The proverb “Don’t look a gift horse in the mouth” comes to mind when looking back on the market’s returns for the first quarter of the year.
The phrase advises against critiquing or finding fault with something given as a gift. Boy, was the first quarter a gift . In my line of work, a chart that moves in one direction – up and to the right – is a gift.
The market has been on a historic run since November of last year, driven by several factors:
- The Treasury issued fewer coupon bonds than expected, affecting the supply of government securities.
- Inflation has been largely trending in the right direction, easing concerns over purchasing power and interest rates.
- Earnings have exceeded expectations, indicating stronger corporate health and profitability.
While all these reasons probably have some truth to them, one underlying truth always holds in such market conditions: There has been stronger demand to buy than there has been to sell.
I am talking about sentiment. The market has teetered between “greed” and “extreme greed” on the CNN fear and greed indicator for quite some time, and while this is not a great indicator for future returns, I would argue it does a pretty good job of gauging current sentiment. It raises the question: Who is left to be bearish? Especially considering there has not been a day when the market has been down 2% in over six months? Where the indices are closing in on double-digit returns in the first quarter?
This market can be described as “not letting bears in.” If you have been bearish and waiting for a large pullback to be able to put money to work, then you’ve been out of luck.
OAKWORTH INVESTMENT COMMITTEE’S STRATEGIC ALLOCATION
So, what does this mean for our allocation? What have we done, and how are we positioned for where we are going?
In our last issue (4th quarter, 2023), I wrote about how technology stocks had been outperforming. While this largely continues to be the case, we are seeing more names, more sectors and even smaller companies starting to contribute as well. This broadening out has been something that we have been expecting to happen. I also wrote that this didn’t mean tech would do poorly, or even that it would underperform, just that more names would start to contribute.
For our portfolios, this meant finding areas to trim over the 1st quarter. Naturally the outperformance of tech stocks resulted in a greater overweighting than we wanted in our portfolio. As a result, we trimmed the sector a bit with a goal of obtaining a more balanced distribution between growth and value investments. This rebalancing effort has been difficult to achieve given the continued run that the technology sector has been on.
With a portion of funds raised from the tech sector, we added to our gold exposure as well as our cash reserves.
GOLD
Gold, the long-loved precious metal, seems to have had a second wind, as the oft-sleepy asset has outperformed many stock indices through the 1st quarter. While the metal is commonly viewed as a hedge against inflation, gold’s performance is more directly correlated with real interest rates. That means any given interest rate minus the expected inflation over that period. In
essence, gold can be considered a non-interest-bearing currency. Naturally, if you had a stash of cash sitting around or hidden under your mattress, and the real rate you could earn on it was high, you would probably take it out from under your mattress and find a more effective place to invest the money. However, if real interest rates are low or declining, the desire decreases, as the opportunity cost of holding excess cash in a noninterest- bearing form diminishes. This is largely the framework that I look through for precious metals, specifically gold. Additionally, simple supply and demand always plays a role. As central banks and individual investors pick up their demand for precious metals, it can create this upward movement in prices – much like we saw in the 1st quarter.
CASH
Cash, on the other hand, remains the silver lining of a rising rate environment. The higher rates of 2022, in response to the uptick in inflation, continue to linger, and the market expectations for rate cuts continue to be pushed back further. The mantra “higher for longer” has been here to stay. This is not inherently a bad thing, as the delay in rate cuts is a reflection of the continued strength of the economy. While the Fed waits to gain greater confidence that inflation is headed back toward their 2% target, they continue to be able to buy themselves time with nothing seemingly breaking in the economy yet. As long as this continues to be the case, the rates on cash will remain elevated even if they do come down slightly towards the end of the year.
For us, cash on hand is optionality. It will always be “dry powder” and nice to have a sliver of cash in a portfolio; however, when cash is generating positive real yields, it also has become a significant asset class. It currently takes the beauty of bonds, in generating income, without any interest rate sensitivity. We will take it while we can.
FIXED INCOME
Bonds, on the other hand, continue to struggle over deciding what the going narrative should be.
- Should yields move lower because higher interest rates must eventually impact the economy?
- Or should they move higher as the incoming economic data continues to be strong?
- Should rates move lower as inflation trends lower?
- Or should they move higher as the Treasury is forced to issue more notes and bonds than they ever have?
The narrative literally changes daily, influenced by varying economic data, Treasury auctions and comments from the Fed. All in all, this has led to very little action from the fixed income markets over the 1st quarter of the new year. While the stock market has chosen its narrative, the bond market continues to be perplexed. Frankly, I understand the confusion. At times, the mix of data that we use to build our mosaic doesn’t always seem to be congruent. While some data points show signs of strength, others are showing signs of weakness. Because of this, as well as the favorable rates we locked in in the 4th quarter – as previously discussed – we felt it prudent not to make any significant changes to our bond portfolio.
Credit spreads and municipal bond spreads have not risen enough to justify taking any bets on the riskier parts of the commercial paper space or the municipal bond space, where the risks are often unconsidered. Consequently, we have continued to maintain a heavy weight toward Treasuries as well as investment-grade corporate bonds, the highest rated in this category.
OUR OUTLOOK
Take all of this, and what do you get as far as our outlook? The easy response is that the phenomenal rally that we have had over the past few months should not last forever. This by no means signals a significant pullback. It could be a period of choppiness or a period of doldrums. Such a phase could emerge in the next quarter, later in the year or even farther down the line.
We do not want to look a gift horse in the mouth; however, we do want to be prepared to capitalize on any opportunities that present themselves over the coming few quarters. As always, we will continue with our mandates of protecting downside and maximizing risk-adjusted returns.
The opinions expressed within this report are those of the Investment Committee as of the date published. They are subject to change without notice, and do not necessarily reflect the views of Oakworth Capital Bank, its directors, shareholders or employees.
This content is part of our quarterly outlook and overview. For more of our view on this quarter’s economic overview, inflation, bonds, equities and allocation read our latest issue of entire Macro & Market Perspectives.
