Towards the close of the previous year, the Federal Reserve (Fed) underwent a notable shift in its policy stance, signaling a forthcoming ease in rates for the year 2024—a sentiment reinforced during the March meeting. With the realization that policy rates have likely reached their peak for this cycle, there has been a commendable performance in risk assets. Equities have surged to record highs, while credit spreads have approached their cycle lows making navigating the markets increasingly challenging for investors.
Economics
We foresee the U.S. real GDP growth hovering around 2% in 2024, slightly above trend and consistent with the ongoing pace. Inflation is poised to gradually recede, with headline CPI projected to reach the low 2s by year-end. Consequently, we anticipate the Fed to enact two or three rate cuts this year, with the likelihood of commencement at the June meeting. On a global scale, we anticipate a rebound in European activity from a subdued base, countering the slight deceleration in U.S. growth.
This environment advocates for a pro-risk strategy. Within our multi-asset portfolios, we favor overweight positions in credit and equity, while maintaining a neutral stance on duration as bonds are expected to trade within a range. The prospect of rate cuts is anticipated to mitigate the risk of bond yields experiencing significant upward movement.
While we acknowledge one primary risk to this optimistic outlook—potential stickiness in inflation at current levels, or worse, a reacceleration—recent U.S. inflation indicators, although surprising to the upside, do not alter our belief in the downward trajectory of inflation, particularly in key drivers such as shelter. However, vigilance regarding labor market dynamics is maintained to detect any signs of wage inflation, which have thus far remained subdued.
Equities
As investors recalibrate economic risk from imminent recession to a softer landing, the S&P 500 has witnessed a significant rally since October. Nonetheless, we recognize that the business cycle still has room to progress, albeit not in its early stages. Consequently, we expect more subdued earnings growth and valuation expansion, while retaining a constructive outlook on stocks over the intermediate term.
In the short term, it is conceivable that technical momentum and excessive optimism surrounding the pace of rate cuts may have propelled stocks too swiftly. While we anticipate positive earnings growth in the coming years, recent price momentum may experience a slowdown. Hence, we marginally reduce equity overweights, with the intent of leveraging any consolidation to reassume higher-risk positions.
Across equity markets, we continue to identify attractive relative value and stock selection prospects, with a preference for high-quality, cash-generating entities. The recent diversification of market leadership away from the mega-cap technology sector bodes well for long-term market trends and active alpha generation. Regionally, we favor Europe and Japan, while acknowledging an improved outlook for emerging markets (excluding China), specifically, India, Mexico, and South Korea. Although the US offers appealing stock selection opportunities, it fares relatively lower in comparison to other regions.
Fixed Income
While credit spreads have tightened alongside equity market rallies, supportive technical factors, particularly investor demand for new issuances, sustain the credit market's resilience. Even in the event of equity market consolidation, credit spreads are expected to withstand moderate widening, given the strong demand for new issues and minimal concessions to investors.
Returns from credit are projected to stem primarily from coupon carry rather than spread tightening at this juncture, underscoring the significance of credit in a portfolio context. Notably, shorter-dated U.S. high-yield, non-agency mortgages, and securitized credit are favored within the credit complex.
Anticipating a decline in riskless rates as policy rates decrease, we keep duration targets at slightly longer than normal. However, we remain cautious, given the marginal offset between carry penalties and yield rallies. While we do not foresee a sharp downturn in U.S. yields barring a significant growth slowdown, we identify relative value opportunities in government bonds and actively manage trading within ranges. Our preferences include the U.S., core and peripheral eurozone, and Australia, while Canada and Japan are underweighted. This positioning allows us to benefit if the Federal Reserve waits too long (for which there is ample historical precedence) to cut rates and we experience a growth slowdown and subsequent sharp drop in rates.
The prevailing policy rates, notably 5.5% in USD and 4% in Europe, prompt some investors to favor holding cash. However, we view this as far from a riskless strategy, emphasizing the importance of managing associated negative carry and exploring opportunities across various asset classes.
As policy rates are anticipated to decrease mid-year, further declines in rates volatility are expected. While short-lived spikes in volatility may occur amid stock consolidations, we anticipate overall subdued cross-asset volatility throughout the year. This, coupled with declining inflation, suggests a potential reduction in cross-asset correlations, enhancing diversification prospects for asset allocators.
The Election
All elections, but especially Presidential Elections, introduce uncertainty into financial markets. Both sides of the aisle believe in their candidate and see the other side as being bad for markets. Either way, both sides recognize they can wait to make investment decisions be that in their companies, real estate, or portfolios. This act of waiting generally evaporates as the likely winner becomes more clear and gives both sides of the aisle more clarity on what they are likely to face over the next term. As such, they start to make investments and markets, on balance, tend to move upward going into elections.
In conclusion, an environment characterized by moderating growth, declining inflation, policy rate cuts, and sustained low volatility favors a risk-on approach. While acknowledging the tendency of markets to overextend in the short term, we remain steadfast in our conviction that the prevailing conditions are conducive to risk-taking, actively seeking opportunities to augment positions during any consolidation phase.
5-year Investment Outlook
Opportunity | UW | N | OW | Conviction | Rationale |
U.S. Large Cap | ● | Overvalued and earnings growth likely to grow into current valuations. | |||
U.S. Small Cap | ● | Favor profitable firms with low leverage | |||
Value | ▲ | Moderate | Trading at a discount to growth | ||
Growth | ● | Low | Relatively expensive but the AI theme is not yet fully realized | ||
International Equity | ▲ | Moderate | Steep discount to historic levels | ||
Emerging Equity | ▲ | Low | Earnings outlook shows signs of bottoming | ||
China | ▼ | Low | Property sector remains weak | ||
Japan | ▲ | Moderate | Solid GDP growth and a new focus on shareholder value | ||
Duration | ▲ | Moderate | Fed rate cuts looming but could be pushed farther to the right. we believe this would be a further catalyst for additional duration | ||
Treasuries | ● | Curve likely to steepen, scope for bond rally is limited | |||
Inv Grd Municipals | ● | ||||
Inv Grd Corporates | ● | ||||
High Yield Muni | ▲ | High | Limited spread compression, but strong balance sheets mean limited defaults | ||
High Yield Corp | ▲ | High | Limited spread compression, but strong balance sheets mean limited defaults | ||
Real Estate | ▼ | Elevated rate environment reducing buyers, shelter inflation falling | |||
Gold | ● | Has had a strong run, near 52-week highs | |||
Energy | ● |
Sources and disclosures