Current uncertain rate environment creates great opportunities for investors!

-The higher interest rates recently have been burning a hole in the pockets of consumers globally. These high rates have also driven the cost of capital for businesses visibly higher and chipped away at the equity value of homeowner’s equity. Interest rates not only dictate the borrowing cost for public but also for governments who borrow by issuing debt. This is generally referred to as the “debt supply”. Yet the mention of “debt supply” seemed to disappear from the vocabulary of most investors starting in November 2023.

–Unlike bonds, developed market equities were more focused on the stable or softening core inflation and relatively low unemployment in the US and Eurozone alongside resilient macroeconomic data. Buoyed by the positive sentiment equities had a good month. As of January 26^th, the US equity index S&P 500 and European stock index Euro Stoxx 50 were both up by +2.5% on the month.

–As inflation fears abated, the price of gold reversed its upward momentum and started to soften up going into 2024. Investors turn to gold as a store of value and a hedge against uncertainty and inflation and the reverse happens as uncertainty and expected inflation subside. Case in point, as of January 26^th, the first month futures contract for Gold was down by -1.7% on the month.

–Crude oil had a very strong month driven by both demand and supply dynamics. The improving macroeconomic fundamentals supported the expected demand while the ongoing conflict in the Middle East, which is a major oil-producing area cast a shadow on future crude oil supply. Any conflict or geopolitical instability that has the potential to disrupt global oil production or supplies tend to put upward pressure on crude oil prices.

–Crypto markets had a mixed month on the back of speculation that the US Securities Exchange Commission (SEC) would finally approve the new Bitcoin ETFs which would open the crypto market up to more mainstream investors. Bitcoin continued its rally into the early days of 2024 as the markets speculated the timing of the approval, spiked through $47,000 for the first time in two years before sliding below $40,000 briefly and recovering back above $40,000 towards the end of the month.

–Turkish stock market benefitted from the positive market sentiment and had a strong start to the year. As of January 26^th, Turkish stock market index BIST100 gained +11.7% in local currency terms (+9% in US dollar basis). The reason for the monthly performance of BIST100 in US dollar being lower than its return in local terms is due to the appreciation in the greenback against Turkish Lira by 2.5% in January.

–Equity and bond markets maintain their different expectations regarding the rates which creates great return opportunities for investors. But why? Because the longer a market dislocation persists, bigger the window of opportunity gets. These opportunities seldom present themselves and they surface particularly during inflection periods as economic and market cycles start shifting such as the last couple years. And as we have reiterated before, markets will eventually need to converge.

What has kept investors awake at night lately has been one of the most boring markets: bonds! Apart from the fact that higher interest rates have been burning a hole in the pockets of consumers globally, they have also driven the cost of capital for businesses visibly higher and chipped away at the equity value of homeowner’s equity. Interest rates not only dictate the borrowing cost for public but also for governments who borrow by issuing debt. This is generally referred to as the “debt supply”. Yet the mention of “debt supply” seemed to disappear from the vocabulary of most investors starting in November 2023. This was because interest rates dropped as markets started to price in potential central bank rate cuts. This meant a surge in bond prices (as interest rates drop bond prices increase) which gave many bond investors a sigh of relief in their portfolio returns.

As our readers will remember, softening inflation accompanied by resilient macroeconomic data had sparked bets amongst investors towards the end of 2023 that central banks would not only hold the rates steady but may even start cutting them noticeably throughout 2024. This shaped up most of the action towards the end of 2023 where not only risk on assets such as equities, crypto and some commodities spiked, but safe haven or risk off investments such as bonds also gained. In short, the focus on developed market central bank rate policies took over the supply and demand dynamics in the bond markets.

THE YEAR END EUPHORIA IN BONDS STARTED TO WANE IN JANUARY

This year-end euphoria in bonds started to wear off in the first days of 2024 as market players begun to face the stark reality of increasing debt burden in developed markets. Starting in January, treasuries of large players like the US, UK, Eurozone and even Japan will sell over a $2 trillion of new bonds to finance their spending. According to Bloomberg Intelligence estimates, this is roughly a 7% increase from last year.

With quantitative easing becoming a remote memory, central banks are no longer gobbling up the debt which flooded the markets with cheap money. Instead, they are looking to flood the markets with more debt gradually sucking up liquidity, hence pushing the interest rates up once again.

What does that mean for investors?

This will likely translate into higher nominal interest rates similar to those we have seen in 2023, at least in the near term. The supply/demand dynamics in bonds we described above may in fact delay the rate cuts longer than many expect. How do we know that?

The recent data published by IMF underlines the increasing deficit in the developed world. The public debt is now over 110% across developed economies vs. 75% couple decades ago. Much of this has been accumulated by the government financing during the pandemic, increased healthcare accompanying aging population amongst other socioeconomic trends. As depicted on the chart below, most major economies see net borrowing to be at least 2% of GDP through 2028 led by the US.

