View From The Top: Trust the pilot

Asset Allocation:

• Equities: Global equities have gained over 15% year-to-date, an outcome few would have predicted at the start of the year. Sure, this increase has been helped by a 9% market bounce in November, while the so-called Magnificent Seven mega-cap tech stocks have also played a disproportionate role in driving performance. Nonetheless, the earnings recession ended in Q3 (per FactSet), with US corporates reporting annualised earnings growth for the first time in four quarters. Greater expectations (of over 10% for the S&P 500) are embedded for 2024, which may represent a possible risk for disappointment. However, this could be offset by a transition towards a lower rate environment, which would likely spur multiple expansion. We favour diversification across growth and value, cyclical and quality. The divergence between the NASDAQ Index and the Russell 2000 is at its widest since the dotcom bubble.
• Fixed Income/Credit: After the longest bond bear market in recent history, November saw a massive reversal with yields dropping across the curve. Lower inflation prints and a perceived shift in Central Bank strategy is inevitably a positive for fixed income. 2024 could be a strong year, particularly given the current starting point. We also believe that there will be clear opportunities within the corporate credit space. Bankruptcies are already rising and refinancing risks will only increase. We could be at the start of a true credit cycle for the first time since the end of the Financial Crisis.
• 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: At the same time that equities have risen, while Treasury yields and the Dollar have dropped, gold has strengthened. A more dovish Fed combined with a weaker Dollar would be bullish for gold. We see the asset as being an important one for portfolios, acting also as a buffer against market volatility and geopolitical uncertainties. Central Banks are also current gold buyers.
• Alternative Assets: Owning assets with collateral-based cashflows brings diversification to portfolios and acts as a hedge against inflation. We advocate being selective across this broad and diverse area, favouring businesses with strong balance sheets, reasonable valuations and dividend yields.
• Cash: The logic for holding cash is based more on the interest it can generate than its defensive qualities. Over $1tr has flowed into money markets year-to-date. We expect to see increasing tactical deployments over the next year.

Experts have been confounded in 2023. Assumptions of imminent disaster have needed to be rethought quickly. Being too negative proved to be the wrong strategy. As we survey the landscape at the end of the year, it is clear that the world succeeded in defying gloom. The economy grew and inflation came down. Predictions of a recession fell flat. We think a similar playbook may be required for 2024. Put another way, challenge received narratives and be prepared to be contrarian. Sure, it’s important to be cognisant of the risk environment, but our inclination is to push back against excess caution and adopt a more constructive approach to asset allocation.

Over the past year even the sceptics seem to have accepted that bringing down inflation might not have to be so painful after all. In defence of the Federal Reserve, it has implemented 11 interest rate hikes in the current cycle and the economy has not imploded. March’s banking crisis seems clearly in the rearview mirror. A similar story of economies surviving higher rates has also played out elsewhere around the world. The most anticipated recession in history therefore never arrived. Indeed, in the last quarter, the US delivered annualised GDP growth of 5.2%, well above its long-term trend rate. Unemployment is near record lows. At the same time, headline inflation has dropped from its 9.1% peak to just 3.2%. Globally, inflation peaked at 10.7% in October 2022. Last month, it was 6.2%, per the OECD.

Against this background, expectations have grown for a soft-landing for the US economy. If this scenario were to play out, then it would have to be considered an extraordinary success on the part of Central Banks. The Fed and its counterparts will have piloted their respective economies through challenging terrain. Sure, no-one is declaring victory yet, but the move in risk assets over the past month is perhaps akin to peak rates euphoria. If rate rises subside, then longer duration assets should do well. That, at least, was the broad post-GFC playbook.

A comfortable consensus seems then to have settled on the notion of soft landing, lower rates and a weaker US Dollar. When global investors were polled last month by Bank of America Merrill Lynch in its regular survey, two-thirds said they were expecting a soft landing, while 80% believe in lower rates over the next year. Fed Fund Futures back up the latter contention, with 100 basis points of interest rate cuts priced by the end of 2024 (per the WIRP function on Bloomberg).

