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Commentary: Pitfalls of an everything rally

With 10%+ year-to-date gains across a wide range of asset classes, 2024 has turned out to be much better-than-expected for investors. Despite the burden of high interest rates, simmering geopolitical risks, and record high valuation, volatility has come down and the breadth of the rally has widened. What are the drivers and how sustainable is this?

First, some stocktaking, starting with commodities. Gold and copper, bellwether for precious and industrial metals, respectively, have soared this year, while energy markets have been subdued. For gold, the high yield on US treasuries is typically a bearish signal, but heightened geopolitical uncertainty, especially the weaponization of the greenback by the US authorities in recent years, has kept gold and silver investors interested. Agriculture prices have rallied here and there, including of cocoa, coffee, and rubber, but key food prices like rice, corn, wheat, and soybean have been well behaved. Copper’s rally is a bit puzzling, given high inventory and subdued demand, but it is likely reflecting expectations of a sizeable global rollout of green energy infrastructure.   

Some commodity prices may have rallied in a puzzling manner, but that phenomenon is nothing compared to the utter comfort with the bullish dynamic in equity markets. US stock markets are at an all-time high, while VIX volatility is at its lowest in the cycle. Some of the exuberance is clearly in the tech sector,  related to AI, but there has also been substantial run-ups in a wider array of sectors, including pharmaceuticals, financials, consumer durables, and communications.   This rally is particularly notable given the historically high yield-gap between AAA debt and equities.

The equity rally has not just been US-centric. Several Asian stock markets have returned handsomely in USD terms so far this year, including Malaysia, Hong Kong, India, Japan, and Vietnam.  Pressure from USD rates or USD itself have not held back these markets.

Credit has shown strength, as US credit spreads, both high yield and investment grade, have narrowed to historic lows despite sustained monetary easing. Just like the stock market, credit has rallied beyond the US market as well. A key reason for strong credit performance has been the fact that despite narrow spreads, corporate debt is yielding high in absolute terms. Additionally, market liquidity is ample, assuaging investor concerns about a liquidity squeeze. It is worthwhile to note that despite two years of quantitative tightening, G4 central bank balance sheet size, as a share of GDP, is still higher than the pre-pandemic level. Credit is not uniformly strong. US commercial real estate market, and Hong Kong and South Korea’s property sectors remain vulnerable to high rates. China’s property markets have sizeable stress as well, but they are receiving steady support from PBOC’s policy easing.

The higher-for-longer narrative has manifested in a strong USD this year, forcing investors to reverse their positioning, as they had come into 2024 largely short the greenback. All major currencies have lost their value against the USD, with the Japanese yen the most extreme, down by 10%+ ytd, building on another double digit decline the previous year. What we find remarkable is that the strong USD, coupled with high US interest rates, have not caused any financial stability issues worldwide.

All this boils down to Fed pricing. The markets may have been wrong on the Fed cutting rates expeditiously this year, but the thought process behind the Fed narrative has evolved. We came into 2024 expecting economic slowdown and resultant softening of price pressures. Inflation has proved to be stickier than expected, but not in an alarming manner. Meanwhile, the growth dynamic has been largely constructive. Expectations around earnings and wages have therefore remained sound, underpinning the everything rally, in our view.

But so much strength in the financial markets, such lack of volatility, and such little stress, so far, from high rates make us a tad anxious. How much longer before profit taking makes sense; at what point does quantitative tightening becomes material; and when does the financial system step into a landmine of leverage larking beneath the surface? We worry about the collateral damage from a sizeable market correction, especially as higher the market climbs, the bigger the eventual adjustment becomes. While recognising the global economy’s pleasantly stronger-than-expected shock absorption capacity and genuine underpinning for the markets from the new tech wave, we will keep our fingers crossed for a soft landing ahead. Markets reaching dizzying heights at this point in the cycle have typically been a harbinger for corrections ahead.


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