View From The Top: Get ready to ride the rollercoaster (again)

View from the very top: Timing is everything. A move beyond peak rates accompanied by improving sentiment could result in risk assets continuing to make new highs. The macro backdrop certainly looks markedly more compelling than a year ago, although consensus opinion has pivoted to reflect these more favourable dynamics. We see every reason for both bonds and equities to rally, helped by falling inflation break-evens and lower real yields. However, the return to normalisation for the world economy is unlikely to be either smooth or linear. The descent from peak rates has only been mapped out at this stage, as opposed to having formally started. There is ample room for error. Political grey swans may also complicate the investing landscape in 2024. There are merits then, in adopting a humble approach. Parse through the everything, everywhere rally and look for opportunities. These will be ample, as will be the scope for dispersion over the coming year.

Asset Allocation:

• Equities: The playbook for 2023 was to buy and hold equities. The same formula should work for 2024, but it is important to recognise that there is more to this asset class than just the Magnificent Seven mega-cap tech stocks. For these businesses to continue performing, they will have to keep beating highly elevated expectations. The broader market should benefit from both lower rates (reducing the cost of capital) and the end of the earnings recession. Bloomberg forecasts over 10% earnings growth for the MSCI World in 2024. We believe that the equity rally should broaden beyond tech, benefiting cyclicals and small-caps in particular. A good balance across factors and styles could work in 2024.
• Fixed Income/Credit: Government bond yields have fallen markedly from their highs, reflecting more dovish commentary from the Federal Reserve. The yield on 10-year US Treasuries has dropped from a close to 5% peak in October 2023 to below 4% at the end of last year. While this is pleasing news for bondholders, it does not make up for the bruising period of losses endured since 2021. Against this backdrop, the rally in fixed income has markedly further to go, in our view. Our approach is to play credit across the spectrum and to be flexible, especially as a more normal business cycle likely comes into play again.
• Currencies: We are not surprised that the Dollar has weakened as expectations have grown that the current Central Bank rate hiking cycle is over. This trend may persist in the near-term, benefiting other (non-Dollar) currencies.
• Gold: There may well be further upside for the precious metal, helped both by falling real yields and a weaker Dollar. We have long been advocates of gold, given the diversification benefits it brings. It can also act as a potential hedge amidst more heightened geopolitical tensions.  
• Alternative Assets: Owning assets with collateral-based cashflows brings diversification to portfolios. We advocate being selective across this broad and diverse area, favouring businesses with strong balance sheets and reasonable valuations. Areas such as pharma royalties could be interesting for 2024.
• Cash: We believe the case for considering cash as an asset class will weaken over the course of 2024, as interest rates likely fall in most developed markets. We advocate steady, judicious and unemotional deployment. 

If there was one key lesson from 2023, then it was not to trust expert views. A recession didn’t happen, inflation came under control and equities correspondingly came close to making new all-time highs. As we enter 2024, optimism seems to abound from almost all quarters. We believe that the investment set up for the next 12 months does indeed look highly compelling, but we do not expect the ride either to be totally smooth or linear. Exogenous factors such as politics may also play a potentially destabilising role. Buckle up then.

To the extent that investors have taken on board just how different 2023 turned out be relative to start-of-year projections, they have performed a volte face when considering 2024. Calling for a recession is now considered contrarian. The latest Bank of America Merrill Lynch Fund Manager survey (which is probably a lagging indicator at the best of times) shows cash allocations at a two-year low and investors at their most optimistic in 24 months. The reason: a consensual view that the Federal Reserve is done with hiking interest rates. More than that, however: around 150 basis points of interest rate cuts are being discounted in the US over the course of 2024. For the record, the Fund Manager survey cited above was carried out before the most recent meeting of the FOMC.

It seems only reasonable, then, to consider whether such optimism is justified, or simply unbridled. Have no doubt, comments from Jerome Powell following the conclusion of the most recent FOMC meeting spoke of ill-concealed dovishness. Or at least that was the interpretation chosen by investors. Add to risk and ask questions later seemed to be the strategy. Powell said that the Fed was “very focused on not making the mistake of leaving rates too high.” History has shown that it is generally the right approach not to fight the Fed.

However, after the past year of confounded expectations, a dose of humility might be worthwhile. At the least, some balance. It is fair to recognise that the risks to the economy are still finely balanced. Sure, the expectation of lower interest rates can translate into de facto easier financial conditions. This needs to be offset though against the lagged effect of prior rate hikes on consumers, businesses and banks. Economies can turn very quickly.

