Q4 Asset Allocation Update

Q4 Asset Allocation Update: Thursday 14th November

Podcast Politics

November 2024. by PM

Executive Summary

The largest election day market move will need to consolidate US Federal Reserve seeks to dampen expectations of further immediate interest rates cuts. US inflation measures, such as supercore, begin to track higher. New administration policies will be inflationary, at least at the margin, yet generally earnings-supportive. Pick you spots - we expect certain sectors to dramatically outperform others during the course of 2025

Pop and Drop

The financial markets have cast their vote, and Bidenomics was clearly the second choice. Economic mobility arguably may be higher in social democracies, but try convincing a rust belt State. The last 48 hours have been a spectacle of confirmation bias, with everyone seeking to attribute cause to a result that gives Donald Trump the White House, and effective control over both chambers of government. Bernie Sanders believes the reasoning to be economic inequality, others question the Democratic shortsightedness in fielding an incumbent attached to a radioactively unpopular government, and some have pointed to the cultivation of podcasters – the latter evidently suggested by podcasters though.

As the dust begins to settle, perhaps unsurprisingly, given the nature of the impulsive move, stock markets are currently giving up some of the initial knee-jerk reaction to the US election and the latest interest rate cut by the Federal Reserve.

Hot on the heels of the best-performing week of 2024, the SP500 has now dropped 2.1% marking its worst week since September. The Nasdaq has suffered more heavily, having finally managed to make a new high post the election. Big Tech has lagged the other indices and other sectors in recent months, as some of the AI tailwinds have dissipated. The Nasdaq 100 may yet need to retest 20,000 and find its feet there, before perhaps rising again into the year end.

Figure 1: Pop and Drop: US tech stocks have reversed the election fireworks

Source: ARIA, Bloomberg

The abrupt reversal post election fireworks, was likely a recognition of comments made by US Federal Reserve Chair Jerome Powell, in a speech delivered late last week. Powell was on record to state that “economy is not sending any signals that we need to be in a hurry to lower rates.” He also characterised growth in the U.S. as “by far the best of any major economy in the world.” Given those sentiments, investors are questioning the future of interest rate policy, which hitherto was expected to see more easing in December and throughout 2025. Powell’s comments may also give pause to ponder the need for an outsized 0.50% cut in September, but they also raise some uncertainty over the current outlook for lower rates too.

Fixed income markets took note as well. In recent days, expectations for another interest rate cut in December – anticipated at a quarter of one percent - stood at 82%. After Powell’s speech, the odds have fallen to 62%, and the market currently reflects reduced expectations for additional cuts.

Figure 2: 2 Yr Government Bond yields tend to lead monetary policy

Source: ARIA, Bloomberg

The chart above displays the Fed Funds Rate (blue line) compared to the 2-year Treasury Yield (black line). Historically, 2- year government bond yields often have a track record of leading changes in Federal Reserve interest rate policy. Since rising sharply at the end of September, the 2-year Treasury yield is now just 0.45% below the actual policy rate, suggesting the market anticipates fewer than two additional interest rate cuts.

Recent economic data has shown resilience, which gives the Federal Reserve less room to cut rates – or at least justification for doing so. This may have varying implications on the performance of certain sectors – for instance, the interest rate- sensitive semiconductor sector has dramatically underperformed its tech brethren in recent months, but also could weigh ultimately on the growth and inflation backdrop too.

Figure 3: Semi-Detached – semi conductor stocks have fallen behind in recent times

Source: ARIA, Bloomberg

Stall Speed for Interest Rates

Perhaps Central Banks haven’t quite gone as far as taking victory laps in relation to slaying the inflationary serpent, but by cutting rates, they have essentially announced an “all clear”. That may yet prove premature, at least in the United States.

The US Federal Reserve’s mandate is to pursue price stability and full employment – occasionally, a balance has to be struck. The easy gains in softening inflation pressures have certainly been achieved, and therefore to a degree that makes further interest rate cuts more challenging to justify.

In an updated report on the Consumer Price Index (CPI), the yearly gain in the headline figure was 2.6% in October 2024. The core figure that strips out food and energy prices gained by 3.3%. Food and energy prices are more volatile by their nature, however the core gauges taken into account change at a much more measured pace. Either way, core CPI stopped falling in July, as the chart below demonstrates – core CPI is represented by the blue line.

