Don’t stand in the way of momentum

Equity markets have been driven higher by momentum, pushing past questionable fundamentals with apparent ease. Still, with bond markets now priced for rate cuts to commence from the second half of the year, pressure may continue to build on corporate balance sheets. This month, we have adjusted our portfolio allocations accordingly. Our Chief Investment Office explains further. 

Our view

Inflation printing above expectations, hawkish FOMC minutes, and rate cuts priced out of forward curves would typically see a more sustained sell-off across equity markets. Not so in February.

Despite January’s US CPI and PPI printing above expectations, equity markets were nonplussed. The inflation miss was meaningful too. Core CPI printed at 0.4% m/m, above expectations and December’s 0.3% m/m reading. Annualising this, core would be at 4.8%, well above the Fed’s inflation target and materially higher if running the same exercise only a month earlier.

Since the inflation print, markets have removed more than 30 basis points (bp) of easing from forward curves. The first rate cut from the Fed is now fully priced for July, with less than 80bp of easing expected before year-end. This is in stark contrast to a March kick-off for rate cuts and more than 160bp of easing that was being priced in mid-January.

Even with the Fed’s ‘higher for longer’ narrative being absorbed by rates markets, equity market euphoria has continued unabated. While positioning is not at extreme levels there are signs that investor sentiment is becoming frothy.

CNN’s Fear and Greed Index has shifted to ‘extreme greed’ over the past month. Momentum – one of numerous underlying measures incorporated by the index to assess whether stocks are fairly priced – has picked up markedly since late October, with a sharp jump following Nvidia’s record earnings announcement in late February.

This momentum has stretched already expensive valuations across some pockets of the market where earnings have not kept pace with the growth in share prices. The S&P 500 is now trading at around 21x forward earnings, expensive by historical standards. While Nvidia is trading around 31x forward earnings, this is down from more than 50x a year ago, as the company continues to produce impressive growth.

However, this dynamic can be observed elsewhere. When looking at forward 12-month PEG ratios (price/earnings to growth), four of the ‘Magnificent Seven’ – Amazon, Alphabet, Nvidia and Meta – are trading at a discount to the broader S&P 500.

Interestingly, a similar story is at play regionally. Japan is the best performing developed market over the past 12-months, rising 45% over the period. And despite the Nikkei having just notched a new high for the first time in 34 years, it has the strongest earnings revision ratio amongst its peers.

While share prices have risen strongly, the macro backdrop is still opaque, and outside of a few specific sectors and regions, fundamentals remain questionable.

With the market priced for later rate cuts, it again raises questions as to how some corporates will cope against the ‘higher for longer’ backdrop, particularly given the level of debt refinancing required over the coming 12 months. In the US, defaults amongst investment grade issuers have slowly been picking up. Across high yield, spreads have continued to tighten and are currently sitting around the 320bp mark; while still some way off the 250bp level where they typically bottom during a standard credit cycle, the size of potential upside has diminished further relative to the prevailing risks. 

With momentum strong and showing little sign of abating; but with fundamentals unappealing across the broader market, tactical positioning may become more important for investors in the period ahead.

Investors are greedy and momentum strong

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What this means for our diversified portfolios

Given this dynamic, we have adjusted our allocation to growth assets this month. Across portfolios we have trimmed our exposure to high yield credit, increasing our underweight to the asset class and growth assets overall.

Portfolios remain defensively positioned with global and domestic fixed income our preferred exposures. Within risk assets, we maintain our neutral position to developed market shares, holding a relative preference for European shares that continue to trade at a steep discount to the US. We continue to hold a tactical allocation to the Nasdaq 100, the position allowing us to express a preference for European shares and US tech, while remaining underweight the broader US market on valuation concerns.

The proceeds from the sale of high yield have been deployed to liquid cash for now as we assess other tactical opportunities.

If you’d like a copy of our full House View, please speak to your ANZ Private banker or advisor.