Barometer: Markets getting carried away

Asset allocation: wary of Goldilocks reflation trade

2023 began with prospects for the global economy darkening The fear was that runaway inflation and higher interest rates would trigger a worldwide recession.

A year later, and investors are facing a remarkable change in the economic landscape.

The global economy may be slowing, but it remains resilient enough to avoid a hard landing. Inflation is declining around the world, albeit with bumps, which will encourage most major central banks to terminate their tightening campaign and start cutting interest rates in the coming months.

Expectations for such a Goldilocks scenario have given rise to a powerful reflation trade across asset markets in recent weeks. But we have reasons to be cautious - not least because investors appear to be getting ahead of themselves at a time when end-year market dynamics may be distorting prices.

This is why we prefer to be benchmark weight in our asset allocation, downgrading bonds to neutral and upgrading cash to neutral. We remain neutral in equities.

Our analysis of the business cycle shows the US is unlikely to regain growth leadership among developed economies anytime soon. Manufacturing and housing sectors have slowed down, while leading indicators suggest capital investment will contract in the coming months in line with depressed levels of future spending intentions.

What is more, we expect US services consumption to moderate soon. This is because US consumers continue to run down savings they built during the pandemic. These have fallen to just USD337 billion in October from a USD1.8 trillion peak in mid-2021.

We expect this number will run down to zero by the end of the first quarter in 2024. At the same time, the US labour market is showing early signs of weakness. Job openings are down about 3 million from their peak in mid-2022.

For all this, and even with inflation falling faster than previously anticipated, we don't believe the US Federal Reserve will see fit to lower real interest rates. We expect the US central bank to cut interest rates just three or four times next year, a less dovish scenario than that priced in by bond markets. 

Our liquidity analysis supports our neutral asset allocation stance.

Global excess liquidity -- the difference between the rate of increase in money supply and nominal GDP growth – is only slightly positive. 

Conditions won't necessarily become easier in the event of US interest rate cuts. In our view, while the Fed will lower the Fed funds rate over the course of 2024, it will be keen to keep real interest rates steady. Which means market expectations for easing of as much as 150 basis points, double what the Fed signalled at its recent meeting, look overstretched. Other central banks are equally unlikely to deliver aggressive interest rate cuts given the risk of reigniting inflation.

By contrast, we think China is easing too little. Monetary authorities need further interest rate cuts to counter forces from structural deleveraging which pose risks to highly indebted sectors of the economy.

Our valuation model shows equities remain relatively expensive even after the rally in bonds, particularly in the US where the equity risk premium stands at a multi-year low of 3.8 per cent. We expect corporate earnings growth in developed companies to be well below consensus forecasts, especially in the US where our base case for an EPS increase of 2.5 per cent is less than a fifth of the market estimates. While bonds offer value in the longer term, especially Treasuries, the asset class looks slightly overbought given a recent rally.

Finally, our technical indicators score neutral for both equities and bonds.

Equities regions and sectors: too much too soon

The equity market’s storming year-end performance has, in little more than a month, achieved much of what we were expecting for the whole of 2024. As a result, we remain cautious on the asset class, despite positive signals coming from the Fed on how soon rates are likely to be cut.

Investors have rapidly priced in a Goldilocks scenario of fast-falling inflation, and commensurate rate cuts - all of which against a backdrop of relatively stable growth. US equities in particular look to have got ahead of themselves, both on technical and valuation grounds, which is why we maintain an underweight on the market. 

One red flag emerges when comparing US stocks' price-earnings to measures of market volatility. 

Relative to the VIX index, the P/E of US stocks has been higher than its current levels only once in the past 30 years (Fig.3). Taken in isolation, this suggests US equities will underperform bonds by 15 per cent over the coming year. On a pure P/E basis, meanwhile, the market is about 5 per cent overvalued. The upshot is that any further gain for US stocks can only really come via increases in corporate earnings growth, which will be modest, according to our model. 

Of course, Fed liquidity will play a role in the behaviour of stock markets. Since the pandemic, we calculate that some 80 per cent of the US equity market’s variance stems from the Fed’s relative liquidity position. Technical adjustments by the Fed to some of its monetary operations could end up generating just enough additional liquidity to add another couple of percentage points to the stock market's recent gains. 

If the US market is looking expensive again, stocks elsewhere look better value - we remain overweight Swiss and Japanese equities. The Swiss market contains an abundance of quality stocks, which is where we think investors ought to be allocating capital to at this stage of the economic cycle. Japan equities' strong performance this year means that the market offers less value than it did, but for now structural tailwinds of a break out of deflation and strong corporate reform agenda remain supportive 

Within sectors, we continue to favour quality and value stocks. We remain overweight energy. Although oil prices have softened, a drop in interest rates rates should shore up demand. At the same time, Middle Eastern tensions, not least attacks on Red Sea shipping by Yemeni rebels and pirates, could spark a jump in crude prices.

