The global equity markets, led by US stocks, recovered quickly and strongly after the sudden steep sell-off in early August. Indeed, the S&P 500 Index is now just a hair’s breadth away from its July all-time record high. (At least it was at the point of writing. It may well be at fresh highs by the time this article is published.) Returns on US bonds, on the other hand, while positive year to date, are lagging far behind that of equities — and the Bloomberg US Treasury Total Returns Index remains some distance away from its pre-Covid-19 pandemic high (see Chart 1). So, what are the two markets telling us and how should we position our investments going forward?
Let’s start with interest rates. Both the equity and bond markets are currently priced for imminent interest rate cuts by the US Federal Reserve, fanned by remarks from the Fed chair Jerome Powell himself, though their expectations might differ in terms of quantum. The equity market has generally been more optimistic on rate cuts than bond investors, which explains in part the strong rally in high-growth tech stocks since the start of this year. Expectations have gyrated widely from as much as 1.5% in total reduction (by end-2024) at the beginning of the year to just 0.25%-0.5% and now, back to around 1%. These shifting expectations are reflected in the benchmark 10-year bond yield, which rose from 3.9% in January to above 4.7% in late-April, and has fallen back to near what it was at the start of the year, around 3.8% currently. The decline in yields from the April peak has underpinned both the recoveries in bonds (bond yields and prices are inversely correlated) as well as the equity market.
Stocks recovered from the sell-off in April (when yields rose to year-to-date highs) to hit an all-time record high in July. At this point, however, the equity and bond markets briefly diverged — bonds outperformed the S&P 500 Index, which fell on the back of rising concerns over tech valuations. The profit-taking worsened at the start of August, triggered mainly by the unwinding of yen carry trades and compounded by renewed fears of recession after weaker-than-expected July jobs data. The fear index, the CBOE VIX, soared to the highest level since the pandemic. Bets on large interest rate cuts, even before the next scheduled September Federal Open Market Committee (FOMC) meeting, shot up and the 10-year yield dropped to its lowest level for the year. Equities typically fare well on the back of falling interest rates (lower discount rate = higher discounted cashflow valuation) — except when faced with recession. At the outset of recessions — as well as in times of crisis — bonds tend to outperform.
But the equity market recovered very quickly and turned bullish once again. And the treasury yield curve has steepened (see Chart 3). That is, the short-term yields have fallen faster than long-term interest rates — in the current case, reducing the negative differences between the two (the yield curve has been inverted since July 2022). Long-term yields are stabilising, no longer falling, and bond gains have tapered off.
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The latest surge in stocks, flattish bonds and yield curve steepening are signalling investor confidence in a soft landing for the US economy. Recession fears have receded with more reassuring data on retail sales and consumer confidence, and continued disinflation, albeit very slowly. The job market is cooling but not collapsing and while unemployment is inching up, layoffs remain relatively modest. Of course, what we are seeing is based on investor expectations and beliefs. The markets could be wrong. Let’s not forget how investors have been so consistently wrong on the timing and pace of interest rate cuts.
Tech stocks, and the Magnificent 7, in particular, as we all know have led the rally this year, driven by the hype surrounding generative AI, or GenAI. Therefore, it is interesting to note that while tech is still outperforming year to date, this rally has (finally and perhaps sustainably) broadened out. Since tech stocks peaked in July, real estate, utilities, healthcare, financials, industrials, materials and consumer staples have all outperformed tech (see Chart 4). We believe this is due in large part to growing concerns that exuberance over artificial intelligence has run too far ahead of actual utilisation and monetisation, and that valuations for tech stocks are simply too high.
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So, here we are now. Investors are bullish on the economy — that’s why equities continue to outperform bonds. But they are also reining in some of the exuberance over GenAI and tech stocks. This is also the rationale behind the recent switches in our Absolute Returns Portfolio. Stay invested but exercise caution. And brace for volatility. High stock valuations, relative to historical market average, mean prices will be more susceptible to bad news.
The portfolio is fully invested again — after we disposed of our stakes in Microsoft and VOO (the S&P 500 ETF, which has a heavy tech influence) — with the acquisition of CRH and, most recently, Crowdstrike. The latter’s stock price is down sharply after its software update crashed millions of Windows systems and caused a global IT outage in July. Certainly, there are valid concerns over reputational damage and perhaps liability claims due to the outage in the short term. Nevertheless, we think the integrity of company’s underlying cybersecurity business is intact. The outage was not triggered by a security breach. Crowdstrike’s fundamentals too are solid with positive free cash flow. We think the stock is an attractive risk reward proposition over the longer term.
Expectations on the timing and quantum of interest rate cuts has changed, and will likely continue to change, with new data points. But there is no doubt interest rates have peaked in this cycle. This is why we acquired homebuilder DR Horton and building material and solutions provider CRH. Lower interest rates will improve homeownership affordability and rejuvenate the property market. CRH is also a beneficiary of the US infrastructure bill, which is now starting to flow through. It is well-managed with operations primarily in the US (about two-thirds of total revenue) and Europe. The company has been able to expand its margins over time and generates positive — and rising — free cash flows. Net income margin is expected to increase from 9.8% in 2023 to 10.3% for 2024. Valuations are decent, with a trailing price-earnings ratio of 18 times on the back of an improving growth outlook. In fact, valuations for most of the stocks in the Absolute Returns Portfolio are relatively modest and all the companies have strong operating cash flows. At 0.66, the overall portfolio risk (beta) is also lower than the broader MSCI World Index (see Table). As we said, stay invested but be cautious.
The Malaysian Portfolio fell 1.1% for the week ended Aug 28, underperforming the benchmark FBM KLCI, which gained 2.4%. All four stocks in our portfolio ended in the red with Insas Bhd – Warrants C (-6.4%), IOI Properties Group (-4.4%) and KSL Holdings (-2.9%) being the biggest losers. Last week’s loss pared total portfolio returns to 202% since inception. Nevertheless, this portfolio is still outperforming the benchmark FBM KLCI, which is down 8.4% over the same period, by a long, long way.
The Absolute Returns Portfolio, on the other hand, performed better, gaining 1.2% for the week and lifting total returns since inception to 8.3%. The top gainers were Swire Properties (+5.8%), Berkshire Hathaway (+4%) and Itochu (+3.5%). The two losing stocks last week were Crowdstrike (-3.8%) and DBS (-0.2%).
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
