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“The recession that wasn’t” may be the best way to describe 2023 and the year’s strong market performance. The Fed’s 550 bp tightening cycle did wreak havoc in parts of the market, most notably among US regional banks, but strong consumption and AI excitement were underappreciated offsets. While this outcome was a relief, the market dominance of the “Magnificent Seven” stocks left many allocators disappointed with their portfolio results.
Now, the market has set high expectations for rate cuts, exceeding the Fed’s projections. We agree the growth/inflation outlook has improved and there’s better balance in the economy (Figure 1). But risk assets have already experienced sharp rallies and equity volatility has plumbed pre-pandemic lows, leading us to ask: Has a more benign interest-rate environment already been priced in?
At this juncture, we see several possible scenarios with vastly different investment implications. In one, the lagged effect of higher rates hurts the economy and recession fears reignite. In another, the economy reaccelerates and drives inflation higher, preventing the rate cuts the market expects.
We aren’t sure which way the economy and markets will break, but we are skeptical about the smooth ride markets expect in 2024 and have a neutral view on global equities and rates while focusing more on relative value within asset classes. That said, this is an increase in risk compared to 2023, when we favored global rates over equities.
In credit, we maintain a slight underweight view, as we find spreads tight relative to fundamentals, which we think are deteriorating. Even though bond yields are 100 bps lower since mid-October, this does little to offset the risk for high-yield issuers facing much higher refinancing rates relative to their outstanding coupons. We favor quality in investment-grade corporates.
Our relative-value calls are expressed in regions. Within rates, we favor the US and Europe over Japan, driven by our expectation that the Bank of Japan (BOJ) will pull the trigger on rate hikes sometime this year. Within equities, we maintain our high-conviction view that Japan has more upside than the US and Europe.
Finally, we have stronger conviction in our overweight view on commodities based on our outlook for oil. We see the decline in oil prices as a good entry point to express our view that supply constraints are underappreciated by the markets.
We have raised our view on global equities from moderately underweight to neutral, given our belief that equities can continue to benefit from a policy “sweet spot” in which a mixed growth picture and disinflation have allowed the liquidity backdrop to dominate. What kept us from moving to an overweight view? We expect central banks to pivot to rate cuts in 2024, but in the absence of a severe recession, there is scope for disappointment — especially in the US, where the market expects five to six rate cuts in the coming year. Meanwhile, it remains to be seen whether core inflation is truly under control, and this will remain a focus for investors until inflation is sustainably at or below central bank targets.
Markets are also pricing in strong earnings growth of around 10% globally over the next 12 months. While the earnings downside is likely behind us, we think this is too rosy given our expectation of below-trend growth and potential for further margin compression. The combination of elevated earnings expectations and high valuations, including a tight equity risk premium against bonds, also prevented us from adopting an overweight view on global equities. In short, our neutral view reflects our belief that we are at a crossroads, and we will be monitoring central bank monetary policy, earnings surprises, and signs that the long tail of prior tightening is making its way through the economy as we gauge whether to dial our equity view up or down from here.
Turning to our regional views, we see better valuations outside the US. But within the US, we see better valuations outside of megacap stocks — as of mid-December, the S&P 500 had a 12-month forward P/E ratio of about 17.3 once the megacaps were removed. While gains in the US equity market finally broadened beyond the largest stocks in the last few weeks of 2023, the megacap cohort remains dominant, with implications for global market structure in that it is now larger than any country or region outside the US. For example, megacaps tend to be less sensitive to interest rate and cyclical shifts, and therefore their increasing heft can make the overall equity market more resilient. Another factor to take into account is the influence of US fiscal policy, which surprised on the upside in 2023 but will shift more negative in 2024. These crosscurrents balance out to a modest underweight view on the US in our analysis.
We continue to see opportunities to take advantage of regional diversification, with economic and monetary policy cycles remaining less synchronized than in recent years. Most notably, we have increased our overweight view on Japanese equities, where we continue to see a confluence of higher nominal growth and evidence of corporate governance shifts boosting profitability (Figure 2). While the BOJ shifted its monetary policy stance somewhat, dialing back on yield curve control, it remains accommodative, and the country’s fiscal policy is even more so. The economy remains in cyclical recovery mode, although valuations reflect improving fundamentals to a greater extent than early in 2023. Japan did underperform some other markets in the fourth quarter, but given that there was no change in our conviction level, we saw this as an attractive buying opportunity.
We maintain our moderately underweight view on European equities. They have the advantage of both negative sentiment and attractive valuations, but we expect the region’s macro and earnings downturn will take time to play out.
In China, valuations and sentiment are both at rock bottom, which should cushion against further de-rating. This remains a market where the dispersion of views on our team is wide, but on balance, we think structural factors such as internal deleveraging and geopolitical uncertainty suppress the potential for the market to outperform over a 12-month horizon.
At a sector level, we prefer consumer discretionary stocks, which have the potential to benefit from disinflation and higher disposable income, as well as undervalued utilities. We think the energy sector has strong fundamentals, including high earnings and free cash flow. We have an underweight view on the telecom, consumer staples, and health care sectors. The consumer staples sector has a weaker fundamental picture with low free cash flow and negative sentiment. The telecom sector’s fundamentals are also weak, as capex to depreciation looks low. Capital needs are high for the sector and may increase its cost of capital. Health care is challenged by higher costs and lower utilization at hospitals, as well as continued poor sentiment in biotech.