A softer economic backdrop should continue to favour consumer staples, in which we hold a larger-than-index position, and weigh against consumer discretionary, in which we retain an underweight. The US consumer has been surprisingly resilient so far, but we think that there are warning signs coming from low-income households and the jobs market.

Longer-term, how things pan out for equities will depend on whether economies return to the post-global financial crisis regime of disinflation and near zero interest rates or to a pre-2008 era of more pronounced inflation and higher real rates.

Fixed income and currencies: growth edge for EM

Rarity tends to make things more precious. Next year, as world economy slows down, growth will become an increasingly rare commodity. Emerging markets (EM) will be among the few areas of globe where it can be found. Which means EM local currency bonds should do well. 

While we expect GDP growth in the developed world to roughly halve in 2024 to 0.8 per cent, dipping below potential, the pace of expansion in the developing world should accelerate slightly to 3.9 per cent, just above potential. This has significant implications for asset allocation in fixed income. 

Our research shows that a large and widening growth premium between the developing and developed world tends to benefit EM currencies and bonds, the main reason why we remain overweight EM local currency debt.

US Treasuries also have potential, despite the significant recent rally. For one thing, our valuation models still suggest that US bonds look attractive compared to US stocks. Secondly, Treasuries tend to do well in times of heightened risk aversion so could provide a useful hedge during a year when global political tensions are likely to remain elevated, elections are due in many countries (not least the US itself) and there is much uncertainty over the path of growth, inflation and rates.

Given the current, relatively flat nature of the US yield curve, we see the best potential in shorter-dated maturities (up to about 5 years). For benchmark 10-year paper, our inflation and growth forecasts suggest a fair value yield of 3.75 per cent, compared to current levels of around 3.9 per cent. With inflation expectations now back to pre-Covid levels, we see value in US inflation-protected bonds, especially for global multi asset portfolios.

In credit markets, we continue to prefer higher quality bonds, especially US investment grade debt.

Credit has held up very well, particularly at a time when economic growth has been slowing and expectations for corporate earnings growth have been scaled back.

Even so, high-yield bonds aren't especially attractive. 

While the recent decline in bond yields reduces the cost of debt refinancing for non-investment grade borrowers, we believe US high yield spreads (roughly 350 basis points as of end December 2023) are too narrow to be justified given that default rates are set to rise next year. Indeed, this is one of the most expensive fixed income assets on our valuation grid.

When it comes to currencies, we see further declines in the dollar. 

As US rates head lower – we see three to four cuts in 2024 – interest rate differentials will stop being a support for the greenback. The dollar is also coming under pressure due to its expensive valuation and a peak in the relative performance of the US economy. Beneficiaries of the US unit's decline will include EM currencies. But we are also positive on the Japanese yen and the Swiss franc. In both Japan and Switzerland, monetary policy will get tighter relative to the rest of the developed world. 

The yen is some 20-30 per cent undervalued according to our models and – unlike other major central banks – the Bank of Japan (BoJ) is actually turning more hawkish. We think an imminent policy normalisation from the BoJ, combined with capital inflows, will be powerful catalysts to push the yen higher.

The Swiss franc, meanwhile, benefits from defensive properties as  well as the country's non-inflationary growth and fiscal discipline.

We also continue to be overweight gold and have a price target of 2150 per ounce by the end of 2024. Gold is not cheap but the expected decline in both the dollar and US rates, as well as flat world supply, are significant headwinds. 

Global markets overview: star turn for stocks

December saw another month of strong gains for both bonds and stocks, adding to a rally that began early in the fourth quarter. The end of year surge left the MSCI World Index up a remarkable 22 per cent in local currency terms in 2023, the best annual showing since 2019 as investors heralded the end of interest rate hikes and prepared for a likely easing of monetary policy in 2024.

The rally was especially strong in the US, where the S&P 500 finished the year within touching distance of its all-time high after Fed chairman Jerome Powell said the central bank has “done enough” and rates were “likely at or near” their peak. Stock markets also took heart from Fed’s updated policy projections pointing to 75 basis points of cuts during 2024.

Elsewhere, Japanese equities ended their best year in a decade, with the Nikkei gaining 27 per cent as the economy continues to do well, deflation has given way to inflation, and years of corporate governance reforms appear to be paying off. 

December also saw broad-based gains among most sectors, with the exception of energy, which was hit by a retreat in oil prices. For the year as a whole, IT and communication services were the clear winners. 

Having suffered for most of the year, bond markets ended 2023 some 4 per cent higher in aggregate as expectations of rate cuts pushed down yields in November and December.

Yields on benchmark 10-year US Treasuries dropped by around 100 basis points in the final two months of the year in the face of increasingly dovish signals from the Fed and falling inflation. Similar trends were also in play in the euro zone.

Falling yields drove down the dollar in December, pushing it into the red for 2023 as a whole, with losses particularly pronounced versus the Japanese yen.

The prospects of lower US rates revived investor appetite for risk in the final weeks of the year to the benefit of emerging market assets, prompting gains across EM currencies, bonds and equities.