Market Insights - May 1st, 2023

Nearly two thirds of S&P 500 companies have published their Q1 results, and it’s shaping up to be an excellent earnings season. Close to 80% of companies beat the consensus – and by a comfortable margin of 6.7%. Market expectations now seem more reasonable, so analysts can be expected to stop downgrading their US growth estimates.

Investors expect the European Central Bank (ECB) to raise interest rates by 25 basis points this week. This round of tightening probably won’t end just yet, since the ECB began tightening its monetary policy later than the US Federal Reserve (Fed) and inflation is higher in the eurozone than in the States.

Governor Ueda, the new head of the Bank of Japan (BoJ), announced that it would continue controlling the yield curve and keep its asset purchase programme in place. In doing so, he has temporarily extended the bank’s ultra-loose monetary policy even though the BoJ is lagging behind other central banks in its normalisation process. That’s why the yen lost ground last week.

One for the road?

The Fed is set to meet this week, and the gathering could mark the end of its monetary policy tightening. Economists expect the Fed to raise rates by 25 basis points. We think there’s a very strong chance this will be the last hike in this cycle. If so, the Fed will have raised rates by 5 percentage points in just over a year – one of the fastest and sharpest rounds of monetary tightening in its history. It hasn’t raised rates by so much since the early 1980s, when the US was grappling with stubborn hyperinflation.

With inflation slowing sharply in recent months, Fed Chair Jerome Powell seems to have achieved much of what he set out to do. The March figure for the Fed’s favourite price gauge – the personal consumption expenditures price index – has just been published. Year on year, prices were up by just 4.2%, versus 7.0% when inflation was at its peak in June 2022. And it looks like inflation will continue to ease in the coming months. As is often the case, anti-inflationary measures have had a knock-on effect on the economy, which will only prolong disinflationary pressure in the medium term. It’s therefore not surprising that growth slowed quite sharply in Q1, coming in at 1.1% (annualised) compared with 2.6% in the previous quarter. This more sluggish growth is likely to continue in the second quarter, as reflected in the continued decline in consumer and manufacturing confidence in April.

At the same time, the credit crunch brought on by the Fed is still claiming victims in the banking sector, as we saw again this weekend with the rescue of First Republic Bank, another mid-sized US financial institution. In this gloomier context, Jerome Powell has no choice but to signal that the Fed’s rate hikes are nearing an end. Investors are already predicting that rates will start heading downwards, perhaps as early as the end of this year, but more likely in 2024. This more favourable prospect has boosted both the stock and bond markets in recent weeks. The foreign exchange market has also done well as the US dollar continues to adjust to a less favourable interest rate environment. 

Alternative funds – bullish on directional strategies

Market trends have reversed since last October, with the funds that fared best in 2022 now lagging behind. Diversification strategies – and systematic and macro strategies in particular – are struggling, while long/short equity strategies are looking strong.

Even though they are starting to regain their appetite for risk, investors continue to show a preference for decorrelated strategies. Multi-strategy funds are the most popular. Their diversified portfolios are commonly managed by numerous teams focusing on specific niches. They are also subject to very strict risk management processes, which means they have significant leverage.

They have been taking in enormous amounts of capital in recent years, however, and we fear that these volumes will limit their ability to deliver attractive returns in the future. That’s why we’re taking a more moderate stance on these funds. We’re also cautious on macro funds. In 2022, their performance was boosted by the upswing in interest rates, which is not likely to continue this year. This will limit these funds’ upside potential, and they could ultimately disappoint investors.

We are still bullish on more directional strategies, in both the credit and equity segments. Managers in these segments are in a good position, as they are able to take advantage of the overall reduction in research budgets among brokers and the 20-year low in short positions, which together generate exploitable inefficiencies. And if the markets perform well this year, as we expect, that will provide further support.