Markets Update - January '24

1. Key takeaways from 2023

2. Japan continues to improve corporate governance

3. Higher rates’ effects on government, corporates, and consumers

4. Lower rates and no recession is the perfect scenario for small and mid-caps

1. Key takeaways from 2023

• Narratives: The excitement around Artificial Intelligence drove the market for the first half of the year (mostly benefitting only the Magnificent 7), whilst 2H was mostly a yield story (yields up and markets down in October, only for this to reverse in spectacular fashion in November/December).

• Performance: The Nasdaq 100 had its best year since 1999 (up 54%), the S&P 500 closed the year with the longest winning streak since 2004 (9 weeks), and the Eurostoxx hit at two decade high. Commodities lagged last year with the exception of gold.

• Valuations: The S&P 500 has now expanded by more than 30% since the bottom in October 2022, and currently trades at a 20.5x PE multiple. We don’t get too hung up on headline multiples as we believe the driver of this rally is liquidity and not fundamentals and, as we’ve explained in the past, as long as the US continues to receive more inflows than the rest of the world, valuations will expand.

• Activity: We saw last year the largest inflow ever into Money Market Funds (we’ve explained why this matters and what the implications are of a reversal of that in our latest Research piece), it was the least active year in IPOs since the GFC, and the US saw the most significant two-month easing of financial conditions over the last 40 years – credits due to lower yields and the expectation of 6 rate cuts next year (double the Fed’s expectation).

• The Economy: Inflation eased and a recession has failed to materialize (best of both worlds) in 2023, but the de-inversion of the Yield Curve (which has been in place for long enough) and the crossing of the US unemployment rate with its 12-month average indicate that the recession story will probably be a 2024 story.

• 2024 Outlook: We recommend you revisit our December Markets Update if you want to have a summary of what Wall Street is expecting, and our somewhat contrarian take “What if the Fed Doesn’t Cut Rates in 2024?”.

2. Japan continues to improve corporate governance

As we wrote in June last year:

• “The Tokyo Stock Exchange has recently announced the single most important initiative in over a decade that could boost Japanese equity markets.

• The TSE is aware that there is a structural undervaluation of Japanese companies (low P/B ratios versus global counterparts) that mostly stems from low profitability (low ROE, ROA, ROIC) – which, in part, can be attributed to the large cash balances that Japanese companies currently sit on.

• The TSE is trying to solve this issue by “forcing” companies to improve corporate disclosure, promote periodic updates to keep investors aware of improvements and, most importantly, requiring companies that trade below 1x P/B to produce specific goals and strategies to explain how they will move this ratio above the 1x threshold.”

This is a key reason why Japan, last year, has seen the largest volume of inflows in a decade.

The latest update on this from the TSE just came out, and it shows some progress on this initiative. Interestingly, 78% of companies that trade below 1x P/B value and have a market cap of 100bn JPY ($680mn) or more have started to take some action already.

As you can see above, disclosure progress on initiatives to be undertaken to bring the P/B ratio above 1x is more advanced the lower the P/B value of a company is, and that’s normal as those are the companies that are being most pressed by the TSE (remember, the TSE has threatened in the past to de-list them if they don’t take action). Within the banking sector, for example, 94% of companies have disclosed (or currently have under review) initiatives that focus on bringing P/B ratios above 1.

• To be clear, the true narrative here isn’t the resurgence of enthusiasm around the Japanese stock market – we’ve had that at various points in time over the past couple of decades, and those bull calls have tended to be proven premature.

• What’s really different this time is the cultural change that the TSE is forcing upon the market by shamelessly pointing the finger at underperforming companies, in stark contrast to a historically conservative corporate culture.

That being said, we’re still in the early innings of a long-term structural change in the mentality of treasury management. As highlighted by Jason Rosenwald at Dalton Investments: “Japanese management should manage the balance sheet a little bit better because they can borrow at less than a 1% interest rate for seven years. With the capital, you can either pay dividends to shareholders, buy back more stock, use it to buy high-return businesses or do something rather than just sleep. Take advantage of the government's current central bank, just like Warren Buffett.”

Keep in mind:

• Global investors are significantly underweight Japan when compared to history.

