Q1 2024 Market Review

ECONOMIC COMMENTARY

The equity market rally that started in the fourth quarter of 2023 continued in the first quarter of 2024. That being said, if the first leg of that rally was primarily driven by the prospect of imminent rate cuts, the second leg is driven by a combination of rising earnings expectations, receding inflation, and improving sentiment in Europe and China. Against this backdrop, the MSCI All Country World Index[1], the S&P 500 Index, and the S&P/TSX Composite gained 9.50%, 10.44%, and 6.62%, respectively, during the quarter. US large cap stocks extended their dominance during the first quarter, but there was a lot of dispersion among the most widely held stocks. For instance, Nvidia, Microsoft, and Meta (Facebook) appreciated significantly, while Apple, Adobe, and Tesla suffered meaningful pullbacks. The heightened degree of dispersion among stocks also caused increased dispersion in active managers’ performance. Small capitalization equities, which are more financially leveraged and thus more negatively impacted by higher interest rates, continued to lag the broader markets.

In contrast to equities, fixed income markets were flat to mildly down in the first quarter, depending on the segment. To be specific, the ICE Bank of America Global Government Bond Index, the ICE Bank of America Global Corporate and the ICE Bank of America Global Corporate & High Yield Index returned -0.83%, 0.36%, and 0.10%, respectively. In Canada, the ICE Bank of America Canada Broad Market Index lost -1.23%. Shifting anticipations toward fewer rate cuts in 2024 caused short-term bonds and floating rate bonds (like bank debt) to outperform, and the absence of major corporate default events caused corporate bonds to outperform government bonds. We note that the consensus at the beginning of the year called for the Federal Reserve to make 6 or 7 rate cuts in 2024. At the end of the quarter, the consensus was only calling for 2 or 3 cuts, aligning itself with the Federal Open Market Committee’s (“FOMC”) own projections. While analysts were debating about how many rate cuts the Federal Reserve, the European Central Bank and the Bank of England would do, the Bank of Japan became the last major central bank to exit the unconventional monetary policy era when it ended its negative rate and yield curve control policies. The decision was long overdue and widely expected, but it did not do much to relieve pressure on Japanese Government Bonds (“JGB”) or the yen. I elaborate more on this further.

Commodities markets, as proxied by the S&P GSCI Commodities Index, advanced 10.36% during the quarter but, as with equities, there was a lot of dispersion across and within segments. For example, the energy complex was up as the oil made steady gains, while natural gas declined. That said, the most spectacular move in the quarter happened in cocoa, which more than doubled as a drought ravaged crops in West Africa, a region which contributes around 80% of the world’s cocoa output. Cocoa supply will decline by almost 11% over the 2023/2024 season[2].

JAPAN JOINS THE PARTY

As mentioned above, the Bank of Japan abandoned its negative interest policy when it hiked its overnight benchmark rate in March. Japan’s short-term interest rates had been negative since 2016 and it was the Bank of Japan’s first interest rate hike in 17 years. Kazuo Ueda, who has taken over the governor role less than a year ago, did not have much of a choice. Days before his announcement, the Japan Trade Union Confederation declared that the average negotiated pay increase was standing at a 33-year high of 5.28%[3]. In other closely monitored negotiations, Toyota fully accepted union demands, and Nippon Steel even offered more than what its employees demanded[4]. While inflation has been declining in Japan, as it has elsewhere, these headlines were likely enough to convince the Bank of Japan’s leadership that it would likely remain sticky for at least a while. Just to show how much the world has changed, it is worth remembering that as recently as December 2020, there was 16 trillion of sovereign debt globally that traded at a negative yield to maturity[5].

Still, I feel that Japan is not out of the woods. In fact, despite structural upward pressure on wages and post-covid boost in tourism due to a weak yen, consumer spending and other growth measures are stalling. With that in mind, unless the Bank of Japan makes additional moves, it is hard to envision how the downward pressure on the yen and Japanese government bonds recede. After all, government bond yields run significantly higher than expected inflation elsewhere in the world, while they’re still significantly below inflation in Japan. In other words, Japanese bonds are still not competitive.

THE LIQUIDITY CRUNCH THAT NEVER WAS

I started to worry about a build-up in risk aversion when short-term rates began increasing and the Federal Reserve began to reduce its balance sheet. I felt that higher rates could choke leveraged households and corporations. I also felt that the UK bond market scare experienced in late 2022 and the US regional bank scare that we went through a year ago could be a prelude of things to come, and that there could be more unintended consequences to quantitative tightening (“QT”).

