk), run away (underweight risk) or do-nothing (neutral risk).  

The answer is not easy.  

The overweight equities argument initially relied on a very thin narrative: “It’s all about AI and pending rate cuts”. That was easy to dismiss as an exaggeration. AI valuations reached exorbitant levels and rate cut expectations were clearly way above the Fed’s intentions. However, in the past few weeks, European equities have been catching up to the Magnificent 7 (until 14 March when tech picked up again). Value has been also performing well. So, instead of thinking about mean reversion, we are seeing other markets catching up to the hottest American stocks. As months pass, rate cuts are brought closer. Given that Quantitative Tightening doesn’t appear to have the adverse effect we thought it would, if anything it seems that stocks which have underperformed are now catching up, fleshing out a more robust argument for being ‘long’ equities.  

The underweight argument makes more fundamental sense. At the time of writing, equities have already given investors nearly +8%, a standard year’s average, with many major indices near or at record highs. Equity risk premiums in the US (the differential between the earnings yield and the bond yield) have been negative for over a year – which means that investors aren’t compensated properly for the amount of risk they are taking if we think of that risk in terms of earnings. Also important is the bond/equity trend from 2009, which has now broken above the third standard deviation. This means that equities are abnormally outperforming versus bonds – and rate cuts are coming. But the momentum of the equity bull market gives pause. Who wants to stand firm against such bullishness, especially when none of the usual metrics warn of ‘irrational exuberance’ are flashing red?  

The Do-Nothing approach is not always a favourable one. A manager is as likely to be criticized for underperforming, as they are for flying too close to the benchmark. After all, an investor would argue that they pay active managers to be… well… active. And they would, rightly, point out that there’s never a clear case for a market to go in one direction. However, from an investment management standpoint, being neutral is also a choice.  

The key is, that this depends on the benchmark. When the benchmark is an established index, then criticism may arise as to whether a 'neutral' manager is rightly earning their fees.  

In some cases, however, the benchmark may not be an index, but the Strategic Asset Allocation. This is an asset allocation plan based on long-term assumptions about the risk and return of various assets. So the 'do-nothing' option, in that case, is not about being inactive. By adopting a Strategic Asset Allocation (SAA), a manager has sought to remain permanently active over the long term.  

Being neutral the SAA is the admission that there’s not a clear case for a tactical asset decision, at least in the short term and it’s prudent to stick with the longer-term direction of the portfolio. Putting it differently, making an asset allocation decision just to satisfy the demand for one is probably riskier than sticking to long-term strategic planning.  

An asset manager with a Strategic Asset Allocation is never inactive. They have already made decisions at a strategic level. Over the shorter term, they just have to decide when they can rely on their long-term assumptions, or whether they have a clear view of a certain asset class and invest more in it to generate 'alpha’.  

Mr Martinez’s students were not cowards for not reacting. They went in and strategically placed themselves to achieve the primary goal of being in a bull ring: Getting out unharmed. 

George Lagarias – Chief Economist 

A mid-week surge in global equity indices following the Fed interest rate decision on Wednesday evening saw global stocks rise by +2.9% by the end of the week. US stocks were significant beneficiaries, up +3.4%, as Fed Chair Jerome Powell indicated that robust employment data would not prevent the central bank from reducing interest rates. UK stocks followed closely, rising +2.7%, while European stocks saw a more modest increase of +1.5%. Meanwhile, Japanese equities outperformed strongly in GBP terms, surging +4.9% over the week thanks, in part, to little mention of further rate hikes by the Bank of Japan in the wake of their decision to end the negative interest rate policy. 

In the bond market, the US 10-year Treasury yield decreased approximately 9 bps, settling at 4.22%. The UK 10-year gilt yield also fell, dropping by 17 bps to 3.92%. Similarly, the German 10-year bund yield fell by 12 bps to 2.32%. 

Finally, price movements in the commodities market were mostly positive, with the price of gold increasing +1.4% to $2171/oz, and oil prices rising slightly, up +0.5%. 

Macro news 

The Bank of Japan raised interest rates for the first time in 17 years last week, shifting from a negative rate of -0.1% to a new range of 0%-0.1% for its key short-term policy rate. The move marks the end of eight years of negative interest rates in Japan, which was the last remaining country in the world to have a central bank with a negative interest rate policy. The move came after companies agreed to larger than expected wage increases at the annual 'shunto' wage negotiations.  

The Federal Reserve kept rates steady at its most recent policy meeting. Despite a pickup in monthly inflation, Fed Chair Jerome Powell signalled that it may become appropriate to cut interest rates during 2024. Powell also noted that it could be appropriate to slow the pace at which the Fed reduces its bond holdings “fairly soon”. The Fed’s dotplot showed a median of three rate cuts expected by policy makers in 2024, unchanged from the previous dotplot. However, fewer policy makers expected more than 3 rate cuts, compared to the previous dotplot. 

The week ahead 

Investors will be looking towards the US this week as Core PCE, the Federal Reserve’s preferred gauge of inflation, will be released, along with data on durable goods orders. Federal Reserve chair Jerome Powell is also due to give a speech on Friday.