Andrew Pease

GLOBAL HEAD OF INVESTMENT STRATEGY

“There is nothing more deceptive than an obvious fact,” according to the fictional detective Sherlock Holmes. A year ago, the industry consensus thought it obvious that the U.S. economy was on the brink of recession. The respondents to the Federal Reserve Bank of Philadelphia’s survey of professional forecasters predicted the highest probability of recession in the survey’s 45 year history. The U.S. Federal Reserve (Fed) had embarked on the most aggressive tightening since Former Fed Chairman Paul Volcker’s tenure in the early 1980s, the yield curve had inverted, sending a classic recession warning sign, and the cyclically important Institute of Supply Management (ISM) manufacturing index had fallen into contractionary territory.

The U.S. economy is on track for above trend growth in 2023, global equities have posted double digit returns and government bond yields have risen. Having been humbled in 2023, the consensus has reversed direction. A recent survey by Bank of America found that 74% of fund managers expect a no recession “soft landing” for the economy in 2024. This optimism is evident in bottom up industry consensus expectations for 11% earnings growth in 2024 by S&P 500 companies, and in spreads on high yield corporate bonds that are below their long term average.

Are U.S. recession risks still elevated?

We are not as confident that the all clear can be sounded on recession risks. Corporations and households built strong defenses against Fed tightening following the pandemic, accumulating large cash reserves and locking in low interest rates on 30 year mortgages and longer term corporate bonds. These defenses, however, are beginning to crumble. Households will soon exhaust their excess savings, while significantly higher interest rates which have become a constraint on new borrowing will create refinancing issues. We think this cycle may be a case of this time is longer rather than this time is different with regards to the lagged impact of aggressive Fed tightening on the U.S. economy. Recession in 2024 might be avoided, but the risks are elevated.

Slowing jobs growth and declining inflation are signs the economy has begun to cool. The good news is that the Fed has probably finished lifting interest rates and may contemplate easing during the first half of the year. It also means, however, that we are entering a period of heightened uncertainty as investors debate whether recession can be avoided. It may appear for a time that the U.S. economy has achieved a soft landing, but this could be a waypoint on the path to a mild recession later in 2024.

Is the UK at a greater risk of a recession? What about Europe?

The other developed economies are also under stress from aggressive tightening. Europe has been hard hit by the global manufacturing downturn and demand weakness from China. The UK economy has had a larger inflation shock than others and is still battling the fallout from Brexit. Both are likely to underperform the U.S. economy in 2024.

Japan remains an outlier with accommodative monetary policy and above trend gross domestic product (GDP) growth. This should continue through 2024, allowing the Bank of Japan to progressively step away from its yield curve control policy.

China’s economy appears to be stabilising in response to piecemeal stimulus policies. The debt and property market problems will continue to be a headwind and growth is likely to remain lackluster.

What’s the outlook for equities in 2024? What about bonds?

Slower economic growth and the threat of recession provide a cautious equity market backdrop. The S&P 500 Index is expensive with a forward price to earnings ratio of 18 times as of November 2023 and has priced a soft landing cycle view based on double digit earnings growth expectations. Asymmetry seems the best description of the outlook, with significant upside only if both the economy and earnings beat already optimistic expectations. Our concerns about elevated recessions risks make us worried about downside potential. The likelihood, however, of rapid Fed easing in the face of recession fears should limit the magnitude of market declines and set the stage for an eventual rebound.

10 year U.S. treasury yields around 4.5% offer good value and recession risks should provide cycle support for bond returns.

We expect that 2024 will be the transition year that the consensus anticipated for 2023. The over pessimism about 2023 has become over optimism for 2024. We are in a twilight zone between slowdown, possible recession, and recovery where nothing is likely to be quite what it seems.

Our key asset class views for 2024:

• Government bonds offer attractive value as yields trade well above expected inflation. Yields should decline as recession risk looms. Our target is 3.5% for the U.S. 10 year Treasury yield by the end of 2024.
• Equities have limited upside with expensive valuation and recession risk on the horizon.
• The Quality factor is our preferred exposure within the equity market.
• The U.S. dollar could weaken early in the year on soft landing hopes but strengthen later in the year if recession fears take hold.
• High yield and investment grade spreads are uncomfortably tight for an environment of elevated economic uncertainty, leading us to dampen our typical strategic overweight to corporate credit.
• We are neutral on emerging markets despite their relative cheapness due to negative sentiment. The structural changes facing China’s economy mean we need to see extremely oversold conditions before overweighting.