However, it turned out that these events marked the low point in aggregate market liquidity and that there was no risk contagion afterwards. On the contrary, liquidity has been improving since. To this point, while the Federal Reserve’s balance sheet was shrinking, so were the Treasury General Account[6] size and the Federal Reserve Overnight Reverse Repo Facility[7] usage. At the same time, commercial lending in China grew nicely last year. Basically, my concern was misplaced.

Nonetheless, I now find myself concerned by the speculative behaviour that an over-abundance of liquidity usually tends to fuel. One of the market segments where speculative excesses seem to have become prevalent is in long-term corporate debt where the risk premium relative to government bonds[8] of equivalent maturity is back to multi-decade lows. To this point, the popularity of Exchange-Traded Funds (“ETFs”) with retail investors and liability hedging activities by institutional investors have driven cash premiums to levels which I feel are unsustainable. To be clear, I’m not recommending to rid portfolios of corporate bond exposure. After all, it is very possible that the benign macro scenario we are witnessing continues and defaults remain contained, in which case corporate credit exposure will continue to deliver small premiums over government bonds exposure. But if the macro environment sours and the recession that was still consensus not too long ago finally hits, within our internally managed hedge fund of funds strategy, we are looking to introduce a strategy that would benefit from a significant widening of credit spreads without getting hurt significantly if credit spreads tighten further.

Another area of concern, even though it may still be a little too early to think about, is that of a second turn for Donald Trump as President of the United States now that he has formally clinched the Republican Party nomination and that he is comfortably leading Joe Biden in the polls. Should he become President and even though he would unlikely be able to implement all the policy changes he wants, thanks to the US Senate filibuster rules[9], chances are that it would be a more populist government than the first time around. The challenge with this is that a recent study[10] showed that the economic cost associated with a populist Prime Minister or President tends to be high, generally resulting in 10% Gross Domestic Product (“GDP”) per capita decline after 15 years, due to ill-advised fiscal, trade, and labor policy choices that provide little to no relative productivity boost. In an environment where debt to GDP ratio is already high and set to increase at a pace of roughly 1 trillion per quarter according to the Congressional Budget Office, a second Trump term could potentially be negative for the US dollar. With that in mind and since clients already have a significant amount of unhedged US dollar exposure via both public and private investments, we have started to explore various levers that we could use to reduce unhedged foreign currency exposure with our external partners. The US dollar is well supported at the moment, but it may not always be the case.

OF DANIEL KAHNEMAN AND LOTTERY TICKETS

On March 27th, we lost Daniel Kahneman, one of the most decorated[11] psychologists and economists. Kahneman, together with fellow economists Paul Slovic and Amos Tversky[12], [13], are often regarded as the founding fathers of behavioral economics.

Kahneman’s empirical research findings challenged the assumption that humans behave rationally in their decision-making process. He demonstrated how the prevalence of various cognitive biases such as:

• availability heuristic bias (the tendency to use information that comes to mind quickly and easily);

• loss aversion bias (tendency to prefer avoiding losses than seeking equivalent gains or, in other words, the tendency to require maximum gains that dwarf maximum loss to justify an action);

• pattern recognition bias (tendency to mistake randomness for momentum);

• herding instinct (tendency to copy others and assuming that they are right); and

• confirmation bias (tendency to favor information that confirms or strengthens existing beliefs), has led to systematic judgment errors and sub-optimal outcomes.

Kahneman’s entire body of work deeply influenced how the financial services sector designs, develops, and markets investment products to capitalize on the well documented biases of investors. 

I believe that we are witnessing a live demonstration of Kahneman’s theories at many levels in the on-going appreciation of Bitcoin and other digital currencies following the widely anticipated approval of the first round of Bitcoin ETFs by the SEC on January 16th[14]. To this point, Bitcoin surged from around US$40,000 to a little over US$70,000 over a few weeks, topping its November 2021 highs of roughly US$65,000. Days before the SEC approval, Cathie Wood of Ark Invest forecasted that Bitcoin would be at US$650,000 by the end of 2024. Would Kahneman argue that this might be a case of pattern recognition bias (see above)? 

I have written about Bitcoin around the time it made its prior peak[15]. That was before China imposed a ban on crypto mining and trading[16], before the FTX debacle, before Celsius, and before the Three Arrows Capital episode. While other investors that I respect, such as Howard Marks[17] of Oaktree, have warmed up to Bitcoin, I remain pessimistic about its long-term prospect because it is not a cash flow producing asset, it cannot widely be used as a means of exchange for goods or services, and it is too volatile to be considered a store of value. I acknowledge, however, that it is a formidable gambling tool whose mass appeal comes from the simple promise of a looming supply squeeze[18] and exponentially growing demand. In a sense, it is a lottery ticket. And it plays to Kahneman’s loss aversion bias demonstration (see above) because, frankly, who cares if the ticket costs $20,000, $40,000, or even $100,000 if the gambler is convinced that the upside is at least $650,000. The small chance of infinite upside, combined with the knowledge that others are also in the game, are fantastic arguments which justify the risk of losing everything. Would this qualify as herding instinct bias for Kahneman?   

