Played Out. Priced In. Now What? An Alpha Approach
Many investments have had their run. The market has already priced in significant rate cuts. The question is, now what? We believe a rebalance makes sense. In this article, we lay out a “Played out. Priced in” problem and make an argument for alternative strategies as part of the solution.
In recent years, investors taking advantage of attractive yields, stability and capital gains have put their trust in cash-like instruments such as cash, Guaranteed Investment Certificates (GICs), and short-duration, single-name bonds. As rates peaked, these products thrived and afforded attractive returns with minimal risk. However, the tide has turned. As central banks shift their policies and lower rates, the yield potential of these instruments has declined from recent highs. GIC rates for example, once above 5%, are trending down at a steep pace and will likely tumble below 3% by 2025.
Mega-cap technology stocks, even more notably the “Magnificent 7,” have been the darling in the equity market and have played a significant role in driving the strong performance of the S&P 500 in the first half of 2024. However, they have been lagging the rest of the market in recent months.
The 3rd and 4th year of U.S. presidential cycles have historically had good average returns for U.S. equities. We have already had a tremendous return in the last two years of the current cycle.
On September 18, 2024, the U.S. Federal Reserve (the Fed) made a 50bps rate cut. The Fed chose to stimulate a slowing U.S. economy rather than remain firm to buffer against potential inflationary forces on the supply side. Even though the level of cut was more than the market’s expectation of 25bps, the U.S. 10Y Treasury rates were up after the announcement, meaning the rate market has already priced in a large rate cutting cycle and duration may be a challenging risk/reward.
In Canada, as of September 24, 2024, the market has priced in 175 bps of rate cuts over the next 12 months. This is equivalent to six rate cuts, which makes a total of 250 bps of easing when adding the 75 bps of cuts the Bank of Canada has made already this year. Market expectations reflect a cooling economy and falling inflation.
Some investors, hoping to benefit from future rate cuts, are extending the duration of their fixed-income portfolios with longer-dated bonds. However, the market has already priced in that number of cuts so unless the economy experiences a severe downturn, the potential gains from taking on additional duration risk is limited. In fact, even if these rate cuts materialize, our analysis suggests the 10-year government bond yield may rise from here as the yield curve normalizes and gets back to a positive slope.
As described above, there are clear implications from the current market and the start of this rate cut cycle:
Expected returns for cash instruments are likely to be less attractive.
Equity market reacted with risk on sentiment while valuations remain stretched across.
Long-duration bond investments have priced in future rate cuts.
There are deeper potential implications:
Risks that inflation may come back sooner if growth re-accelerates given the structural issues in both housing and commodities.
The shorter economic cycles would mean higher market volatility.
Stocks and bonds have returned to the historical norm of positive correlation from the negative or low correlation that balanced portfolios have enjoyed from 2000 to 2020. Traditional 60/40 balanced portfolios might be challenged.
What should we do now? Where should investors turn to find diversification, potential decent returns and stability?
We suggest to “Fix the Mix” in the portfolio by adding Alpha. In other words, diversifying absolute return strategies.
How can they help in investor’s portfolios?
No or low market risk exposure to traditional assets – less impacted by stock and bond volatilities.
Low volatility – dampen the overall portfolio volatility and aim to provide a smoother ride to financial goals.
Consistently positive and cash plus return potential over time – a better replacement for cash while providing better downside mitigation and target to outperform cash during negative market scenarios, enhancing the quality of returns in the portfolio.
This material has been published by Picton Mahoney Asset Management (“PMAM”) on November 13, 2024
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