Investing in the Dragon year: No room for complacency

IN TRADITIONAL Chinese folklore, dragons are one of the most powerful animals as they symbolise strength, prosperity and success. We have just entered the lunar Yang Wood Dragon year. The biggest events in the previous Wood Dragon year – 60 years ago – could point us to what lies ahead in 2024.

In 1964, the US experienced the most powerful earthquake in its history at 9.2 magnitude in Alaska. That same year, Europe committed to build the Eurotunnel, and the 1964 Summer Olympics was held in Tokyo, the first in an Asian country.

While there were immense challenges, there were also great opportunities in that Dragon year. Applying this pattern to the investment context in 2024 suggests we would see a volatile market brought about by global challenges, but with the potential for exciting opportunities.

At the start of the year, we are commonly asked where the S&P 500 index would be at the year-end. Based on the S&P 500 daily market close data for eight Dragon years, starting from 1928, we discovered that on average, $100 invested in the index on Lunar Day 1 would grow to $107.80 by the last trading day. Not all lunar years produce a similar performance though. In Snake years, that $100 fell to $98.50.

Of course, past performance is not indicative of future results. It is more important for investors to acquire or utilise available knowledge and tools to ride out market volatilities and uncertainties, especially in a Dragon year that is typically characterised by big changes.

Equities turn red hot

From mid-October to end-December 2023, the US Treasury 10-year yields fell 119 basis points, signalling market expectations of a Fed rate easing in the first quarter of 2024.

In that period, the Volatility Index (VIX), a gauge of greed and fear in equities, fell 9.6 percentage points to a low of 12.1 in mid-December 2023, reflecting investors’ complacence. The S&P 500 index rose from a low of 4,117 on Oct 27, 2023, to 5,089 on Feb 23, 2024, an impressive 24 per cent gain in three months.

This surge in equity prices was spurred by expectations of early and sustained rate cuts by the Fed this year. But based on the notes of the latest Federal Open Market Committee statements, the expectations were not in line with the mindsets of Fed policymakers. Further unwinding of these expectations may dampen the stock and bond market rally. Already, some market indicators are signalling a correction.

First, the VIX remained low even though the likelihood of the first rate-cut is now pushed to second quarter.

Second, market sentiment turned too bullish too quickly. Net long S&P 500 positions in the equity futures market have shot up and reached levels that typically warn of price vulnerability. Also, the “Fear & Greed Index” on CNN currently points to an “extreme greed” warning.

To be greedy or fearful?

This question never fails to make investors uneasy, especially when they are presented with a quote from Warren Buffett that it is wise for investors “to be fearful when others are greedy and to be greedy only when others are fearful”.

Are we to follow the greed momentum or start to be fearful? To answer this question, we make a careful observation of the following narratives.

First, we believe US equities have started a new bullish phase since a recent bottoming out in October 2022.

Although stock prices have risen by more than 40 per cent from their cyclical lows, many institutional investors have not fully participated in the run. Weekly money market funds injection by institutions is increasing at a 20 per cent year-on-year pace. Those who have underperformed the market would be forced to increase risk exposures, particularly if the Fed eases this year.

Second, although we view the current US economy to be in a late cycle (exemplified by tight labour market, contractionary monetary and fiscal policies, and poor corporate sentiments), the enhanced pricing power of corporates due to the inflationary environment over the past two years will still provide a strong boost to earnings. So far, 80 per cent of US companies surprised market expectations on the upside.

Meanwhile, our private bank’s earnings per share model also shows that S&P 500 earnings growth hit a bottom in the first quarter of 2023, and earnings momentum has been strengthening since.

Additionally, a few other market developments will provide some tailwinds for stock prices. First, the US Treasury yield curve continues to dis-invert, which is a helpful trend for banks and financial institutions.

Second, mortgage yields have dropped from a recent peak of 8.08 per cent to 7.29 per cent, providing some relief for new homebuyers. In fact, most US homeowners are locked into the fixed 30-year mortgage, which is at a much lower interest rate of 3.8 per cent, a key reason why the higher interest rates have not hurt the average US consumer.

Third, coupled with interest rate cuts, we expect the Fed to slow down or even stop its quantitative tightening in the coming months, to avoid a repeat of the liquidity crunch that plagued the banking system in 2019.

With such supportive observations, we will use any major price pullback to add equity exposure.

The above narrative, however, is largely contingent on the Fed’s rate cut path, which is in turn conditional on the speed of disinflation in the US and globally. Despite the fact that the US’ Consumer Price Index (CPI) came in higher than the consensus forecast in January, we still observe a disinflationary trend across the goods and services sectors.

Supply-driven disinflation looks set to continue as global commodity and food prices are still falling, likely pushing overall inflation lower.

Demand-pulled disinflation will also continue as the prices of US accommodation climbed at a slower pace versus the Covid pandemic period when people rushed for homes. The Zillow Observed Rent Index signals that rental inflation could drop to 3 per cent by mid-year. This will have a major dampening impact on core inflation; shelter inflation accounts for 44 per cent of core CPI and 18 per cent of core Personal Consumption Expenditure inflation.

Wage inflation is also mellowing with US unit labour cost growth falling to 2.3 per cent year on year, after a major surge in 2021 and 2022.

Recession or not?

Between 2022 and 2023, economists forecast a global recession that never came. Fast forward to 2024, economists now expect the opposite – no recession and a soft landing, predicated on the expectations that Fed will start cutting interest rates this year while the US enjoys a robust labour market and strong consumption.

There is a big contradiction here.

If the labour market remains strong, inflation is unlikely to fall further towards the 2 per cent mark. There would then be no urgency for the Fed to cut rates at the risk of driving exuberance and additional demand to push inflation higher, and potentially undoing their inflation fight since 2022. Investors could start getting disappointed by the non-action, pushing the rate cut schedule further into the future.

If the Fed maintains a high interest-rate environment, the labour market could weaken as corporates would have to start laying off workers due to margin pressures from high labour and capital (read: interest rate) costs. We are already seeing signs of a weaker labour market from the rapidly falling job quits due to fear of future job security, and job openings as employers are less inclined to hire for fear of further margin squeeze.

There is no guarantee that the Fed will always do the right thing. Holding rates too high for too long could inflict undue damage on the economy and raise recession risk.

Therefore, even for optimists who bet on a new bull market in stocks and bonds, there is no room for complacency. In volatile times like these, alongside a classic Dragon year prognostication, outsourcing decisions to professional investment managers can make investing less stressful.

The writer is investment strategist at UOB