The past couple of years have been tough for investors with diversified portfolios. The classic portfolio model of 60% equities and 40% fixed income suffered one of its worst years in 2022 and has managed only a hesitant recovery in 2023. Equity and bond returns have become positively correlated, which means that declines in equity markets have not been offset by gains in government bonds.

The renormalisation of interest rates is at least partly to blame. This has seen the 10 year U.S. Treasury yield rise from 1.5% at the beginning of 2022 to near 4.5% at the end of 2023. As a result, bonds have not helped stabilise portfolio returns during periods of equity market volatility and have been a drag on overall returns. In addition, the diminished diversification value of bonds likely contributed to the rise in long term yields.

Could the stock bond correlation become negative in 2024?

The stock bond correlation tends to be positive when there is an unexpected surge in inflation. If discount rates (i.e., Treasury yields) rise significantly without a commensurate rise in earnings expectations, the valuation of both stocks and bonds will decline. This is most likely to occur when inflation expectations are unanchored or when the economy suffers an adverse supply shock as it did in 1973, 1980 and 2021. Going forward, our baseline is that supply chain healing, the Fed’s commitment to bring inflation back to target, and the potential for a recession should collectively flip the stock bond correlation back toward the negative levels that prevailed for most of the 2000s.

The bottom line is government bonds are likely to re-establish their role as effective diversifiers for multi-asset portfolios, and as a result we expect the 60/40 portfolio is set for a comeback.

Former U.S. president Bill Clinton’s chief adviser, James Carville, mused in 1994 that he would like to be reincarnated as the bond market because he would then be able to intimidate everybody. After three quiet decades, the bond market has its menacing mojo back.

U.S. debt to GDP ratio is on the rise

The problems are that government debt shot up in response to the pandemic, and aging populations make it hard to wind back deficits. The International Monetary Fund (IMF) forecasts that based on current fiscal deficit projections, the U.S. debt to GDP (gross domestic product) ratio will rise from 123% currently to 137% by 2028. Debt was just 53% of GDP back in 2001.

Higher bond yields mean that interest payments are going to be a larger part of fiscal deficits. The IMF thinks that by 2028, interest payments on government debt will equal nearly 4% of GDP.

The arithmetic of government debt sustainability hinges on the difference between the interest rate paid on government debt and the growth rate of the economy. An interest rate greater than GDP growth means that the government will need to run a primary fiscal surplus (excluding interest costs) to prevent the debt to GDP ratio from rising. The chart below shows how the past decade has been an unusual period in which the government bond yield has been consistently below economic growth. This gap has recently closed and could turn negative if nominal GDP growth returns to its recent trend near 4% and the bond yield remains near current levels.

The U.S. primary fiscal deficit is currently around 5.5% of GDP. The last surplus was in 2001 and the deficit has averaged 4% of GDP over the past decade. The Congressional Budget Office predicts that the primary deficit will average 2.9% over the next decade. The yield on government debt would need to fall below 2% to prevent the debt to GDP ratio from rising further. The problem, of course, is that ongoing deficits will keep upward pressure on Treasury yields.

What steps can governments take to reduce deficits?

There are only two available choices for governments. One is to undertake the politically painful process of reducing spending and increasing taxes. The other is to allow higher inflation to boost nominal GDP growth and reduce debt in real terms.

Former Prime Minister Liz Truss’ short lived government in the United Kingdom discovered the intimidatory power of the bond market last year when it tried to boost the economy with unfunded tax cuts. Bond investors saw there was no plan to reduce the fiscal deficit and control inflation. The yield on 10-year gilts rose by over 100 basis points in three days, Sterling plunged, and Truss was forced to resign.

A fiscal crisis in the United States or other major developed economies seems unlikely anytime soon (aside from Italy, which has made improvements). The UK example stands as a salutary lesson to other politicians. Our main conclusion is that the era of big fiscal expansions is over, and politicians are going to be constrained by the realities of debt burdens and interest costs. There will be less ability to respond to the next economic downturn with fiscal support. There is a risk that central banks will be forced to accommodate inflation above their targets, but as we learned in 2023, inflation is unpopular with voters. The bond market bullies are back.