The Federal Open Market Committee’s December meeting validated and accelerated the rally we’ve seen in rate markets since the yield on the 10-year US Treasury hit 5% in mid-October. Markets appear to have latched onto a couple of positive narratives. One is that if inflation continues to fall, then mathematically, real rates rise and become more restrictive. Therefore, the Fed will need to cut rates even if the economy doesn’t slow. Another narrative is that inflation’s decline has been driven not by a harmful decline in demand, but by supply factors, including increased labor participation and immigration, as well as a continued unwinding of supply chain distortions.
Our neutral duration stance is based on our view that slower global growth and lower inflation will bring lower rates but that the rates markets have repriced too much too fast. (As of this writing, Fed funds futures imply that the first rate cut will come in March and that we will see 150 bps of cuts by December.) Rates could go lower in a deep recession scenario or they could rise if inflation reaccelerates or the term premium expands as it did in the third quarter.
In a global context, we still prefer US and European rates to Japanese rates. Europe is flirting with recession, so the European Central Bank is likely to join or even preempt the Fed in cutting rates. Japan is unique: Amid loose monetary and fiscal policy, inflation is running hotter than target, so the central bank is under some pressure to tighten ultra-loose policy.
The economy has been resilient and spreads have been narrowing. Inflation has come down quickly, giving central banks the room to cut rates this year. Against this backdrop, we retain a slight underweight view on spreads, but think there may be opportunities to add risk on any weakness. We believe the risks remain somewhat skewed to the downside, especially with tight spread levels, but we see an environment where spreads could remain rangebound for some time and where income could dominate returns.
Defaults began picking up in high-yield markets in 2023, but were largely concentrated in a few sectors, including technology, health care, and autos. We see some risks around the need to refinance at higher interest rates. High-yield issuers have been able to push out the impact of higher interest rates by delaying refinancing. But many issuers have debt maturing in 2025, meaning they will need to refinance within the next 12 months (Figure 3). Even with 150 bps of interest rate cuts priced in, refinancing will be at much higher rates than existing debt and could lead to higher defaults.
Meanwhile, as refinancing has been delayed, corporate balance sheets have been weakening, as issuers have spent cash rather than issuing more debt. We don’t think this risk is quite priced in. High-yield spreads are narrow at around the 30th percentile in the US.
Having said all that, we don’t see an immediate catalyst for wider spreads, and so we remain only marginally negative on the asset class in the near term. The opportunity to add on weakness may be helped by the more positive starting point for yields, which is a strong determinant of long-term returns. We prefer higher-quality credit in this environment, and therefore remain more positive on investment-grade credit relative to high yield.
We have increased our conviction in our overweight view on commodities, primarily driven by our more positive outlook for oil, as well as a view that inflation could remain somewhat stickier and more volatile than the market anticipates.
We have raised our view on oil from neutral to moderately overweight, with recent price declines creating what we think is an attractive entry point. We expect supply to remain relatively constrained, driven by both an incentive for OPEC to support prices and the US actively refilling its Strategic Petroleum Reserve (SPR), which should outweigh the headwind from slower demand in 2024. We are also monitoring the impact that attacks on commercial ships in the Red Sea could have on prices in coming months.
We maintain our moderately overweight view on gold, which has reasserted its status as a potential safe haven and a store of value as demand has picked up around the world. Central banks have been buying gold recently in light of geopolitical issues and the trend of de-dollarization. This buying has been robust and we expect it to continue.
Copper remains structurally constrained from a supply perspective, and we expect long-term demand to be strong given its role in the green economy. However, we believe there could be downward pressure on prices in the near term, as there may be some supply surplus coming through, and demand may be slightly weaker given our expectation of below-trend growth this year. With these contrasting short- and long-term trends, we moved to a neutral view on copper, preferring to watch for opportunities to add risk in the months ahead.
Upside risks include a scenario in which the loosening in financial conditions lifts growth above trend without stymying disinflationary momentum. Another positive scenario would be a reacceleration in China’s economy, with positive spillover effects on the global economy. We might also see unexpected upside from high cash levels on household balance sheets being reallocated to risk assets.
Downside risks include the potential for core inflation to reaccelerate, leading central banks to push back against aggressive rate cut expectations or even to resume hiking. There’s also the potential for the economy to “break” due to the lagged impact of tighter monetary policy on commercial real estate or parts of the banking sector. Finally, if the Middle East or Russia/Ukraine conflicts broaden, it risks increasing macro uncertainty.
Consider rotating equity exposure to less expensive areas — We think an improved fundamental backdrop of slowing growth and inflation combined with the prospect of Fed rate cuts warrants at least a neutral exposure to equities. But given relatively expensive valuations in megacaps, we think there are better opportunities in the underpriced utilities and energy sectors. Disinflation should be positive for the consumer discretionary sector.
Look for regional advantages, especially in Japan — Equities outside the US are less expensive and are at different stages of the cycle. We think Japan still has a long runway for improved profitability, even if monetary policy tightens slightly.
Consider maintaining a neutral duration stance — The Fed’s pivot is positive for rates markets, but we think that has been priced in and rates could go higher or lower depending on inflation and Treasury supply. Among rates markets, we believe Japan has more downside than the US and Europe given the shift in monetary policy we envision. We lean slightly negative on spreads given rich valuations and heavy refinancing needs at higher rates.
Be prepared for disruptions in the market’s benign expectations — The inflation story may not be over. We see upside for oil prices and a case for gold amid heightened geopolitical risk and strong central bank buying.
Monthly Market Review — August 2024
A monthly update on equity, fixed income, currency, and commodity markets.
By
Brett Hinds
Jameson Dunn