In the end, I find it ironic that what started in 2009 as an anti-system gamble has now been hacked by the system itself. To this point, Blackrock, which is one of the most mainstream asset managers globally, has already amassed over 15 billion in assets for its Bitcoin ETF (Nasdaq ticker: IBIT) on which it charges a management fee of 0.25%[19]. Blackrock is not gambling. It is the casino. That’s a great example of a hack by the system, but an even better one is the case of Microstrategy. 

Microstrategy (Nasdaq ticker: MSTR) was, until 2018, an enterprise software company whose stock had not done much in the prior 20 years, but things changed after it rebranded itself as a Bitcoin development company a few years back[20]. What this effectively means is that the firm’s strategic priority has shifted from software development to Bitcoin accumulation. At the end of 2023, it held roughly 190,000 bitcoins[21] that were acquired at an aggregate purchase price of just under 6 billion[22]. Microstrategy issued over 2.2 billion in debt (mainly convertible notes) and over 3 billion in equity solely to purchase Bitcoins. Naturally, Microstrategy’s stock price has become linked to Bitcoin’s price. But there is a twist. As Bitcoin moves higher, it allows Microstrategy to issue more debt and equity with which it acquires more Bitcoin and so on... Perhaps Microstrategy’s CEO Michael Saylor has developed a form of lottery addiction. May Daniel Kahneman rest in peace.

Dimitri Douaire, M. Sc., CFA
Chief Investment Officer

[1] Local currency returns unless specified otherwise

[2] Source: International Cocoa Association.

[3] Source: Japanese Trade Union Confederation (Rengo)

[4] Source: Japan Times

[5] Source: Bloomberg

[6] This account is used for Federal government disbursements. It is the account in which proceeds from the sale of US Treasury issuance and tax payments are deposited.

[7] A facility through which the New York Fed sells a security to an eligible counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. An increase (decrease) in the Treasury General Account decreases (increases) market liquidity because it means that more (less) money is saved by the Treasury than it spends.

An increase (decrease) in the reverse repo facility reduces (increases) market liquidity because it means that eligible counterparties have deposited more (less) reserves at the Central Bank instead of deploying it in the system.

[8] The reason why a structural risk premium exists between corporate and government bonds is that a government can in principle print money to repay current obligations, something a corporation cannot do.

[9] Rule XXII of the Standing Rules of the United States Senate allows the Senate to vote to limit debate by invoking cloture on the pending question. In most cases, however, this requires a majority of three-fifths of the senators duly chosen and sworn. So a minority of senators (presumably Democrats) can block a measure, even if it has the support of a simple majority (presumably Republican).

[10] Funke, Schularich & Trebesch, Populist Leaders and the Economy, American Economic Review, submitted on September 19, 2023

[11] Nobel Prize award in Economics in 2002

[12] Kahneman, Daniel; Slovic, Paul; Tversky, Amos (1982). Judgment Under Uncertainty: Heuristics and Biases. Cambridge University Press.

[13] Kahneman, Daniel; Tversky, Amos (2000). Choices, Values and Frames. Cambridge University Press

[14] We note that while Bitcoin futures have been trading on the Chicago Mercantile Exchange through the Globex electronic platform since 2017. However, as these contracts settle in cash and not in Bitcoin, their existence did not really create incremental demand for Bitcoin. The advent of Bitcoin ETFs, which are buying spot Bitcoin as new shares are created, creates real demand. In that sense, it was true game changer.

[15] https://www.patrimonica.com/all-news/q4-2020-market-review

[16] Admittedly, the ban has not been successful as the Chinese simply switched from trading Bitcoin using Tether instead of Chinese yuan after the trading ban.

[17] In a memo to investors in June 2017, Marks wrote: “…in my view, digital currencies are nothing but an unfounded fad (or perhaps even a pyramid scheme), based on a willingness to ascribe value to something that has little or none beyond what people pay for it.”

[18] Roughly 19,5 million Bitcoins have been mined out of a programmed maximum supply of 21 million.

[19] A portion of the fee is waived in the first 12-month following the inception of the ETF if assets do not exceed 5 billion.

[20] Source : Microstrategy Incorporated 2023 Form 10-K

[21] Nearly 1% of all bitcoins mined to date.

[22] Source : Microstrategy Incorporated 2023 Form 10-K