1. Emergence of TARA, after the end of TINA
The inflationary shock of 2021-22 encouraged the emergence of a correlation between equities and bonds in the wrong direction (decline in both equities and bonds). The disinflation of 2023 has already moderated this correlation, and fixed income and equity products have once again become diversified. We have gradually moved from an end-of-TINA (There Is No Alternatives) rationale, with the attractiveness of money market products, to a TARA (There Are Some Reasonnable Alternatives) rationale.
2. Falling interest rates and sector choices
The main event at the end of 2023 was the powerful bond rally of October-December 2023. It was triggered by a number of factors (a spike in the Fed Funds Rate and expectations of future cuts in the US key rate, disinflation surprises, a slowdown in US real and nominal growth, etc.). It should also be remembered that the earlier bond correction was somewhat disconnected from macro fundamentals and fuelled by technical factors (selling of duration, adjustments imposed by VAR models on US institutional investors, etc.). This bond rally was undoubtedly excessively violent and deep, especially as there are still uncertainties over the equilibrium real long-term rate in the United States. The fact remains that the fall in nominal long-term rates is not (yet) completely over if we look ahead to 2024 as a whole. The resulting sector choices, in a soft landing environment, are as follows in our view;
- Long Growth/Value & defensive quality
- Long utilities, telecoms services, staples
- Long tech
- Long listed property companies
3. Falling interest rates and property opportunities
The fall in property prices is almost exclusively due to the interest rate shock we have been experiencing for over 2 years. Today, the interest rate shock is behind us, and lending conditions are no longer as bad. For listed property companies, whose valuations are almost instantly linked to interest rates, the effect is immediate. For unlisted property, there is obviously more inertia. Nonetheless, the fall in interest rates bodes well for a recovery in transactions (without any further deterioration in the economic situation for commercial property) and for prices to stabilise more quickly than previously envisaged.
4. Lower rates and convertibles
As in the case of credit, most of 2023 saw a stabilisation in the convertible situation, with rising interest rates penalising convertibles versus support from rising equities. The fact remains that the main driver of convertible performance is equity performance and, to a lesser extent, volatility. The ideal situation for the asset class would be a configuration of bullish and volatile equity markets, bearing in mind that volatility is currently excessively low.
Technically, convexity is good, with a low delta in both the United States and the eurozone.
5. Resilience of private equity
2022 and 2023 were rather difficult years for private equity (deal value and volatility-adjusted performance). Some may have concluded that the attractiveness of this asset class would be permanently affected by rising interest rates, given a double excess in terms of valuation and leverage. In fact, the most recent data shows no such excess compared with previous cycles. In our view, the past rise in interest rates does not call into question the attractiveness of the asset class (possibility of investing in companies at different stages of the growth cycle, better management of the timing of an equity investment, good compliance with dollar cost averaging strategies, non-negligible alpha, etc.). At the very most, developments in 2022-23 will accelerate the dispersion of fund performance. Against this backdrop, we would expect to have to (a) favour funds that offer discounts to NAV, (b) avoid funds with excessive leverage, and (c) avoid funds with unsatisfactory interest rate hedging (given the variable rates applied to leveraged loans and CLOs).
6. Infrastructure resilience
There is reason to believe that, whatever happens to interest rates, in 2024 infrastructure will still be a resilient asset class in a number of scenarios. Why is this? They are tangible assets with a long lifespan that guarantee a source of recurring income over the long term (long concession contracts) and which also benefit from relatively inelastic demand and high barriers to entry. Not to mention legislation that generally limits political risk (government guarantees). We should also bear in mind that the political impetus in both the United States and Europe (with India and China as well) remains favourable, and that needs remain substantial, with certain components being of vital importance to society (energy and digital transition, water, etc.).
7. The return of European small caps
Small caps suffered an extremely powerful derating in 2022 and 2023. The underperformance of small caps far outstripped that suggested by European domestic macro. In addition, long-term EPS growth forecasts are very low and the stabilisation of the euro-dollar exchange rate should be a positive factor relative to the big caps.
We should also bear in mind that the attractiveness of small caps to investors is quite clear at the start of the cycle. Finally, it should be remembered that, in the context of European equity management, the European mid caps index is much more geographically diversified than the MSCI Europe index.
8. Vulnerability of the „Magnificent 7
2023 saw an extreme concentration of US equity market performance on the „Magnificent Seven“ (Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia and Tesla), which contributed three-quarters of the index’s performance.
This concentration does not necessarily mean a particularly vulnerable market, let alone a stock market bubble.
At first glance, there is no obvious anomaly in tech valuations in general. At most, we are seeing very high medium-term EPS growth expectations, which could prove problematic in the more distant future.
As for the Magnificent Seven’s premium over the rest of the tech sector or the stock market, it seems fairly high on the face of it, without being extravagant, and seems to us at least partly justified by the earnings gap.
However, there are a number of risks associated with the Magnificent Seven. Firstly, given the high earnings expectations, the slightest disappointment could prove problematic. Secondly, hedge funds have a very high exposure to these stocks, which makes them vulnerable. In addition, there is the risk of regulation on artificial intelligence, to which the Magnificent Seven are very exposed, which would significantly reduce the outlook for margins, even though analysts are very optimistic in this respect. It is therefore probably better, out of an abundance of caution, to return to a position of neutrality for the Magnificent Seven within US tech.
9. The return of Trump
5 November 2024 is still a long way off. But we believe that this theme will affect the markets throughout the year, starting with the early stages of the primaries at the beginning of 2024.
Let’s focus on the purely economic and stock market aspects of a Trump re-election. Like it or not, Trump’s first term in office was generally satisfactory. His fiscal and budgetary stimulus in 2017-18 had a positive impact on investment and productivity. And overall, his record (excluding 2020, which was affected by Covid-19) is on average better than that of Obama’s 2 terms in office (excluding the first half of 2009, which was still marked by the great financial crisis) in terms of growth, productivity, employment, investment in tech, etc.
A Trump victory would have clear-cut directional implications. We would undoubtedly have to play up US exceptionalism (overweight US equities vs. European equities, widening of the transatlantic spread between T-bonds and the German Bund, rise in the dollar). In equities, a short position on ESG and renewable energies vs. a long position in oil & gas, healthcare and defence stocks would probably be appropriate.
10. Re-industrialisation of the West
The long process of deepening the global production chain has come to a halt in recent years, and industrial activity in the developed world has rebounded slightly as a share of GDP. The forces driving the reindustrialisation of the West are powerful: (a) convergence in living standards and incomes at global level (rising wage costs in emerging countries); (b) automation of the production process; (c) the end of the decline in transport costs at global level; (d) geopolitical tensions.
Some political decisions, such as the IRA in the United States, reinforce the process.
The practical interest of this theme is the emergence of baskets and trackers that include winning reshoring stocks.