Figure 4: Annual Change in US Consumer Price Index

Source: Reuters, Bureau of Labour Statistics, LSEG, ARIA

So ever since September 2022, when inflation peaked, we’ve seen a disinflationary pulse falling from 6.6%. However, that dynamic has now stalled, whilst ‘supercore inflation’, which is a focussed on core services excluding housing, remains stubbornly high. Chairman Powell considers Supercore as the most important measure for understanding inflationary pressures, both as a current read and as an indicator of future trends. In short, when excluding some of the falls attributable to housing, supercore inflation is still running at 4.38% as below.

Figure 5: Supercore Inflation: Fed’s favoured measure which strips out housing costs

Source: Bloomberg, ARIA

Deficit spending continues to run well above what would be considered usual during an expansionary phase as the US economy remains in. The degree to which a Trump administration would add fuel to the inflationary fire is a moot point. Many of his policies, prima facie, including the deportation of millions of illegal immigrants, who help to dampen labour supply costs, could have ramifications. Not to mention the imposition of unilateral tariffs with global trading partners, yet the unpredictability of these policies remains high. Scott Bessent who is considered a fiscal hawk and likely candidate for the Treasury Head role, would seek to implement policies which would counter those deemed inflationary, such as cutting the deficit.

Trump, assuming he can put these proposals past Congress, would likely extend the expiring tax cuts, with the potential for new tax cuts to be enacted as well. At the rising on steeping into political polemic, we’ll simply limit the analysis to the implication of the proposals heard to date. To that end, the chart below from Bloomberg draws very definitive conclusions in the estimated impact on GDP and CPI from tariffs and tax proposals.

Figure 6: The Trump Trade: Tax and Tariff Impacts

Source: Bloomberg Economics, ARIA

So given the renewed uncertainty in the interest rate path, supercore inflation remaining difficult to budge, and the prospect of a Trump administration and circus that it may bring, 2025 is likely to be one which exhibits much higher volatility than the stock markets of 2024 have. Our previous posts have highlighted the historically low equity market volatility, and it seems to have set the stage for a bumpier year ahead. However, that doesn’t necessarily mean an immediate end to the bull market, but rather it may usher in a period of trading opportunities.

Earning Power

By our lights, the current stock market bears more than a passing resemblance to that of 1995, even if monetary policy seems less certain going forwards. Similarly, core CPI was pointing higher and as the disinflationary pulse petered out, the market continued to scale new heights. The smoking gun in that saloon was earnings.

Ultimately, the stock market is a weighing machine (over the short term, it is a voting machine). Stock market progress is inviolably attached to earnings. The chart below displays the forward earnings expectations over the next year for small, mid and large capitalisation companies. Post the 2022 falls, the S&P 500’s outperformance has been predicated upon the fact that large-cap earnings have led the way.

Figure 7: Forwards Looking Earnings Expectations for small, mid and large cap companies

Source: Ben Carlson on X, ARIA

We expect going forward that, with animal spirits re-ignited by a Trump Presidency, US small and mid-cap companies will outperform. Just these past few days, US retail sales came in stronger than expected with a 0.4% monthly gain in October, while the prior month was revised to a 0.8% increase. That very data was instrumental in pushing up the Atlanta Fed’s GDP current estimate to an annualised gain of 2.5%%. That is also putting a handbrake on any rally in saferhaven government bonds, even whilst the Middle East tensions, and the Ukrainian conflicts seem to be gathering pace.

Using our quad regime approach, which describes any given economic environment in terms of the direction of travel in inflation and growth, we can have something of an understanding of where best to be positioned. Should inflation accelerate, that would firmly push us into the ‘reflationary quad’, which favours certain sectors in elevated inflationary regimes.

