Q1 2024 Investment Market Update
2024 started the year on a positive note as investors saw a continuation of the Q4 2023 rally, with strong returns seen across most asset classes. As we enter 2024, market sentiment is notably more upbeat than the previous year, driven by a period of disinflation and economic resilience, particularly from the U.S. economy. The easing inflationary pressures have allowed for potential moderation in monetary policies, restoring confidence among investors. With the U.S. showing strong economic resilience, corporate earnings have been better than anticipated, supporting higher market valuations and promising a more favourable environment in the coming year.
While investor sentiment remains buoyant as we navigate into 2024, a myriad of challenges still looms on the horizon. Chief among these is the uncertainty surrounding inflation; questions persist about whether it will decelerate sufficiently to align with central bank targets, potentially justifying rate cuts. Additionally, the lagged effects of previous monetary policies are yet to manifest fully, leaving economists and investors speculating on their potential impacts on global economies. Another critical consideration is the performance of the 'magnificent seven'—a group of leading global equities—which have been market frontrunners but now face scrutiny due to their elevated valuations at the start of the year. The unpredictable nature of the unknown continues to cast a shadow, adding a layer of complexity to investment strategies and portfolio positioning.
Regarding portfolio performance, our portfolios climbed across all three months in the first quarter, generating positive returns, ranging between 4.5% and 9.1%, depending on the strategy. Throughout this period, the investment committee implemented several strategic adjustments to portfolios. By the end of the quarter, the portfolios were positioned with an underweight allocation to risk assets and an overweight allocation in defensive solutions.
International Equities
International equities advanced and rallied very strongly during the March quarter, returning 13.28% in Australian dollar terms. Currency strongly contributed to returns as the U.S. dollar climbed over 4.5% against the Australian dollar. Our international equity allocation underperformed the benchmark but generated a strong absolute result. Detractors were associated with currency hedging and exposure to emerging markets, which didn’t keep pace with the developed world.
As mentioned earlier, global markets have been uplifted by expectations that the Federal Reserve will significantly reduce interest rates in 2024, spurred by optimism that a recession is not on the immediate horizon. However, this optimistic thesis encountered challenges already in the year, as the latest two CPI (Consumer Price Index) reports unexpectedly exceeded forecasts, casting doubt on the feasibility of a soft landing. These surprises to the upside challenge the consensus, suggesting that inflationary pressures may not be subsiding as anticipated, potentially complicating the Fed's path towards easing monetary policy.
From an equity valuation perspective, the recent market rally has pushed valuations into more expensive territory relative to historical averages. As of the end of March, the forward price-to-earnings (P/E) ratio for the S&P 500 stands at 20.96x, positioning it more than one standard deviation above the 30-year average. This elevated valuation places investors in a challenging predicament: deciding whether to remain invested in the S&P 500 and the 'magnificent seven' stocks, which have shown remarkable performance or to consider reallocating to other market segments. For example, emerging markets and small-cap stocks currently trade at more conservative valuations and may offer safer investment opportunities. This scenario underscores the difficult choices facing investors as they navigate potential overvaluation risks in well-performing sectors versus the potential for value in less frothy areas of the market.
*Source: JPMorgan
Potentially, the most significant event of the first quarter was Nvidia's Q4 FY23 earnings call, where the AI chipmaker posted another set of solid results and also significantly influenced market dynamics, with its stock surging a further 82% over the quarter. This stark outperformance highlights the broader U.S. Q4 earnings season, which, while seemingly satisfactory with a 2.9% year-on-year EPS growth and a 3.9% sales increase as reported by FactSet, presents a nuanced picture. This apparent growth was disproportionately driven by the 'Magnificent Six', whose earnings soared by 53.7%. In stark contrast, the rest of the S&P 500 experienced a 10.5% contraction in earnings. This divergence underscores the significant impact that major tech players have on market indices and raises questions about the underlying health and breadth of the broader market's earnings resilience.
We refined our global equity allocation in the recent quarter, consolidating some positions to enhance conviction. A review focused on the overlap and redundancy between our index and enhanced index strategies, both primarily targeting the MSCI World. Consolidating the positions allowed us to reduce costs within the portfolio.
