Monday digest

Posted 8 April 2024

Bumpy start to the quarter

Last week saw 2024’s first real bout of volatility. The S&P 500 had its biggest one-day percentage range in over a year on Thursday. This came after two extremely strong quarters for investors. Indeed, we suspect it was a response to the bull run, and the valuation gap between large and small caps it made.

Commentators attributed it to more headline-grabbing news, like Israel-Iran tensions and the sharp increase in oil prices. It could also be down to asset reallocation from big investors though, as tends to happen at the start of the quarter.

If so, that would mean investors moving away from the US mega-caps that have dominated for so long. Small and mid-cap profits and expectations actually fell over the last year, despite strong US growth. As a result, small and mid-caps are trading at valuations around their historical average price-to-earnings ratio, while the S&P 500 is trading well above. This seems logicical, given small and mid-cap earnings have fallen about 11% since 2023, while large caps’ have climbed 8%. However, this still leaves a 20% unexplained valuation gap between the two stock market segments.

Part of that is about the difference in available financing – since higher interest rates usually hurt smaller or riskier companies more. Small caps will struggle to get capital before rates fall, but 2024 rate cuts keep being pushed back thanks to the resilient US economy. Jobs and wages are still growing, and nominal growth around 5% looks set to stay.

Fed members are playing down the prospect of rate cuts soon. Not only is growth still strong, but the Fed doesn’t want to be seen as partisan in an election year – especially so considering they still hold massive amounts of US treasury debt. This has already created distortions they have had to clean up.

There are good reasons to think small and midcap equities could catch up and outperform US mega-caps. If recession risks fade and rates do start to come down, smaller companies will find it easier to borrow and their risk premia – the return investors demand for a given level of risk – should come closer to that for large companies. The only way this wouldn’t happen is if people think US growth will stay top-heavy, which is unlikely if rates fall and the recovery goes ahead.

The risk is that rates go higher rather than lower, though. Although it might be a good long-term view, rational investors could be in for a rocky ride.

March Asset Review

Global stocks gained an impressive 3.3% in sterling terms through March, capping off an impressive 9.2% rally for Q1 2024. Falling volatility was a key theme of the month and quarter. It tells us investors’ appetite for risk assets has increased – evidenced by the fact virtually all major stock markets were positive.

Markets appear convinced of “immaculate disinflation” – lower price pressures but growth staying decent – and central bankers now seem to be reading from the same page. The Bank of England and the US Federal Reserve both said last month that interest rates will likely be cut by the summer. That led to a 0.9% pick up in global bond prices (the inverse of yields) in March – contrary to the virtually flat trend overall for Q1.

Underlying the -0.1% return for bonds in Q1 is the fact that markets are now pricing in significantly fewer rate cuts for 2024. But it shows how good markets feel, givenstocks have roared ahead anyway. Since the late October trough, global stocks have jumped 20% in sterling terms.

UK stocks finally caught up in March too, beating all other regions with a 4.8% jump. BoE messaging and brighter growth prospects were key, but so too was the rally in oil prices, as the FTSE 100 features several big energy companies. Brent crude quietly rose to a five-month high of $90 per barrel.

Europe beat expectations too, rallying 3.7%. China was on the lower end, gaining just 0.8% on the month and finishing Q1 down -1.5% in sterling terms. Chinese stocks improved into the end of March, though, thanks to policy support and stronger business sentiment.

China’s long underperformance might be ending, but that could well mean its disinflationary impulse ends too. If it starts exuding inflation instead, that could hurt markets’ rosy view of the world economy. Let’s hope that view isn’t too good to be true.

Oil breaking higher

Oil prices have had an impressive but underappreciated rally this year: Brent crude is up more than 17% year-to-date, to its highest level since October. Back then, weak global demand preceded falling prices into the end of 2023 – contributing to market excitement around disinflation. The current oil rally therefore threatens to undo some of the progress on inflation.

Middle Eastern tensions and Ukrainian strikes against Russian refineries are constraining supply, but OPEC+, led by Russia and Saudi Arabia, is sticking to its production cuts of 2.2 million barrels a day until June. The cartel’s discipline and cohesion in the face of sharply higher prices has been surprising.

There are also suggestions that Russia’s underproduction is down to a lack of expertise or capacity, following the departure of Western oil companies. Russian production is running significantly below quota, with little sign of improving.

Demand has been strikingly strong, too. Oil inventories declined January, a month they usually build, and demand is way ahead of estimates. The growth recovery in China and the continued resilience of the US consumer are two key factors.

Technical factors could support oil too. History suggests the break above $90 per barrel might mean speculative trading, and spot prices have gone higher than future delivery. There is clearly price momentum and speculation, which seems likely to support prices for now.

The rally doesn’t fit with markets’ overall disinflation story, and if rates fall and growth recovers as expected, it should mean even more oil demand. On the other hand, the very dynamic US production could fill some of the supply gap, and OPEC might allow more production if Russia is lagging. The cartel doesn’t want to crush demand with too high prices.

Speculative rises can often fizzle out too, especially in the era of AI-related high frequency trading. Brent might reach $100, but anything beyond that will be hard to maintain.