Figure 8: Equity sector performance in elevated inflationary regimes (3%+ average) from 1973 to 2023.
(Av. 12 month inflation adjusted return %)

Source: Hartford Funds, ARIA

Concluding Thoughts: DIstributed Ledger

So, whilst such a backdrop can challenge stock markets generally, certain sectors such as energy, commodities, and even banking may fare well, delivering positive absolute returns. Therefore, given such sector potential performance, exposures that include energy, and even those offering attractive yields such as Master Limited Partnerships and natural resource exposure have a more than fighting chance of outperforming in the year to come. Visibility in the coming US administration, will likely be a commodity in short supply, and at least in the earliest part of Trump’s term, we should expect that all roads will lead to an extension of the business cycle, resilient GDP, and inflationary readings too. Should inflation become a headline once more, doubtless the President will point to the shortcomings of the current Fed Chair Jerome Powell, who may well become another casualty of this administration just like price stability could be. It’s not beyond anybody’s imagination that any such ‘retrenchment’ of a public official could also be broadcast via podcast.

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As a condition to your use of this Website, you agree that you will not, and you will not take any action intended to: (i) access data that is not intended for you; (ii) invade the privacy of, obtain the identity of, or obtain any personal information about any other user of this Website; (iii) probe, scan, or test the vulnerability of this Website or ARIA’s network or breach security or authentication measures without proper authorisation; (iv) attempt to interfere with service to any user, host, or network or otherwise attempt to disrupt our business; or (v) send unsolicited mail, including promotions and/or advertising of products and services. Unauthorised use of the Website, including but not limited to unauthorised entry into ARIA’s systems or misuse of any information posted to a web site, is strictly prohibited.

22. Amendment:

ACME may delete or make changes to these Terms and to the information contained on this Website at any time. Where such amendments are made, you will be required to accept any such changes in order and prior to continue to use the Website. If you do not accept such revised Terms, you may no longer be able to access this Website. If any provision of these Terms is found by any court or authority of competent jurisdiction to be illegal, void or invalid under the laws of any jurisdiction, the legality, validity or enforceability of the remainder of these Terms in that jurisdiction shall not be affected and the legality, validity and enforceability of the whole of these Terms in any other jurisdiction shall not be affected.

23. Third Parties:

The Umbrella Funds, ACME, and its affiliates shall have the benefit of the rights conferred on them by these Terms but otherwise no person who is not a party to these Terms may enforce its terms under the Contracts (Rights of Third Parties) Act 1999.

24. Applicable Law:

These Terms and any non-contractual obligations arising from or connected with them shall be governed by, and these Terms shall be construed in accordance with, the laws of England and Wales.

25. Jurisdiction:

You agree that the English courts shall have exclusive jurisdiction in relation to any legal action or proceedings arising out of or in connection with these Terms (whether arising out of or in connection with contractual or non-contractual obligations) (“Proceedings”) and waive any objection to Proceedings in such courts on the grounds of venue or on the grounds that Proceedings have been brought in an inappropriate forum. You further agree that this paragraph operates for the benefit of the Umbrella Funds, or ACME and accordingly the Umbrella Funds, or ACME shall be entitled to take Proceedings in any other court or courts having jurisdiction.

26. About ACME and the Umbrella Funds:

Aria Capital Management (Europe) Limited is licensed by the Maltese Financial Services Authority with its registered address at The Hub, Triq Sant ’Andrija, San Gwann, SGN 1612 under Malta Registration number C 26673.

Absolute Return Investment Advisers (ARIA) Ltd is authorised and regulated by the Financial Conduct Authority, under reference 527575, with its registered office at Building 2, Ground Floor, Guildford Business Park, Guildford, GU2 8XG.

ARIA SICAV P.L.C. (the “Company”) a self-managed open-ended collective investment scheme organized as a multi-fund public limited liability company with variable share capital registered under the Laws of Malta and licensed by the Malta Financial Services Authority in terms of the Investment Services Act (Chapter 370 of the Laws of Malta). The Company qualifies as a self-managed „Maltese UCITS‟ in terms of the Investment Services Act (Marketing of UCITS) Regulations 2011.

ARIA SICAV PLC (including each of its sub-funds) is licensed as a collective investment scheme by the Malta Financial Services Authority under the Investment Services Act (cap. 370, laws of Malta) and qualifies as a „Maltese UCITS‟ in terms of the Investment Services Act (Marketing of UCITS) Regulations, 2011 (S.L. 370.18 laws of Malta).

27. Contact Us:

If you have any enquiries in relation to this Website or the information on it, please contact us at funds.enquiry@ariacm.com

Effective as of 1st September 2022