Liquidity and US mega caps drive share prices

Author: Filippo Casagrande, Chief Investment Steering & Sustainability Officer of Generali Investments

After the sharp drop in yields seen in the later part of 2023, this year has so far been characterised by some rise in core yields, both in the US and in Europe. The 10-year US Treasury rate returned to the 4.3 % area (from 3.8 % in December) and the Bund rate rose to 2.4 % (from 1.9 % in December). Similar trends were seen all along the curve, with an initial steepening of the curves in January quickly receding in recent weeks due to higher short-term rates.  

Generating this upward movement was a reassessment by investors in the timing and magnitude of the expected central bank cuts during 2024. Indeed, while in recent weeks there had been talk of a possible first rate cut as early as March, now the market is pricing in a first cut - for both the ECB and the Fed - no earlier than June.

The resilience of the US economy and the less pronounced than expected drop in inflation numbers were the main drivers behind this repricing of expectations.  

In this context, the market has continued to reward carry trade strategies in the bond world: I recall that the expression Carry Trade refers to one of the many investment strategies that consists of borrowing capital in a given currency in order to invest it in financial instruments denominated in other currencies and in any case with a return higher than the cost of financing. The profit obtained is precisely equal to the difference between the return on the investment and the cost of financing.  

The BTP-Bund spread has fallen below 150 basis points and credit spreads have fallen to their lowest level since early 2022, both in the Investment Grade world and to an even greater extent in the High Yield segment. At the same time, the continued increase in excess liquidity in the US once again supported the equity markets, which remain led by the Mega Caps, especially in the technology sector (Nvidia, Meta Platforms and ASML in Europe have risen between 30% and 50% since the beginning of the year).  

The trend of excess liquidity is proving to be a key factor in supporting stock markets. Looking at the Fed's balance sheet, we see how Reverse Repo Agreements have fallen further, to just over 500 billion (they were at 2300 billion in spring 2023).   

As we know, the reduction in Reverse Repo Agreements has a far less negative effect on equity markets than the reduction in excess liquidity in the strict sense. The latter, on the other hand, has risen further in recent weeks, exceeding 3.5 trillion, a year-on-year increase of 500 billion, concentrated in the last quarter of last year.  

As long as excess reserves continue to rise, the stock market remains supported by liquidity, which counterbalances the negative impacts of high real rates and valuations above historical averages, especially in the US.   

This evolution of excess liquidity and the decisions that may affect it over the next 2-3 months should be the focus of analysis and portfolio management.   

In the short term, the dynamics still remain favourable for equities (and for the riskier assets in the credit world), but in the absence of a stop to Quantitative Tightening, the dynamics look set to change direction in the near future.

A look at macroeconomic data

The big surprise came from the resilience of the US economy, while growth in the Eurozone basically stalled at around zero. In the fourth quarter, year-on-year growth in the US was 3.1 %, while the Eurozone at a very modest +0.1. In the US, the average growth estimate for 2024 rose to +1.6% from the previous +1.3%, thus surpassing the Eurozone's estimate for this year, which was stuck at +1.4% (2023 was revised downwards to +0.5%). For inflation, on the other hand, the average annual figure for 2024 sees a slight decrease for the Eurozone from +2.5% to +2.3% and a slight increase for the US from +2.6% to +2.7%.

Given the growth data and the slowing pace of decline in core inflation, it is therefore not surprising that markets have repriced expectations of rate cuts by the ECB and Fed.  

As always, the main antagonist to an easing of monetary policy remains fiscal policy developments. In the US, there is little progress on curbing government spending and in an election year it will be difficult to see moves towards more restrictive policies that would damage growth. By contrast, in the Eurozone there are countries that have made significant progress (such as Germany and to some extent Italy over the past year and a half), while others (France above all) are still struggling to contain spending.

Financial markets and outlook

In the short term, liquidity remains supportive for risky assets (equities and riskier spread products), but the more expensive level of valuations cannot be ignored. On interest rates, short-term dynamics offer no particular cues and a sideways phase seems to be the most likely scenario.  In the medium term, the risk/return balance seems once again to be more favourable for bonds and credit with high quality ratings.    

Among government bonds, we remain constructive on BTPs, despite the already significant drop in the spread. The decisive reduction in deficits over the past 15 months has secured rating levels, while growth, although falling sharply, remains broadly in line with the European average.   

In credit, we prefer carry trade strategies, with a combination of high yields and low duration, combined with a focus on quality. Here we favour a balanced stance between financials vs. non-financials.

On the equity side, it is hard to ignore the high levels of valuations, especially in the US, and the euphoria associated with Artificial Intelligence. Stellar performance remains concentrated in a few sectors and stocks, which must confirm the very high earnings growth expectations. In the short term, high liquidity remains a supportive factor, especially in the US and for cyclical sectors such as Tech, but we also advise caution in the medium term, given the expectation of a gradual reduction in excess liquidity in the second half of the year.