Our cycle, value, and sentiment (CVS) decision making process is slightly cautious on the outlook for 2024. Equity valuation multiples are expensive and credit spreads are tight, which constrains the upside potential for risk assets. Meanwhile, government bonds are attractively priced with U.S. Treasury yields trading two to three percentage points above expected inflation. There are real alternatives (TARA ¹) for investors as fixed income offers a competitive expected return for multi asset portfolios.

Is investor sentiment shifting toward more optimistic levels?

Uncertainty around the global business cycle is high as developed market economies face a stiff test from restrictive monetary policy, and China navigates structural challenges. Meanwhile, markets appear priced for a soft landing of the global economy in 2024, characterised by double-digit earnings growth, record dividend payouts, and a gradual pace of rate cuts by central that would leave interest rates at restrictive levels for years. This optimistic market pricing creates downside asymmetry for risk markets, which means we see greater downside potential for equities if the economy slips from slowdown to recession than upside potential if a recession is avoided.

Our proprietary index of market psychology also shows that investors transitioned toward a more optimistic outlook as of mid November. Current sentiment readings reinforce the earlier evidence for downside asymmetry in markets, but sentiment has not moved to an unsustainable extreme that would warrant a significant risk-off posture in portfolios.

Composite contrarian indicator:
Investor sentiment is somewhat overbought, though not yet euphoric

Source: Russell Investments. Last observation is -0.8 Standard Deviations, as of 20 November 2023. The Composite Contrarian Indicator for investor sentiment is measured in standard deviations above or below a neutral level. Positive numeric scores correspond to signs of investor pessimism, while negative numeric scores correspond to signs of investor optimism. The chart shows sentiment as somewhat overbought, though not yet euphoric.

Instead, as we look toward 2024, we see select opportunities within asset classes to build a slightly cautious stance in portfolios:

• Equities offer limited upside as valuation multiples are expensive given elevated recession risks. The Quality factor is a preferred exposure within the equity market. It trades at a reasonable relative valuation to the market and the style’s emphasis on profitable companies with strong balance sheets can offer useful defense if the economy slows and interest rates decline.
• Our portfolio strategies are neutral across major equity regions. Non U.S. developed equities trade at a steep discount to U.S. equities but lack cycle support, particularly in Europe, where economies are flirting with recession and earnings trends have been weaker in recent quarters.
• Chinese equities have sharply underperformed the S&P 500 Index in 2023, lagging by almost 30 percentage points. Given the structural challenges facing China’s economy, we need evidence that the market is extremely oversold before overweighting the region. Our sentiment indicators show pessimism but not a panic extreme leaving us neutral on China and broader Emerging Markets.
• Government bonds offer attractive value as yields trade well in excess of expected inflation. If developed market economies slip into recession, we expect central banks to cut interest rates more aggressively than currently priced into forward curves. U.S. Treasuries are a preferred overweight exposure. Our fixed income strategy team sees particularly good value in the five-year segment of the yield curve and potential for the curve to re steepen if more aggressive rate cuts are delivered in 2024 and 2025. Our favourable outlook for government bonds extends across most major sovereigns, including Canada, Germany, Australia and the UK. The only notable outlier is Japan, where yields are depressed and out of synch with the rest of the world.
• High yield and investment grade spreads are uncomfortably tight into an environment of elevated economic uncertainty, leading us to dampen our normal strategic overweight to corporate credit.
• Real Estate Investment Trusts (REITs) and Global Listed Infrastructure look attractively valued relative to global equities. Our business cycle outlook is more positive for REITs than infrastructure, as REITs are more interest rate sensitive and could benefit from lower yields in the year ahead. Oil is likely to be volatile in 2024 given the potential for further supply cuts from OPEC+² , geopolitical risk in the Middle East and slowing global demand. Industrial metals should benefit from increased construction, infrastructure and capital expenditure in China.
• The U.S. dollar is expensive on a purchasing power parity basis, which suggests potential for the greenback to depreciate over the medium term. However, the potential for a global recession in 2024 could result in further upside for the dollar in the short term as investors flock to the relative safety of U.S. assets. These two sided risks warrant a neutral stance.

Asset performance since the beginning of 2023

Source: LSEG DataStream, as of 23 November 2023. EMU refers to the European Economic & Monetary Union.