Title: Market Overexuberance: What Lies Ahead for ETFs?
In recent developments, fixed income and equity ETFs closed out 2023 with impressive returns, marking multi-year record gains. However, as we step into 2024, market sentiments are shifting as the odds of a March rate cut are halved. Fund selectors are now faced with the challenge of managing the subsequent market whiplash caused by the disproportionate market response to the Federal Reserve’s pivot.
During the November meeting, the Federal Open Market Committee (FOMC) hinted at the possibility of three rate cuts totaling -0.75% by the end of 2024. Prior to the meeting, forward market prices had already factored in a cut from 5.25%-5.50% to 4.25%, but post-meeting, markets priced in cuts to 3.75%-4%. This hypothetical dovishness led to a surge in investor confidence in fixed income, with the Bloomberg Global Aggregate index recording its best two months of gains since 1990. Additionally, the giddiness spread to the equity markets, as evidenced by the S&P 500 gaining 16.7% and the Nasdaq 100 experiencing its strongest year since the dot-com bubble.
However, some warning lights have begun to flash, indicating potential risks ahead. The Russell 2000, consisting of small caps with lower profitability and higher leverage, gained 26.8% in eight weeks, while the IPOX SPAC index added 20%. These frothy market conditions prompted JP Morgan’s global strategy report to describe the markets as overbought and sentiment in complacent territory. Investors were engaging in a year-end performance chase, driven by the immaculate disinflation thesis, which warned policymakers of potential challenges in the face of disinflation hurdles.
As we entered the new year, several indicators suggested a potential shift in market sentiment. December data revealed that US new jobs exceeded expectations, while retail sales growth and consumer price inflation (CPI) were higher than predicted. Fed Governor Christopher Waller’s speech, in which he emphasized a cautious approach, led to the largest daily increase in US 10-year Treasury yields in over two months. Consequently, the CME Fedwatch pricing of a March rate cut by the Fed fell sharply from 90% to 42% within a fortnight. Long duration trades took a tactical break, with hedge funds taking out the largest short position on the duration in history.
While markets are still pricing in rate cuts, experts warn that the economy may face challenges ahead. Inflation is expected to remain above the 2% target levels, implying that the Fed funds rate is likely to settle at 4% or above. Those hoping for a return to post-2008 low rates may be disappointed. Given these uncertainties, investors have started allocating funds to inflation protection ETFs, such as the iShares $ TIPS UCITS ETF (ITPS). Advisors suggest that inflation protection, particularly in the US, could be an attractive option for investors seeking to mitigate interest rate risks.
In the equities market, rate-sensitive small-cap stocks have responded to the movements in Treasury yields, with the Russell 2000 Index experiencing a decline since the start of the year. However, this trend has not impacted US large-caps, as evidenced by the S&P 500 and Nasdaq 100 recently reaching fresh all-time highs.
Investors now seek diversification away from market cap equity and consider defensive allocations. The global healthcare sector is seen as an attractive option due to its earnings stability and less dependence on the economic cycle. Furthermore, equally weighting US equities has historically proven to be a profitable investment strategy during uncertain times.
Although many analysts agree that US inflation is unlikely to dip below 3% in the short-term, the market implied rate cuts could result in structurally higher inflation. This brings forth new risks and the possibility of tighter policies to curb inflation, which could potentially lead to a recession.
In conclusion, policymakers face the challenge of walking a tightrope as they navigate the shifting market sentiments. Fund selectors must exercise caution and moderation amidst the uncertainties. With multiple investment banks predicting rate cuts in the coming months, there are still many unknowns. However, it is important to maintain a balanced view and consider different perspectives when analyzing the potential outcomes of these market dynamics.