The optimists would, of course, cite a simple formula at work: mission accomplished by the Fed. Risk-on as we move beyond peak rates, enjoy slowing inflation, rising profits and improving sentiment. A bond-led equity rally could easily continue into 2024 as both inflation break-evens and real yields drop. At the same time, there is close to $6tr sitting in money markets (per Bloomberg), waiting to be deployed. Further upside could occur should the IPO market re-open and dealmaking accelerate as policy eases from its prior tightening bias.

This set up could spur an everything, everywhere rally were the once unthinkable soft landing now to occur. Bulls would also assert that should the economy contract, then it is unlikely to be severe. It might not even matter though. The market is an effective discounting mechanism, most likely to look beyond a temporary period of weaker growth. Look further ahead and a disinflationary boom could usher in a period not dissimilar to the last time the phrase ‘roaring 20s’ was deployed. The (US) economy could be poised to enjoy a period of solid supply-side led growth helped by productivity gains from artificial intelligence.

Hold on, the pessimists would say. It is worth wondering whether the rally has got ahead of itself, embedding lofty expectations and leaving little room for error. A falling VIX index of volatility – at its lowest since 2019 – may also speak of potential complacency. As we noted at the start of this report, sentiment can be a great contradictory indicator. If everyone is extremely bullish, then perhaps the only way to go is more bearish.

It’s important to take the Fed Funds Futures projections (visible using the WIRP function on Bloomberg) with a pinch of salt. The street clearly drastically underestimated the extent to which the Fed (and the ECB, Bank of England too) needed to hike on the way up. Markets have done, and always will, create their own reality. It is logical then, for the Fed to seek to temper optimism. This has been reflected in more recent comments from FOMC officials, asserting that the perceived pivot has gone too far. Expect to hear more similar rhetoric in early 2024.

Investors should ask why the Fed would be in a rush to cut rates anyway. Doing so could potentially risk throwing away a hard-won victory on inflation. Sure, inflation (and the Fed Funds rate) have peaked – no-one disputes this – but do not forget that core inflation is still running at double the Fed’s target. ‘Sticky’ inflation, as measured by the Atlanta Fed is at 3.0% and last-reported US wage growth at 4.0%. At the same time, rate cuts haven’t even started yet.

There may also be an inherent contradiction in the idea of the Fed pulling off a soft landing in 2024 and also cutting rates. Perhaps the correct question to consider is not whether the US Central Bank needs to cut, but why. We believe the debate can best be reconciled via the idea of normalisation. Take a step back. The period we have all lived through since 2020 has been far from a normal business cycle. Consider then that normalisation would be the process whereby the post-COVID economic readjustments are over and a more traditional business cycle can resume. This would imply de facto easing of monetary policy and tightening of fiscal policy. Recession may not be either necessary or needed if the Fed reacts to lower inflation with interest rate cuts, as the economy normalises.

Timing is everything. If policymakers can get this right, then the rally in risk assets will be sustained. There is, however, still ample room for mistakes, even if Powell has given himself some room for manoeuvre. Data-dependence remains the ultimate get-out clause. The descent from peak rates has only been mapped out at this stage, as opposed to having formally started. Any return to normalisation can still be bumpy. At the least, it will be important to consider the realities of an economy under stress. Watch for rising delinquency rates on credit cards and auto loans. Expect also to assume that default rates rise next year, even if far from the extent witnessed during either the GFC or the bursting of the TMT bubble.

Don’t forget about the risk of (more) grey swans emerging in 2024. Over half of the world’s population will be voting over the course of the year, with most eyes inevitably on the US. America may turn more hawkish on China ahead of its election in order to pre-empt any possible criticism from the Trump camp. The risk of retaliation and escalation, or just simple miscalculation, should not be under-estimated. Were Donald Trump to win the Presidency, then expect more fiscal largesse and increased protectionism. In a scenario where the Republicans lose (with Trump at the helm), then the result will almost certainly be contested, perhaps very vocally. Febrile situations remain elsewhere: in Ukraine, the Middle East and Taiwan.

Against such a backdrop, humility will remain essential. It will be important for all investors to parse through the everything, everywhere rally. There will be much scope for dispersion and multiple opportunities over the coming year. Get ready to ride the rollercoaster, again.

Alex Gunz, Fund Manager, Heptagon Capital