Sell in May and go away?

April was the month the market realised inflation would be stickier than expected. The US Consumer Price Index rose by 3.5% in March, beating expectations of 3.4%, and up from February’s 3.2% print. After pricing in 150bps worth of cuts for 2024 at the start of the year, the market has adjusted their rate cut expectations to only one rate cut this year. This saw bond yields rise, with the US 10-year bond yield backing up 50bps to 4.7% at the peak in April and the US 2-year yield hovering around 5%. Commodities rallied almost 4%, credit spreads widened and equities sold off by 5% peak to trough. For the first time since the ‘Powel Pivot’ at the end of 2023, the market started to worry.

We have been making the case for our preference for equities over bonds based on our view that stickier inflation would be offset with higher growth. 

However, we mentioned a likely pullback in risk for three main reasons – rate pricing was too dovish, sentiment was exuberant and positioning was stretched. In our last commentary, When Doves Cry, we asked whether higher growth and stickier inflation would cause the remaining doves to capitulate on their rate cut calls. While it’s too early to say whether the last cut gets priced out for this year, or even whether the market shifts to pricing in rate hikes, we are getting closer to more reasonable market expectations in rates.

Sentiment and positioning is also starting to improve, but not yet at contrarian buy levels. US equity positioning fell from 2 standard deviations long back down to 0.5, mainly from a reduction in retail participation whose quarterly capital gains tax bill came due on April 15th. Momentum trading funds, risk parity and volatility targeting funds have also pared back their positions, but could have further room to sell if volatility remains high or momentum rolls over. Sentiment is also improving, the AAII bull-bear spread fell down to a more neutral level. Technical indicators like the relative strength index (RSI) approached a buy zone and price levels on the S&P 500 found support at 5000 and the 100 day moving average. So while still early to say sentiment and positioning is positive, it’s moved from being a strong negative to neutral.

The biggest question this month came from our outlook on growth. 

The US first quarter GDP print came in lower than expected at 1.6%, well below the 2.5% consensus forecast and the 3.4% print from the prior quarter. Is this the canary in the coalmine? Any sign of economic weakness combined with sticky inflation would point to a shift from a goldilocks backdrop to stagflation, in which case both equities and bonds would suffer. US GDP was held back by net exports and inventory, but underneath the surface, domestic demand remains strong.

Consumer spending climbed a solid 2.5% and business investment rose more than expected. Contribution of consumption to real GDP remained above the post-GFC trend signalling no slowdown from consumers. Contribution of residential fixed investment to real GDP picked up noticeably, indicating continued demand for new homes and renovation, not a sign of a weakening household. The contribution from inventories will continue to be volatile given the ongoing bullwhip effect, so by itself not a cause for alarm. The decrease in net exports, despite detracting from GDP, point to a solid consumer who is buying more from overseas. Global growth is far weaker than the US, so this is to be expected, but recent trends show green shoots with global industrial production and global manufacturing PMIs (both ex-US) starting to improve. For these reasons, we choose to look through this data print and do not see it derailing our view on strong US growth.

US equity earnings have continued to deliver this quarter. While only half way through, earnings are beating expectations by 8.4%, which is higher than last quarter’s 6.9% and better than the historical average. First quarter estimates also declined less than normal leading into the season, resulting in a strong uptick in overall earnings per share (EPS). EPS growth is still highly dominated by mega cap tech pointing to growing dispersion in company profitability. Smaller companies are still suffering from higher costs and reliance on floating rate debt, but mega cap companies are reaping the rewards of terming out their debt and delivering strong cash flow. Based on our view that the manufacturing cycle in the US is rebounding, there is still the possibility that the S&P 500 laggards catch up in the coming earnings season, but for now quality remains the winner.

We continue to favour equities over bonds. 

With more appropriate rate cut expectations, a washout of extended sentiment and positioning, and a still positive view on US growth, we believe we are closer to buying the dip than capitulating on our pro-growth call. Within equities we still prefer the US and Japan but have moderated our underweights to Europe and emerging markets. We added 2% to equities over the month, increasing our delta-adjusted equity weight from 33.5% to 35.5%. We continue to hold S&P 500 puts which expire in May with a strike of 4900 – around 3% below current levels. We would like to see further weakness, more negative sentiment and positioning or even more hawkish rate expectations before adding more.

While we believe rate cut pricing is becoming more reasonable, we still think it’s too early to extend duration more meaningfully. We have added 0.25 years to target 2.5 years at the portfolio level adding to both US 2-year and 5-year futures. Despite the uptick in inflation, we believe the US Federal Reserve will err on the dovish side relative to the inflation backdrop, and combined with likely increased fiscal spending post the elections, could see the US yield curve steepen. We continue to hold exposure in German duration, where the growth dynamics are less favourable and the need for rate cuts is more likely. In currencies, we reduced our foreign currency position to favour AUD by selling USD and CHF. Foreign currency positioning stands at 8% at month end.

Finally, the portfolio continues to build inflation protection. We added another 1% to commodities at the start of April to insulate the portfolio from any surprise supply shock or geopolitical risk. Given our view on a no-landing, commodities still appeared relatively cheap compared to this view. We continue to hold positions in commodity-related equities and inflation-linked bonds.

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