Consensus expectations for GDP growth in 2024 don’t look too bad, but the economy still has to be weaned off the ‘sugar high’ of COVID-era fiscal stimulus and economic data doesn’t generally lead market returns anyway. Liquidity is certainly supportive, with rates peaking and a dovish mood spreading among the central banks, but rising consumer delinquencies and bankruptcies may herald a credit downcycle which would certainly undermine growth.

Politics will also be influential over the next 12 months: 2024 will bring elections in the US, UK, Europe and many other countries, including South Africa. As ever, incumbents and challengers will both be tempted to promise fiscal largesse which may reawaken inflationary fears, but the markets have fired warning shots across politicians’ bows in the last year or so: in August 2023 Fitch downgraded the US government’s long term credit rating and the UK bond market went into ‘cardiac arrest’ in September 2022 following the government’s disastrous ‘mini-budget’ of higher borrowing and tax cuts. The market exercised its veto and Liz Truss became the shortest-serving PM of all time, resigning after 44 days in post. These events constitute a clear warning that sovereigns will be held accountable by the market – the governments of New Zealand and Germany have recently taken steps to limit spending – so on balance we can expect government spending to normalize from extraordinary levels under COVID. As investors based in South Africa we have our own sovereign concerns: February is budget month, and we are expecting more fiscal promises with only a passing relationship to reality.

So where does that leave us?

We think markets are priced for good news and have likely pulled forward some (if not all) of the returns to be made in 2024 if fundamentals remain supportive. At the time of writing equity indices around the world, including the S&P 500, are trading at or close to their all-time highs.  

The coordinated rally in bonds, credit and equities has been driven by a Goldilocks combination of softening inflation, lower rates and a resilient outlook for growth, consumption and corporate earnings: a soft landing (or indeed no landing at all). There are clouds in the sky, of course: markets are comfortable that a recession can be avoided but growth expectations are no better than pedestrian and household balance sheets are stretched in many countries.

Is this an environment in which equities will outperform bonds?

Firstly we think that both equities and bonds are priced for 150 bps of rate cuts by December 2024; if those cuts don’t materialise, whether because inflation reignites or because growth and employment prove resilient once again, both asset classes will suffer.

If those rate cuts do come, on the other hand, we expect the most likely reason to be rising unemployment rather than falling inflation, a scenario in which real rates must fall to support a weakening economy. Once again, the yield curve will be seen as the great predictor, although with a lagged effect. The historic implications of the curve’s current inversion cannot be dismissed; investors should remain wary of premature celebrations that the central banks have safely shepherded the global economy into a new upcycle.

From an asset allocation point of view, the utility of a traditional 60/40 balanced portfolio is in question when bonds and equities are likely to move in the same direction; fine when things are looking up, not so good when things don’t go as expected. Simply put, bonds will prosper if fundamentals deteriorate; if growth remains resilient that obviously sounds good for corporate earnings but on balance equities will suffer if rate cuts are pushed back and bond yields are marked higher.

Our view

Our own view is more nuanced. We were nicely positioned for the rally in asset prices during the later part of 2023; the balance of risk and reward across bonds, credit and equities looked attractive to us and we were heavily positioned. Today’s market environment couldn’t be more different.

Since the end of October, cross-asset volatility has retraced and there has been a significant shift in the outlook for central bank policy.  Markets have rallied quickly to celebrate the prospect of a soft landing (or no landing at all) despite the historical improbability of exiting the downcycle unscathed.

Since 1970 the Fed has engineered only two soft landings, in 1995 and 1998; equities outperformed bonds both times but on both occasions the yield curve was positive and credit conditions were supportive. Neither of these conditions are in place today, and so we are curbing our enthusiasm: the most likely outcome is a rangebound environment for risk assets. To perform, equities will need earnings to grow while shouldering the weight of higher bond yields. We will only feel confident to sound the ‘all clear’ for risk assets when the yield curve is positive once again. Historically, a yield curve moving from inverted to positive has signalled that a recession is at hand; this would be our opportunity to add risk into the bear market which usually follows.

We are wary of the market’s conviction that fading inflation will give the Fed room for 150bps of cuts by the end of this year; we think the Fed will wait for unemployment to rise before it starts cutting. The political cycle will make the Fed even more reluctant to cut: the Fed’s political independence is a precious commodity and cutting rates in an election year can be seen as a gift to the White House incumbent.

In short we believe that a good outcome for risk assets in 2024 is possible but not likely. The market will need to digest the moves we have seen and validate central bankers’ reaction function to the looser financial conditions, the condition of the consumer and ultimately employment. While employment may hold up, we do think the one-off savings generated by the fiscal response to COVID have largely worked their way through the system. The looser financial conditions and uptick in our liquidity indicators is positive for risk assets but we think it is largely priced in. If those indicators improve from here that would shift our range of outcomes in a positive direction and suggest that, unusually, Central Bankers have successfully walked the tightrope.

During 2023 the biggest change in our outlook was the reduction in the likelihood of a ‘hard landing’ (as opposed to a typical recession). We still expect a recession to materialize during 2024, though the more forgiving outlook for rates should keep it on the mild side: after such a steep hiking cycle the Fed has the dry powder to cut rates quickly and deeply if needed (assuming that unemployment climbs).

With equities close to all-time highs there is always a chance of a significant drawdown when the recession hits but we think that risk has receded over recent months.