As the market waits for greater clarity, now is a good time to diversify portfolios

MAPFRE Gestión Patrimonial Monthly Report

The turn of the year has started with a slight adjustment to market expectations regarding the evolution of interest rates and corporate profits. The pendulum has now come to a halt having swung to one extreme during the final two months of 2023 and we are still waiting for more clear information about what financial markets can expect from 2024 (which we might start to see by the end of the first quarter).

Meanwhile, these small adjustments are on the right track, as the expectation of six or seven interest rate cuts in the United States and Europe seemed excessive to us. Whether on account of macro data that continues to improve or business results that have surprised by their upward trend, the truth is that the conditions are not there for central banks to cut interest rates as quickly as the market initially predicted at the start of the month.

And the different spokespersons for the US Federal Reserve (Fed) and the European Central Bank (ECB) have asserted exactly this in recent weeks. However, this adjustment in expectations, which not long ago would have caused a downturn in risk assets, was not seen in January, as the scenario as a whole is positive for financial markets.

This bears the question as to whether risks have disappeared in this positive scenario. This is particularly the case considering the headlines published in some media such as “stronger for longer” or “flying free” regarding the current strength of the US economy, despite keeping rates at 5.5%. Much of this strength can be attributed to fiscal stimuli and a sharp reduction in savings, with factors expected to lose their impact in the coming months. Therefore, optimism is justified although, as is always the case, without getting over excited.

Different perspectives

The United States seems to continue leading the way for growth worldwide, as growth expectations clearly indicate. What's more, data for the start of the year indicate that this could continue in the short and medium term barring a financial crash or global geopolitical crisis.

This buoyant situation in the United States (although, as mentioned, this has been based on two factors that seem to be losing strength), contrasts with weak growth in Europe, which continues to be dragged down by the German economy. It does not seem as though the situation there will change in the short term, since industrial production is greatly affected by the increase in energy costs and its reliance on China. Furthermore, although the public deficit remains well under control and the debt/GDP ratio stands at 70%, it does not appear as though Olaf Scholz's government is going to use fiscal stimulus as a tool for economic support.

For us to see solid growth, we would need an increase in productivity (the impact of artificial intelligence still seems premature in this sense) and/or a significant increase in investment in capital (whether human or goods). For the time being, we do not expect any of these conditions to occur, meaning growth will remain fragile and particularly exposed, as mentioned, to negative circumstances that may arise.

Is the manufacturing sector on its way back up?

This would undoubtedly be welcome news. Having suffered serious supply chain problems caused by shutdowns during the pandemic, manufacturing companies faced a second problem: a backlog of outstanding orders at a time when energy prices were skyrocketing. Having resolved these problems, many manufacturing companies found themselves with very high inventory levels due to consumer spending having shifted towards the services sector and because growth prospects for 2023 were particularly bleak at the start of last year.

Thus, after almost two years of perseverance in which sentiment in the sector was very negative, the latest business confidence results seem to point to a change in trend. It is true that two data points alone do not set a trend, but if this improvement continues in the coming months, both economies (US and Europe) would see the return of a fundamental pillar for growth that had been missing for the past two years.

There are two opposing sides as to what the market might make of this possible change in trend: on the one hand, the recovery of a sector that has remained particularly depressed would mean a new boost to growth (although in the most developed economies, it is the services sector that leads growth), while, on the other hand, it would generate more employment, thus reducing the need for central banks to cut interest rates. As we reflected in the cover image of this report, we will have to wait for the lights to come back on.

Corporate profits

After a hesitant start to the earnings season, the situation has improved considerably following the publication of the accounts of important firms including Amazon, Meta and Netflix in the United States and ASML, SAP and Unicredit in Europe. While we await Nvidia's results, it is very likely that 2023 will have ended with flat profit growth in the United States and in excess of 5% in Europe.

The main reason for this improvement has been the broad margin by which many important companies have exceeded analysts' expectations, although without a doubt, it has been the magnificent seven who have tipped the balance towards a more positive quarter than expected (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta).

This group of companies already accounts for 28% of the total weight of the S&P500 and has seen its profits grow by 44.7% compared to the expected 36.6%. As if that were not enough, following quarters in which the net margin declined, as a whole they have once again exceeded the peak seen a few years ago, standing at 21.7%. All this despite the fact that the earnings reported by some companies, such as Tesla, Alphabet or Microsoft, were not altogether well received by the market. These results have encouraged analysts to revise their profit expectations for 2024 and 2025 (especially in the United States), so, as indicated previously, there are reasons to be moderately positive in relation to equities if we stick to a fundamental analysis.

Conclusions

Although we have not yet referred to inflation as we have in previous reports, it remains the most important variable because the decisions of central banks will largely depend on this factor. In this sense, the latest data continue to point towards inflation returning (slowly but surely) towards the 2% target and expectations that remain well anchored.

Central banks continue to convey the message that the number of interest rate cuts this year will be limited and that they will only come when there is a strong conviction that the target has been achieved. Liquidity in the system is no longer a major burden, which is good news given that there have been no incidents to this end.

For the markets, the macro situation is cause for certain optimism (the situation improved at the start of the year), although we must be cautious (as demonstrated by the behavior of the basic consumer sectors compared to the discretionary sector so far this year). We are on the verge of a change in monetary policy (we can now firmly state that central banks have ended their policy of interest rate hikes) and reliance on data means that movements continue to be very abrupt.

Investors will have to continue to wait and see how the markets react in February and March to have a clearer picture of what we can expect for the year as a whole and therefore, reposition portfolios if necessary. Our recommendation continues to be to take advantage of the situation to continue diversifying portfolios and preparing for whatever may lie ahead.