Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Q1 earnings, valuation, and positive March despite banking crisis
Peter Garnry
Chief Investment Strategist
Summary: There is nothing like a heavily concentrated equity market. March brought on a banking crisis and tighter credit conditions which will be felt in the months to come, but these events also triggered lower bond yields and a market pricing the Fed to cut the policy rate by 60 basis points by January 2024. These moves in bonds coupled with excitement over GPT 4 have ignited a speculative fever and buy-the-dip dynamics across technology stocks pushing the overall equity market into gains for the months.
Technology stocks save equities in March
The first quarter is coming to an end with a volatile March driven by a banking crisis and emerging cracks in the real estate sector. Despite worries over the longer term impact of the banking crisis and the emerging signs of a recession this year, equities have managed to rebound ending March higher. To no surprise, the weakest industry groups this month have been banks, diversified financial, insurance and real estate as the these sectors have reflected higher funding costs for banks and the tighter credit conditions. In an ironic twist, these concerns have pushed the market to price the Fed Funds Rate 60 basis points lower in January 2024 from the current level. The uncertainty around bank deposits and the overall banking crisis have pushed bond yields lower as investors have engaged in hedging activities and safe haven trades. This in turn has lifted technology stocks with semiconductor stocks rising 11% in March followed by strong performance among industry groups such as media & entertainment, technology hardware, and software. The excitement over GPT 4 has also helped on risk sentiment in technology stocks.
How do we square leading indicators with valuations?
If we exclude the data points during the worst months of the pandemic, then US leading indicators y/y are the worst since February 2008 lower than the December 2007 rate of change which marked the beginning of the recession back then. How do we reconcile the outlook of a recession with the MSCI World Index valued at 0.5 standard deviations above its long-term average?
One explanation is that, US leading indicators are not a good fit for describing the timing of the next recession. The US leading indicators are fitted on past recessions, so if the next recession is triggered by an unique sequence of events or variables then it cannot be captured by this index. Another possible explanation is that the equity market is in fever mode driven by retail investors that are back engaging in strong buy-the-dip dynamics. It is quite telling that if you add up the gains for the S&P 500 outside the top 15 on market cap then we are actually observing a small decline in equities this year instead of a gain. In other words, the breadth in equity markets is quite small.
Q1 earnings are around the corner
Next week’s earnings calendar is light we no important earnings releases scheduled. Instead the market will be waiting a couple of weeks before the Q1 earnings season kicks off with US financials. This time, US financials are more important than ever as they will provide fresh insights into balance sheets and credit provisions at major US banks.
Two other important themes to track during the upcoming earnings season are the ongoing margin pressure and strong operating earnings growth in Europe. We had expected the margin pressure to be more severe in the general corporate sector, but for now the pressure has been concentrated in the technology sector. This might reflect a considerable lag coupled with high industry concentration, but in any case, with profit margins coming off their highs it will cause a significant headwind on earnings growth going forward, especially for US companies.
European companies have enjoyed an earnings tailwind not seen in two decades as the physical world has staged an impressive comeback with bottlenecks and high prices on many physical assets from energy, metals to industrial components.
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