Such a smooth transition depicted above would be undoubtedly reassuring for investors, but it does also leave little room for error. An important balance needs to be struck between complacency and scepticism. Our sense is that because many investors were surprised by how markets in 2023 panned out, there is now a certain default towards circumspection. The sceptics (perhaps justifiably) contend that growth is slowing and that inflation is still too high, or at least above the Fed’s desired level. Hard landings are often preceded by growing conviction in a soft-landing narrative. Do not forget, there have been many ‘head-fakes’ in this cycle so far.

It also pays to consider other scenarios. Perhaps a tendency towards looser financial conditions and a perception of falling inflation will serve to boost demand and keep inflation stubborn. Alternatively, were inflation only to fall from current levels in fits and starts, then this might force Central Banks to keep policy restrictive, thereby amplifying the possibility of a slowdown. Many would argue that getting inflation down to 2% has never been done before without a recession. Look further out and the latest University of Michigan survey sees 5-10 year inflation at 3.2%, still an uncomfortably high level for many policymakers.

Inflation arguably holds the key to the macro outlook. The faster it drops, the better the odds of a soft landing, and the easier it becomes for the Fed et al. to contemplate reversing monetary policy. The reality, as we see it, is that the indicatorsfor lower inflation look good. Supply chain constraints have eased considerably and are now back to pre-pandemic levels in most industries. Shelter inflation is dropping and has further to fall. Labour market imbalances are also improving, with the job quits rate in the US at its highest in four years, creating more liquidity. Wage growth in the US has dropped to sub-4%. Disinflation has further to run in our view.

At the same time, there is no denying the lagged effects of monetary policy. Companies (and governments) must refinance eventually. At some point, excess savings will also have been spent. Sentiment has a tendency to turn very quickly. In the absence of perfect foresight, however, we will never know whether  the Fed over-tightened. Data do show that corporate bankruptcies in the US are already at their highest level in over a decade. Look ahead and next year will see $790bn of corporate debt maturing in the US, a c.50% increase on 2023’s figure (data from Moody’s and Goldman Sachs respectively). When the high yield and leveraged loans markets are added in, there is around $3tr of outstanding debt that requires imminent refinancing. A reckoning may be due.

It would therefore be foolhardy to disregard the sceptics altogether, particularly in a world of still elevated geopolitical uncertainties. We recognise that it is only logical to believe that economic growth does slow from current levels and that 2024 will be a year when the world more fully adjusts to the lagged effects of higher interest rates. Remember, however, there is no formally agreed upon definition of what constitutes a soft landing, beyond the avoidance of recession. We believe that recession will likely be avoided. Regardless, in order to believe in a soft landing, you have to trust the plane’s metaphorical pilot. Look no further than Jerome Powell (and his peers). Maybe the playbook is no more complicated than it’s ever been: don’t fight the Fed.

The more important conclusion we are inclined to is that markets tend to be forward-looking. We have moved beyond the finishing-hiking phase of the current cycle to the starting-cutting phase. Investors could plausibly see over the trough and possible economic contraction into a better future scenario, with lower rates. Naturally, the more quickly inflation falls back to target levels, the faster the hurdle rate for rate cuts will drop. Any squeeze in corporate profits from an economic slowdown could be moderated by lower wage growth inflation. Earnings multiples would also rise as Central Banks shift from a more hawkish to dovish stance.

Even if the economy does manage to land softly, it may start another wild ride at the end of 2024, were Donald Trump to be elected as US President. While hard to predict at this stage, fiscal profligacy and more protectionism could be the hallmarks of a Trump Presidency. Most disruptive nations around the world would likely prefer Donald Trump to Joe Biden as President too. Investors have become conditioned to ignore geopolitical risks, but such a strategy only works until it doesn’t. The post-GFC equilibrium of broad geopolitical stability and falling rates looks like a distant aspiration. At best, we can hope for a fragile equilibrium in 2024, but this would still be more than what the sceptics may be willing to discount.  

Alex Gunz, Fund Manager, Heptagon Capital