Diversification and active management, essential in the current market environment

MAPFRE Gestión Patrimonial Monthly Report

The markets maintain a positive tone, supported by an improved macroeconomic outlook that is alleviating concerns about a recession. Moreover, stock markets are increasingly immune to interest rate hikes: the gains accumulated at the beginning of the year have occurred simultaneously with the rise in yields on government bonds, without any change in the discourse of central banks.

Thus, there’s a “healthy” market backdrop where the capitalization of companies rises for fundamental reasons and not so much because of the expectation of interest rate cuts. It’s no less true that investors are beginning to draw parallels between the current situation and that of the end of the 1990s, as the artificial intelligence (AI) boom reminds older investors of the dot-com bubble and its subsequent crash.

A robust growth scenario (at least in the United States), together with higher-than-expected corporate earnings and a healthy employment market, place longer-duration bonds in a difficult situation, as their prices have fallen by nearly 2%. The exception in this case can be found in high-yield bonds, whose low credit quality is boosted by the good macroeconomic climate and market optimism.

As a result, inflation remains the primary factor to monitor, despite many investors currently viewing it as under control. If inflation were to rebound, as observed at the start of February, it would lead to prolonged high interest rates, prompting a readjustment of projected rates for the year and increasing the risk of economic harm. All this, alongside a geopolitical situation that shows no signs of calming down, and which could take a new direction following the US presidential elections.

USA: “Stronger for longer”

Nothing seems to be holding back the U.S. economy, which month after month sees its expected growth for 2024 revised upwards. The Atlanta Fed GDPNow index, which attempts to estimate the growth of the US economy by considering various components of GDP, already points to growth of 2.5% in the first quarter of the year (well above the analyst consensus), and none of the recently published data leads us to believe that this trend is going to change.

How is it possible that, with interest rates at 5.5% since July 2023, there has been no slowdown in the economy? There may not be a single answer to this question, but some of the most plausible explanations could include the wealth effect triggered by the appreciation of financial assets over the past year and the beneficial impact of rising interest rates on households with low levels of debt.

Some choose to think that AI is beginning to be reflected in the real economy through an increase in productivity (measured by productive capacity per hour of work). This idea is in line with what CEO of Nvidia, Jensen Huang espouses, who stated on February 21 during the company's results presentation that “generative AI had reached an inflection point.”

With Nvidia came new heights

Following the release of its results, the semiconductor company experienced a 16% surge in the stock market, resulting in a single-day capital increase of over $277 billion, marking the largest such rise in history since Meta’s surge just a few weeks prior. The company based in Santa Clara (California) not only beat Q4 2023 earnings expectations ($22.1 billion in sales vs. $20.4 billion expected), but also far exceeded forward sales forecasts.

In addition to the company’s own significant surge in the stock market, on that same day, the Nikkei in Tokyo, the German Dax, and the Stoxx 600 all reached new highs, despite their respective economies not being in a robust state. This leads us to question whether these surges are reflective of a fundamental analysis of the companies’ valuations or if they are driven by a herd effect, where individuals are reluctant to be excluded from the trend.

Whatever the case may be, at least the strength of the market is being felt in other sectors and companies beyond the magnificent seven, which makes the positive sentiment of the market a good thing. In this regard, it appears that the exclusive group of companies is starting to shrink, given the recent stock market performances of Apple and Tesla.

The fall in sales of mobile devices in China by the former and the reduction in demand for electric vehicles by the latter have caused both companies to stray from their five peers. This isn’t to say that Nvidia or Meta have to follow suit, but it serves as a warning to those who want to join the party or invest passively in the indexes.

Liquidity reduces the likelihood of frictions

The most effective but least visible tool that central banks have for modifying monetary policy is the monetary base (liquidity) injected into the financial system. Just as the parts of an engine can become blocked without proper lubrication, leading to continuous friction, economies can’t operate effectively without money circulating within them.

The amount of money (monetary base) with which economies are “lubricated” (the engine) depends solely and exclusively on the central banks. So, after a period where the engines were running low on oil (2020 and 2021), there came the need to drain the excess lubricant that central banks had poured into the financial system.

The process that started in 2022 seems to be coming to an end, and, as of today, this monetary policy tool seems to have moved into neutral territory. This development is promising, keeping in mind that withdrawing excessive liquidity from the system could lead to frictions in the financial system that could derail monetary policy abruptly or make households and businesses unable to finance their activities. On the downside, if the conclusion of this drainage process occurs prematurely or in insufficient quantities, there’s a risk of another upsurge in prices, complicating the tasks of central banks. Thus, we would find ourselves back at the root cause of the situation that brought us to this point: inflation.

Conclusions

The most notable surprise of the past month was undoubtedly the improvement in growth expectations in the United States, leading to a slight upward movement in the reference rates anticipated by the market. What’s surprising about these movements is that inflation expectations have hardly budged, which doesn’t align with the theory we’ve unpacked throughout the report.

The main reason for this lack of adjustment in inflation expectations stems from an exceedingly positive market sentiment that envisions an ideal scenario where economies thrive and inflation gradually recedes to the 2% target. In Europe, despite the sluggish economic growth figures—particularly influenced by Germany—the macroeconomic surprise index, which gauges whether the published data exceeds expectations, has begun to rise. This suggests a potential improvement in the European situation as well, albeit from relatively lower levels.

If we add to this positive sentiment the fact that liquidity is no longer in short supply and that the Chinese authorities have begun to stimulate their economy with expansive fiscal and monetary policies, it's reasonable to expect the continued strong performance of financial assets in the short term. Nevertheless, given that indexes are currently at record highs and there’s a high concentration in certain assets, it’s prudent to exercise caution when engaging with the market, through diversification and active management.