Will a “Goldilocks” economy be just right for equity markets?

In 2023, cautious initial positioning along with better-than-expected economic and earnings data, sustained consumer resilience, and supportive government fiscal flows buoyed equities. Looking ahead to 2024, we believe the risk/reward picture for global equities is relatively balanced. We currently view the most attractive potential investments as a barbell, with quality compounders on one end and more heavily discounted macro- and rate-sensitive sectors and regions on the other Here, we provide an outlook on the ongoing shift to a new investment regime and the market segments that we expect will most heavily influence global equity performance in the coming year.

Regional roundup

United States
While equal-weighted US equity valuations aren’t overly stretched, megacap technology stocks do appear fairly valued. Given tech’s current dominance within US indices, this is a key risk in the event of a rates-driven, risk-off shift in market sentiment. As Figure 1 shows, the S&P 500 Index is the most concentrated it’s been since the 1970s. One market segment that has room to run in 2024 is small caps. Despite their year-to-date (as of this writing) underperformance, small caps are worthy of attention as economic conditions stabilize and rates and inflation moderate. Small caps currently trade at extreme valuation discounts to larger caps, particularly in the US.

Figure 1

Japan
During the past year, equity market performance has been more broad-based and better supported by domestic fundamentals than in other regions. Against this backdrop, Japanese equities continue to look relatively attractive versus the US, especially given lower valuations (Figure 2) and continued corporate governance reforms.

Europe
European equities turned in a surprisingly strong performance in 2023, only modestly trailing US equities and outperforming on an equal-weight basis. Heading into 2024, as Figure 2 shows, European equities also look extremely cheap relative to the US (even on a sector-adjusted basis). While parts of Europe might already be in a recession, this is increasingly reflected in growth estimates and sentiment. In 2024, we expect financial conditions to surprise on the upside. If that happens, Europe’s relative outperformance versus the US could continue throughout the year. In addition to being attractively valued, shareholder returns (dividend yield plus buybacks) are now above those of the US. European companies also have significant exposure to some major global trends, including automation and the energy transition. European banks continue to look attractive, as the swing to profitability, strong stress-test results, and easing regulatory headwinds have yet to be reflected in valuations. Overall, we remain constructive on the medium-term outlook for European equities.

United Kingdom 
Pressured by the rapid escalation of inflation and interest-rate expectations, UK equities are now among the most inexpensive globally (Figure 2). While the risk/reward is currently high, any moderation in investors’ economic fears could lead to meaningful near-term upside.

Figure 2

China
Since the COVID reopening boost in late 2022, Chinese equity performance has been a significant disappointment, pressured by the country’s tepid economic rebound, growing concerns around the property market, and compressing valuations. As with the UK, risk/reward is high but balanced somewhat by depressed investor sentiment. Given economic and geopolitical risks, we believe China warrants a higher equity discount rate than other regions. 

Emerging markets (EM) ex China
After 15 years of relative underperformance versus developed markets, EMs broadly are worthy of investor attention. Historically, EMs have performed best during the early cycle after a US-led developed market recession. While China could remain a drag on EM equity performance in 2024 given its dominance of EM indices, we believe relatively low inflation, improving fundamentals, low valuations, and high market inefficiency could make EM equities attractive for active managers.

What could a new investment regime mean for global equities? 

In 2024, we expect inflation to remain persistent and growth to moderate, with central banks forced to choose between supporting economic expansion or constraining price increases. This trade-off should lead to shorter, more frequent cycles and less synchronization across regions. As a result, we expect to see increasing global equity volatility and dispersion. 

Markets appear too sanguine about this risk, which is not a surprise. Since 1996, the global economy enjoyed a “Goldilocks” scenario, marked by steady growth and low rates/disinflation, about 75% of the time — with the COVID-19 slowdown and a challenging 2022 being recent notable exceptions. The 2023 rally in risk assets was likely undergirded by an expected return to a not-too-hot, not-too-cold regime, with modest but positive economic growth and moderating or falling inflation. Whether developed market central banks will soften current 2% inflation targets or risk triggering a recession and/or systemic instability with additional rate increases remains an open question. As such, the range of potential outcomes for global equities remains wide. 

In 2024: 

• Closer correlation between equities and bonds and greater dispersion within equities (as the liquidity tide goes out) could strengthen the case for active management.
• Fundamentals will matter more. Markets may place greater value on earnings, balance-sheet strength, and cash-flow visibility.
• Consistent top-line growth and margin expansion could be increasingly valued.
• Governance quality could determine idiosyncratic performance, as companies grapple with profit-defining uncertainties, from deglobalization and constrained labor supply to generative artificial intelligence (AI) and climate change. 
• Converging private versus public equity valuations may leave less margin for error.
• Valuation differences will likely continue to make non-US equities relatively attractive.
• Shifts in globalization and capital spending cycles may drive greater country dispersion.
• Increasing global diversification could prove key to mitigating risk amid greater cyclical volatility and divergence among nations.
• Index concentration will provide both risks and opportunities for active managers. In the US, investors may want to consider a barbell approach with allocations to “The Magnificent 7” of 2023 alongside sectors that have been pressured by macro/rate fears, namely small caps, health care, and utilities.

Key questions 

Amid the ongoing uncertainty clouding the market and the macro picture, key questions for investors to consider include:

• Are markets overly optimistic about the prospect of a soft economic landing? Even if recession is avoided, do current valuations provide enough upside potential relative to the 5% risk-free rate of return from US Treasuries?
• Higher global bond yields have dampened equity risk premia. What is the current relative attractiveness of stocks versus bonds versus cash?
• In 2022, investors started to get more positive on equity segments and sectors that had lagged since the global financial crisis, including value stocks, small caps, energy, and EMs. In 2023, all these underperformed. Is now the time to reengage?
• In the US, defensive sectors including utilities, health care, and consumer staples underperformed in 2023, in part due to their long-duration nature. Do these sectors now provide some combination of offense and defense?
• Has the upside potential of generative AI been overly hyped, or can these technologies really boost long-term growth and profitability? Are heavily AI-exposed companies currently in a bubble, and if so, at what stage? 
• What other potential systemic risks could higher-for-longer rates pose for commercial real estate, private credit/equity, corporate debt, and government debt?

The bottom line 

As we described in our mid-year 2023 outlook, I continue to see a market regime shift that is clearly underway. Looking to 2024, I anticipate lower but steady economic growth and moderating inflation on tap for the coming year. With this, I expect US equity market concentration to broaden, and for greater cyclical volatility and dispersion to provide more opportunities for active managers to deliver alpha. Regional and market-cap valuation dislocations also present a potential roadmap for capturing upside. Japan, Europe, and EMs look attractive, as do macro- and rate-sensitive segments and sectors. And as the global economy swings back toward a “Goldilocks” environment, I am optimistic that 2024 could be a good year for equity markets overall.