Descending the wall of hope

We wrote in our October 2023 commentary that equities will begin to climb the wall of worry as overly pessimistic expectations would be overcome by stronger than expected economic growth. 

Since then, US equities have rallied over 42% as the US averted a slowdown and delivered above-trend growth in 2024. As we say goodbye to the year, our projections for US growth is 2.8% for 2024. US growth has outperformed the rest of the world, with regions like Europe expected to deliver a muted 0.8% for the year. This translated to significant outperformance of US equities, delivering 25% in USD terms over 2024, outperforming the MSCI ACWI ex USA index by a whopping 19.5% over the year.

2025 is expected to be much of the same. We released our 2025 outlook piece (Will Growth Trump Inflation?) two months ago and made the case for continued strong US economic growth which outpaces the rest of the world, leading to continued outperformance of US equities. We still believe this to be true. However, so does everybody else. 

Of the 19 strategists tracked by Bloomberg, none expect the S&P 500 to decline in 2025. Investment banks and research houses are falling over themselves to upgrade their 2025 S&P 500 price targets, with some issuing a 7000 target or a 19% rally from here.

It's feeling eerily reminiscent of the froth at the end of 2021. The cyclically-adjusted price to earnings (CAPE) ratio is a hair’s breadth away from the peak seen in November 2021 at over 37x, only being eclipsed by the 1999 dot-com high. Unprofitable tech is starting to lead, with any company claiming to have better chips than NVIDIA going stratospheric, and ‘meme’ stocks are returning to the fore. 

Bitcoin is flirting with 100k and ’alt-coins’ are making a comeback, including crypto fraud whose names I can’t type here without getting in trouble by my compliance department, to celebrity endorsements like ex-Chicago Bulls star Scottie Pippen claiming Bitcoin creator Satoshi comes to him in his dreams to give him price targets. Despite our positive views on the US economy, it’s fair to say the market right now is full of BS (bullish sentiment).

Portfolio changes

We continue to favour equities as our preferred asset class, but have turned cautious over a 1-3 month horizon. We believe US economic growth will remain robust, which will support corporate earnings, but the market has become overly complacent. Investors have focused on all the market-friendly implications of a Trump presidency, without worrying about the inflationary aspects that are likely to follow. Sentiment and positioning is stretched and yields on US treasuries have risen to levels that are historically dangerous for equity multiples.

We therefore de-risked our positioning in December, reducing equities by 8% over the month. This was a mixture of trades, from taking profit on our Australian and US equity call spreads, to selling 2.5% S&P 500 futures and 2% TOPIX futures. Our preference for Japanese equities has waned over the month, with our growth trackers rolling over and output gap narrowing, putting Japan into late cycle. We bought 5% notional in an S&P 500 5800-5200 March 2025 put spread and another 5% in a 5900-5300 February put spread. All these trades were done before the Fed announcement and subsequent sell-off. The February put spread is now in the money and the March put spread strike is 1.3% below current levels. These spreads reduce our delta-adjusted equity allocation by 3.3% at the end of the month.

Credit spreads continued to contract at the start of December to very tight levels. US high yield spreads were extremely tight at the 3rd percentile (spreads have been wider 97% of the time), whereas US investment grade was at the 11th percentile. We therefore reduced our allocation to high yield and investment grade by 4% each in the middle of the month. Spreads have since widened in derivative markets after the bout of equity volatility. We have subsequently bought 2% back in European investment grade via CDS after spreads widened to more reasonable levels. In currency we took profit on our long Japanese Yen (JPY) and short Euro (EUR) trade, reducing it by around 2%. We also increased our USD position by 1.5%.

Our overall fund duration remains unchanged at 1.75 years, but we changed positioning under the surface. We hold the majority of our duration in Australia, particularly in the front end of the curve. 

The more dovish minutes from the RBA’s December meeting caused markets to quickly price in three rate cuts next year, causing Australia to outperform the rest of the world, but also the front end to outperform the back end of the Australian curve. We took some profit on our Australian steepener position, moving 0.2 years from the front end to the back end of the curve. 

We started the month with no US duration exposure, but holding a 0.5 year steepener trade by being long the front end and short the back end. Ahead of the Fed meeting, we increased our US breakeven trade by 0.2 years to 0.4 years and sold 0.3 years from the US back end. Despite the US Federal Reserve cutting rates, US bond yields significantly underperformed with 10-year and 30-year yields increasing 40 basis points over the month. 

The US 10-year bond ended the year yielding 4.6% and US 2-year yield ending at 4.2%. With the 2-year bond yield equal to the current Fed funds rate, we added 0.25 years to duration in the US front end. We also took profit on our long German Bund position and shifted 0.2 years from Germany to UK Gilts, where less rate cuts are priced in. 

We continue to prefer Australia, German and UK duration to the US, hold inflation protection in Australia and the US and prefer steepeners in the US, Australia and Germany.