• There are over 50 activist funds in Japan currently (this is unprecedented), which are likely to increase scrutiny on corporate governance improvements.

• The share of companies with more than half of directors being external and independent has doubled to 60% recently, but this still needs to improve (public companies should have 50% or more of directors as independent and external).

• There is plenty of room for Japan to improve metrics that should help share price performance.

Until there is a confirmation of a continued execution on the metrics above, Japan will continue to mostly be a bet on the Yen and the acceleration of the global economy given how almost 25% of its GDP comes from exports.

💡 A reminder that we released our latest 'Geopolitics of Commodities' podcast this week with guest Arjun Murti (ex-Goldman Partner), to discuss what he calls "the messy energy transition". Check it out here.

3. Higher rates’ effects on government, corporates, and consumers

The credit cycle has been well-behaved so far, thanks to good balance sheet management from most of the corporate sector (not looking at you SVB).

Despite all the negative headlines we read last year about commercial real estate, what we’re currently seeing is that only regional malls and to a certain extent commercial urban office space are really struggling. For the rest of the market, delinquency data is actually getting better across the board.

Same is true for consumer loans – there is a significant weakness in both credit card loans as well as subprime auto loans (which is 20% of the auto origination market, so it matters only to a certain extent), but mortgages and auto loans are as well behaved as they’ve been since the global financial crisis.

On the corporate side, US large caps have been minimally impacted by higher rates as S&P 500 components now have 75% of debt at fixed rates at long-term rates, compared to less than 50% in 2007. (This, however, may not be true for SMBs both private and public, an issue we dive deep on in our “Maturity Walls” Research piece.)

What to make of this?

There are isolated pockets of delinquency stress in the US economy right now. But risk becomes systemic when most, if not all, delinquencies occur simultaneously – we’re not there yet.

Higher rates are, instead, a problem for the US government given that it needs to refinance $7.6 trillion of government debt over the next year, as well as finance a $2 trillion deficit – and that is before we account for the potential effects of a recession.

Luckily, Jeff Gundlach’s DoubleLine Capital has run the math for us.

• Their analysis shows us that, over the last three recessions, federal budget deficits have increased by around 8%-9% of GDP in the three years following the recession. If we increase the data sample to the past 50 years, that number was around 5% of GDP (this shows how the US Government’s reaction to economic recession has been gradually more significant since the 1990s).

• If we’re to believe a recession will occur in 2024, then the deficit over the next couple of years might come in 2x to 3x larger than the one the US is currently dealing with.

US debt to GDP already at 130% and interest payment are already expected to reach 20% of tax income in 2032 BEFORE accounting for any increase in budget deficits going forward (which can only be financed by debt issuance). Imagine what that number would be if we were to see the expansion in budget deficits we saw in the past...

How can we expect rates to stay high for a long time?

4. Lower rates and no recession is the perfect scenario for small and mid-caps

The best setup for equities is for the Fed to cut rates without a recession taking place:

In a market backdrop where the Fed cuts and the economy doesn’t collapse, the Russell 2000 should perform quite well (this would also help assuage the maturity walls concerns we discussed above).

Why?

• Companies within this index are more sensitive to the domestic economy: 90% of their revenue comes from the US (vs 60%-65% for the S&P 500).

• They are more sensitive to rates: as explained above, US large caps have been minimally impacted by higher rates. The same is not true for the Russell 2000, given that their share of floating rate debt is 45% - so significantly higher than that of the S&P 500 – and ND/EBITDA is 2x that of the S&P 500. This is why the Russell rallied hard in November/December, as the rate cut narrative took place. This is also why the Russell 2000 is down almost 5% YTD (as the rate cut narrative is suddenly being reassessed).

Valuation is favourable (if you look in the right places): 40% of companies in the Russell 2000 have negative earnings, but if you exclude those, the valuation discount of profitable IWM companies against the S&P has reached extreme levels.

Worth keeping this in mind for 2024, especially if a recession fails to materialize.

💡 If you're looking for a smart aggregator of Wall Street market trends, trade alerts, and economic forecasts, we recommend you check out Simplify Wall Street. It's a solid resource to keep consensus analyst views front and center for you to then make your own adjustments and form your own opinions. Check them out here.