Australian Equities
During the quarter, Australian equities posted a return of 5.33%, as the ASX200 hit record highs in March. Local equities underperformed global equities but generated a healthy return and contributed to portfolio performance. The portfolio’s allocation to Australian equities performed well across the first quarter, outperforming the ASX200.
On the policy front, the Reserve Bank of Australia (RBA) has kept the cash rate steady at 4.35% since the last adjustment in November. RBA Governor Michele Bullock's recent statements indicate a shift towards a more open-minded approach to interest rates, moving away from a previously tightening bias. Bullock has acknowledged that the current data affirm the central bank's effective strategy in combating inflation, though she emphasised the continued uncertainty in future rate directions. Domestically, the economic outlook hinges significantly on the household sector. Despite the pressures of higher interest rates, increased taxes, and persistent inflation dampening consumer spending in the past year, 2024 is poised to offer some relief. Although immediate rate cuts seem unlikely, implementing lower tax rates, which effectively boost household incomes, is expected to bolster consumer spending as the year unfolds.
The recent surge in the market mirrors trends in the global market, where the rally has pushed valuations of Australian equities to the higher end of the spectrum. By the end of March, the forward price-to-earnings (P/E) ratio for the ASX 200 reached 16.9x, positioning it more than one standard deviation above its 20-year average. Such elevated levels have only previously been seen during the euphoric rally that occurred through the COVID-19 pandemic, in the last 20 years. This heightened valuation presents potential risks and opportunities for investors, as the market dynamics at these levels have historically been volatile and tied to significant economic shifts or investor sentiment changes.
Source: JPMorgan
Property & Infrastructure
In the first quarter, our portfolio saw notable gains from both listed property and infrastructure sectors. Specifically, listed infrastructure grew by 8.34%, while listed property saw a more significant rise of 16.75%.
The Australian Real Estate Investment Trust (AREIT) sector has seen notable benefits from adopting AI, particularly within Goodman Group. This leading industrial property group develops and manages industrial real estate, including data centres worldwide. Through their data centre operations, Goodman Group has benefited from the acceleration of the adoption of AI, driving significant value creation across its global portfolio. Over the past six months leading to March 2024, Goodman Group's share price has surged over 50%, underscoring its strong performance and innovation-driven growth. This rally has markedly increased its dominance within the AREIT index, which now constitutes 36% of the index, far surpassing the next largest constituent, Scentre Group, which holds a 10.87% weight. Goodman Group's substantial share within the index highlights has had a substantial influence in shaping the performance and direction of the AREIT market and has lifted many boats.
On the other hand, their unlisted property continues to face challenges, negatively impacting overall performance. This was primarily due to the ongoing effect of rising interest rates on asset valuations, as reflected in the widening of capitalisation rates. Illiquidity has continued to be a concern in recent months, leading to the implementation of gates in numerous unlisted strategies to manage investor redemptions effectively. On the wholesale front, we are beginning to see several transactions either well below replacement cost or at substantial discounts to the value when an asset was last traded.
Listed infrastructure assets are poised to be well positioned as we move into 2024, assuming the forward-looking yield & rate outlook doesn’t surprise on the upside. This sector's resilience is evident as most companies have succeeded in maintaining their earnings and cash flows, thanks in part to mechanisms that allow for the pass-through of inflation. The regulatory and contractual mechanisms these companies use to adjust for inflation and interest rates often exhibit a significant lag, sometimes up to 18 months. This delay means that the effects of higher inflation in 2022 and 2023 should continue to manifest in price and earnings increases for infrastructure assets well into 2024. Additionally, the asset class is well positioned to benefit from a period of decling rates and yields that align with consensus views.
No changes were made during the quarter within this allocation of the portfolio.
Private Equity & Venture Capital
In the first quarter, private equity's performance was more muted than that of its listed equity counterparts. Core buyout strategies returned 1-2%, depending on the fund, while our venture strategy returned 11.62%. We are still waiting for the end-of-March valuations for some strategies.