Expected Net Borrowing as % of GDP 2022 – 2028

Source: IMF, Bloomberg

Note: Figured illustrated above are for net landing/borrowing as % of GDP, which is also referred to as overall balance

In line with this spike in interest rates, bond indices gave back some of their gains running up to the end of 2023. As of January 26^th Bloomberg Global Aggregate Bond Index, the benchmark for global investment grade bonds, dropped by -1% on the month. Bloomberg Global Corporate Bond was also down on the month losing -0.9% while the High Yield Bond Index remained flat.

Now let’s look at other markets and how they fared through the first month of 2024.

DEVELOPED MARKETS EQUITIES STARTED THE YEAR ON A POSITIVE NOTE

Unlike bonds, developed market equities were more focused on the stable or softening core inflation and relatively low unemployment in the US and Eurozone alongside resilient macroeconomic data. Buoyed by the positive sentiment equities had a good month. As of January 26^th, the US equity index S&P 500 and European stock index Euro Stoxx 50 were both up by +2.5% on the month.

As usual the global equity markets benefitted from this optimistic outlook as well. Over the same period the global equity indicator MSCI All Country World Index (ACWI) was up by +1.1% while the emerging market index MSCI EM dropped by -3.3% on the month. Unlike many of its developed market peers, the UK equity index FTSE100 started the year with a loss of -1.3% due to weaker than expected macroeconomic data alongside stubborn headline inflation.

GOLD GAVE BACK SOME OF ITS GAINS FROM 2023

As inflation fears abated, the price of gold reversed its upward momentum and started to soften up going into 2024. Investors turn to gold as a store of value and a hedge against uncertainty and inflation and the reverse happens as uncertainty and expected inflation subside. Case in point, as of January 26^th, the first month futures contract for Gold was down by -1.7% on the month.

CRUDE OIL PARED MOST OF ITS LOSSES IN 2023

Crude oil had a very strong month driven by both demand and supply dynamics. The improving macroeconomic fundamentals supported the expected demand while the ongoing conflict in the Middle East, which is a major oil-producing area cast a shadow on future crude oil supply. Any conflict or geopolitical instability that has the potential to disrupt global oil production or supplies tend to put upward pressure on crude oil prices. As of January 26^th, the first month futures contract for US crude oil WTI was up by a whopping +8.9% on the month, reversing most of its loss of -11% in 2023.

CRYPTO HAD A MIXED JANUARY

Crypto markets had a mixed month on the back of speculation that the US Securities Exchange Commission (SEC) would finally approve the new Bitcoin ETFs which would open the crypto market up to more mainstream investors. Bitcoin continued its rally into the early days of 2024 as the markets speculated the timing of the approval, spiked through $47,000 for the first time in two years before sliding below $40,000 briefly and recovering back above $40,000 towards the end of the month. After all was said and done, as of January 26^th both Bitcoin and Ethereum were slightly down on the month by -1.2% and -1% respectively. Bitcoin and Ethereum both had a phenomenal 2023 with +157% and 90% gains respectively.

TURKISH STOCKS STARTED THE YEAR STRONG

Turkish stock market benefitted from the positive market sentiment and had a strong start to the year. As of January 26^th, Turkish stock market index BIST100 gained +11.7% in local currency terms (+9% in US dollar basis). The reason for the monthly performance of BIST100 in US dollar being lower than its return in local terms is due to the appreciation in the greenback against Turkish Lira by 2.5% in January.

MARKET DISLOCATIONS CREATE GREAT RETURN OPPORTUNITIES

As we have discussed in our previous issues, equity and bond markets maintain their different expectations regarding the rates which creates great return opportunities for investors.

But why?

Because the longer a market dislocation persists, bigger the window of opportunity gets. These opportunities seldom present themselves and they surface particularly during inflection periods as economic and market cycles start shifting. This is exactly what the markets have been witnessing since late 2021.

As we have reiterated before, markets will eventually need to converge and agree either on the equities’ story line which expects a soft landing and lower rates or that of the bonds which expects inflation to persist and rates to remain elevated a while longer. Regardless, this is a great period for investors to continue adding more credit and rates related products, particularly those with shorter duration that can benefit from a lower but upward trending yield curve.

As global economies continue to learn to live with inflation, having exposure to investments with inflation protection features such as gold and real assets such as real estate and infrastructure through ETFs could help bolster risk-adjusted returns for diversified portfolios. It is impossible to create the perfect portfolio, but it is very possible to enhance the risk return characteristics of any portfolio. Borrowing a famous quote coined roughly a century ago, investors should remember that it is better to be roughly right than precisely wrong.

ELA KARAHASANOGLU, MBA, CFA, CAIA

International Finance Expert

karahasanoglu@turcomoney.com

ela.karahasanoglu@ekrportfolioadvisory.com

https://www.linkedin.com/in/elakarahasanoglu/