Seattle • September 26, 2023

Strategists see limited upside for equities, mild recession in 2024

Team prefers quality factor within equities, views government bonds as attractive

Russell Investments’ strategists expect a mild recession for the U.S. economy in 2024, while market expectations for the U.S. Federal Reserve (Fed) to navigate a soft-landing provide equities with support for the next few months.

“A soft landing for the U.S. economy where recession is avoided is possible, but we still think a mild recession is likely,” said Andrew Pease, global head of investment strategy at Russell Investments. “Fed Chair Jay Powell’s attempt at a soft landing for the U.S. economy may have an even higher degree of difficulty than airline pilot Sully Sullenberger’s miracle landing on the Hudson in 2009.”

Pease added it would be unprecedented to avoid recession after more than 500 basis points of Fed tightening, but not impossible.

“This is the first significant Fed tightening when neither households or businesses are overstretched in terms of debt or interest payments. For that reason, we should not be surprised that the lag between Fed rate hikes and the economic impact is taking longer than usual.,” Pease said.

The team’s quarterly outlook also covers other developed economies, which are under stress from aggressive monetary tightening. Europe appears on the verge of recession and the U.K. economy continues to stagnate. Japan remains an outlier with accommodative monetary policy and above-trend economic growth. Meanwhile, China’s debt and property market problems are intensifying.

The team believes 10-year U.S. Treasury yields near 4.3% offer good value and recession risks provide cycle support.

“Our annual outlook late last year nominated 2023 as the year of the diversified portfolio, where a traditional balanced portfolio of 60% equities and 40% fixed income does well. This still looks to be the case,” Pease said.

Russell Investments’ strategists summarize their Q4 2023 asset-class preferences as follows:

• Equities have limited upside with recession risk on the horizon. Although non-U.S. developed equities are cheaper than U.S. equities, we have a neutral preference until the Fed become less hawkish and the U.S. dollar weakens significantly.
  
  Within equities, the team prefers the quality factor, which tracks stocks that have low debt and stable earnings growth. “Quality stocks typically show good relative performance during periods of economic slowdown, and they are relatively cheap compared to the rest of the market,” Pease said.
  
  
• Emerging markets have underperformed developed markets this year as concerns about China’s economy have been a headwind, and these worries seem unlikely to lift over the near-term. For now, a neutral stance is warranted. Emerging markets usually deliver stronger returns when the U.S. dollar is declining.
  
• High yield has rallied on soft landing expectations and the spread to Treasuries is below the long-term average. Investment grade credit spreads are closer to their long-term averages. The poor cycle outlook is a challenge with default rates likely to rise as U.S. recession probabilities increase.
• Government bond valuations are attractive. U.S. UK and German bonds offer reasonable value, and they have the potential to rally as investors become confident that central banks have finished tightening, inflation has peaked, and economies are slowing. Japan remains the exception.
• Real assets: Real estate investment trusts (REITs) and infrastructure have attractive valuations compared to global equities. While the office sector faces challenges, it is only a small portion of the overall REIT market. The end of Fed rate hikes should favor REITs over equities. Oil has benefited from the OPEC+ supply cuts, though the upside appears limited given the subdued Chinese economy. This should also weigh on agricultural prices and base metals. Recession risks for developed economies are a further headwind.
• The U.S. dollar, which is expensive in real trade-weighted terms, will be under downside pressure if markets lose faith in a soft landing. The Japanese yen is attractive from a cycle and value perspective, while the euro is significantly undervalued relative to its purchasing power parity value.