It is an understatement to say that the past few weeks have been eventful for geopolitics and macro. Our fear at the end of June was that the second half of the year was likely to be challenging for risk assets: slowing growth points to earnings falling short of heroic estimates; markets remain optimistic on the path of future short rates and long end yields; equity valuations remain high, risk premiums, implied volatility too low; and investors focus on the potential inflation risk of second Trump Administration. Accordingly, we materially reduced equity exposure in the first two weeks of July (by around 60%).
From our perch, the risk-reward on equities has deteriorated for the second half of 2024. For us, the key concern is elevated valuation, narrow equity risk premium and low implied volatility. Stated differently, compensation for risk is poor. To be fair, this has been evident for some time. However, by late June our sense was that market prices and consensus beliefs had decoupled from fundamentals for emotional reasons. There was also non-linear or parabolic price action in stocks linked to artificial intelligence and evidence that the prevailing bias and positioning had become extremely crowded on the long side.
The second development over the past few weeks has been a deterioration in the macro news flow or conditions (chart 1). This suggests that economic growth and earnings revisions will likely fall short of consensus beliefs in the second half of this year. Market concentration has been well documented this year. However, weakness outside the major US tech companies was a warning sign that the advance in the major indices was fragile. The leaders have also started to correct since July 10th.
Chart 1
Although US growth and earnings have been resilient in this cycle, the bulk of equity returns over the past 18 months have been driven by valuation multiple expansion. Equities re-rated through last year supported by positive macro surprises and disinflation. However, as noted above, the former has started to deteriorate, while the latter might not be enough to support a meaningful decline in short- and long-term interest rates relative to what is priced or consensus beliefs. Put another way, as Gerard Minack noted recently, unless the Federal Reserve eases by significantly more than 100 basis points there is little room for long-end yields to decline materially from current levels. Moreover, if long dated Treasury yields do not fall, any normalisation in risk premia will require a de-rating in risk markets (credit and equities).
The implication of the political events over the past few weeks is that the odds of a second Trump Administration appear greater than 70%. The first Trump Administration was not universally negative for markets, although it was more challenging for EM and China. The contrast in the macro environment in 2016 was that low trend growth and low inflation were perceived to be a “permanent state.” Therefore, fiscal expansion and tax cuts were a net positive in that episode.
In contrast, a continuation of the current administration’s irresponsibly loose fiscal policy combined with higher tariffs and reduced (or negative) net migration under Trump might lead to a re-acceleration of inflation. There may also be some concern about Fed independence. In that context, the term and inflation risk premium in long-dated Treasury yields is probably too low. The implication for the US dollar is complex given the “dollar-smile” although the factors above might contribute to dollar strength in the short term, rather than dollar weakness (more on currencies to follow).
In conclusion, the outright and relative valuation premium has been evident for some time. However, there had been a widening divergence between price, beliefs, and fundamentals by late June. Moreover, price had become non-linear and amplified by levered investors. In that context, the potential inflation risk of a second Trump Administration might lead to a wider bond term, equity, credit risk premium and an increase in cross asset implied volatility. The contrast in macro conditions from 2016 is the fiscal starting point, low growth, and inflation prevailing bias. On the positive side, Trump might be more pro-markets and lower taxes (not an obvious negative) compared to the current US administration.
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