2023: A rollercoaster for investors
By October 2023 the Federal Reserve was 18 months into the steepest hiking cycle in recent memory, and there was increasing evidence that higher interest rates were starting to impact the real economy. The 15-year fixed mortgage rate had breached 7% for the first time since 2000 while higher rates and weak fundamentals were creating stress in US commercial real estate debt, a $5.7 trillion asset class of which a significant amount is due to mature in 2024 and 2025. Shopping mall occupancies remained under pressure while the shift to remote working had contributed to rising delinquencies in the office sector. Chinese real estate, accounting for 30% of the country’s GDP, was also struggling (for different reasons): property sales were down 20% year-on-year, giant developer Country Garden had defaulted on its USD bonds and 20 million homebuyers had paid for units that might never be built.
Equity performance so far in 2023 had been patchy and narrow: the so-called “Magnificent Seven” (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) had driven almost all the gains in the S&P 500 equity index.
Then came a shift in the Fed’s view of the world. Chairman Jay Powell’s openly softened his ‘higher for longer’ guidance with the recognition that the market itself was implementing policy: ‘the bond curve has added equivalent hikes into the system due to much tighter financial conditions’. As inflation eased in November and leading economies found some measure of stability, the Fed publicly contemplated a move toward greater accommodation. Predictably, investor sentiment strengthened; equity and debt markets surged in November (though not in all countries equally). This growing optimism that inflation had peaked seemed to be vindicated on 13 December when the Fed left rates unchanged: the ‘dot plot’ of the rate predictions of the FOMC’s own members pointed towards 75 bps of interest rate cuts ahead and the Chairman was in dovish mood at the press conference.
Risk was firmly ‘on’. Bonds and stocks rallied, corporate credit spreads tightened and volatility softened, a combination which amounted to a significant easing of financial conditions in the last two months of the year.
2023 was a rollercoaster for investors: in Q1 markets were haunted by the spectre of stagflation as rates looked set to stay ‘higher for longer’ despite a looming recession and US bank failures promised a credit crunch. The weather brightened in Q2 as markets focused on the power of AI to drive productivity expansion but persistent inflation in Q3 refocussed investors on rates staying higher for much longer. Q4 provided a happy ending to the year as inflation retreated and growth remained robust, holding out the promise of a soft landing (or no landing at all).
We enter 2024 with markets in a positive mood after a significant rally in asset markets over the last two months driven by looser policy and softer financial conditions. As the following chart shows, the trend in global policy rates has turned in a dovish direction, led by the Fed, after reaching unprecedented levels of hawkishness in mid-2023.
The next two charts show that while the Fed is guiding for 75 bps of cuts by the end of 2024 (figure 1) the bond markets are now pricing in a 95% certainty of 150 bps of cuts this year, starting in March (figure 2).
Figure 2: Market Based Probabilities of United States Interest Rates
We now have a set-up for markets that appears somewhat binary.
On the positive side, further rate hikes are probably unlikely. Inflation is trending lower and base effects should help it to keep doing so over the short to medium term. Historically asset markets do well between the last rate hike and the first rate cut, so if investors believe that July 2023 was the last hike then their risk appetite should be significantly improved now. The inverted yield curve and falling interest rates (even if they remain historically high) makes refinancing existing debt much less painful than it was just two or three months ago. This should be a good moment for equities: falling bond yields are increasing the present value of future cashflows, the data is pointing to a marginally expansionary economic environment and earnings expectations seem to be exiting a soft patch (figure 3).
Figure 3: Consensus Expectations for Sales and Earnings growth
Less positive market watchers will point out that the yield curve remains deeply inverted, a classic indicator of a coming recession (see Figure 4 below). Seen in the context of an inverted curve, the market’s implied expectations of rate cuts could be reflecting much lower growth rates ahead rather than lower inflation per se; the strength of the equity market would seem to contradict that view. Monetary policy changes always act with a lag and liquidity has been a much more significant driver of asset prices in this cycle than we have seen in the past. Falling inflation is a necessary but not sufficient condition for rate cuts; resilient growth changes the Fed’s calculus, both threatening a return of inflation and reducing the urgency to cut rates.
Figure 4: U.S 10 Year 2 Year Spread or Yield Curve – with recession highlighted
Note: Recessions occur post curves moving from inversion to a steeper curve.
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 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.
As mentioned, given the moves over the last several weeks in asset markets we do believe much has been priced and the current upside is limited versus the potential buying opportunity that lies ahead in next few months and as such we continue to look for rangebound markets (for the time being) with our broad asset allocation attractiveness in our view reflected below.
Stanlib Multi-Asset, Data correct 18 December 2023.
Multi-Asset Team tactical asset allocation view is informed by numerous factors including liquidity, volatility, sentiment, valuations, momentum and economics. Additionally, we build scenarios to help inform our thinking around what multiple futures environments could look like in addition to ascribing probabilities and risks to each of those potential future paths. Our quarterly tactical asset allocation stance represents our current 12-month view at the end of each quarter on a range of asset classes and geographies within our universe.
Importantly, these views do not consider risk budgeting for portfolio construction but rather represent our relative preferences, and hence might not reflect our actual portfolio positioning. This output should not be considered advice.