Private equity exits have languished in a prolonged downturn over recent years, largely due to unaccommodating capital markets that have stifled initial public offerings (IPOs). However, the first quarter marked a noticeable shift, beginning with the high-profile IPO of the forum website Reddit, which debuted on the stock market at a substantial premium to its issue price. This event has contributed to an uplift in sector sentiment, as evidenced by a recent update from one of our core private equity managers. They reported the successful sale of a top-10 position at a 35% premium to its carrying value, underscoring a rejuvenation in market conditions. Additionally, this positive momentum has led the manager to adjust the targeted returns for their strategy upwards, driven by the advantage of lower entry multiples for new investments.
The local VC sector is a space that Arrow continues to be excited about. In the first quarter, AirTree, a leading Australian venture capital firm, published its 2024 edition of tech companies valued at over $100m, highlighting the significant growth of the Australian tech sector (Full graphic at the end of this note). The report reveals a notable increase in startups reaching $100 million or more valuations. From 1990 to 2000, only 9 startups achieved this milestone, 24 in the next decade, and 62 from 2010 to 2020. The period from 2020 to 2024 saw a dramatic rise, with 139 startups crossing the $100 million valuation mark, bringing the total to 234, a substantial increase from 99 in 2021. This growth reflects the Aussie tech ecosystem's maturation, an influx of local capital & investment, an abundance of seasoned talent, and enhanced company-building expertise & support.
There were no changes to the private equity allocation of the portfolios during the quarter.
Enhanced Income
Australian bonds contributed to portfolios, generating a 1.05% return in the year's first quarter. After a few challenging years, bond performance will yet again be under the microscope in 2024.
Recent economic data has shown surprising strength, which has more than offset the impact of a hawkish repricing in monetary policy expectations. At the outset of the year, markets were bracing for as many as seven 25-basis-point interest rate cuts from the Federal Reserve, with the first anticipated in March 2024. However, expectations have since adjusted to just two rate cuts, with the initial reduction forecasted for the latter half of the year. This recalibration has led to a rally in bond yields over recent weeks as investors adjust to a 'higher for longer' interest rate scenario. Interestingly, despite this hawkish shift and the accompanying rise in bond yields, we have not observed a corresponding negative impact on equity valuations. This future direction of monetary policy will remain highly uncertain; however, potentially, the longer it takes for central banks to cut rates, the more likely the next move may actually be a hike, but just a suspicion.
After facing a few challenging years, Enhanced Income strategies have re-established their significance within investment portfolios. The recent climb in base rates has proven beneficial for many solutions within this asset class, especially those focusing on short-duration, credit, and private debt strategies. An analysis of the solutions listed on the Approved Product List (APL) reveals a compelling range of returns, with many offerings achieving returns between 6% to 12% over the past 12 months. This resurgence is a welcome development for clients and investors, who now find they do not need to venture as far up the risk spectrum to achieve their targeted returns. This shift enhances the appeal of Enhanced Income strategies and provides a safer pathway for investors seeking reliable income in a volatile market environment.
We made some changes to the enhanced income allocation of the portfolio throughout the quarter as we continued to allocate to our higher-yielding floating rate strategies. This reduced our interest rate duration and increased the yield level across the defensive allocation.
The year 2024 began optimistically, continuing the robust performance from late 2023 across most asset classes. Market sentiment is significantly upbeat due to a period of disinflation and notable economic resilience, especially in the U.S. However, recent unexpected rises in CPI reports and a hawkish shift in monetary policy expectations have introduced some caution into this optimism. The initial forecast of seven rate cuts has been revised down to two, expected in the latter half of the year, reflecting a "higher for longer" interest rate scenario, which has driven bond yields up without negatively impacting equity valuations.
The remainder of 2024 will likely continue to be shaped by the interplay between inflationary pressures, interest rate expectations, and corporate earnings. Investors are advised to remain vigilant and consider strategic adjustments in their portfolios to mitigate risks associated with high valuations, potential shifts in monetary policy, and geopolitical instability. Our portfolios remain underweight risk assets, with a preference toward defensive solutions offering high absolute returns (8-10%) with a high degree of certainty.
As always, should you have any queries about any of the material outlined in this letter, please do not hesitate to contact us.
