Market
Outlook
Market
Outlook
DEFINITELY MAYBE
The data is saying U.S. soft landing and U.S. Federal Reserve (Fed) rate cuts are underway. Markets are backing the no-recession view, creating risks for portfolios if they are wrong. Weekly jobless claims may provide investors with the best guide to which scenario is playing out.
Andrew Pease
Chief Investment Strategist
“If we had to choose one indicator to watch over the next few months, it would be weekly initial jobless claims.”
- Andrew Pease, Chief Investment Strategist
2024 Global Market Outlook: Q4 update
Definitely Maybe
1990s nostalgia is back with the announcement of a reunion tour by Britpop band Oasis. Investors are hoping for another 1990s throwback in the shape of an economic soft landing: the last time the U.S. economy avoided a recession after aggressive Fed tightening was during the mid-1990s.
The stakes are high. Markets are priced for a soft landing, so even a mild recession is likely to trigger a significant equity-market correction. The economic data supports the soft-landing thesis, but a slowdown consistent with a soft landing could still be the pathway toward a recession.
For now, a soft landing looks the more likely outcome. Inflation is declining, growth in wages is moderating, and labour-market pressures are cooling. Importantly, the Fed has begun easing before clear signs of economic stress have emerged. We’re not yet out of the woods in terms of recession risk, and the slowdown could overshoot into a hard landing if Keyne’s paradox of thrift1 takes hold. This is when jobs weakness makes consumers cautious and they spend less, causing firms to cut back on spending and jobs, which in turn triggers more consumer caution. What seems sensible for individual firms and households becomes calamitous in aggregate.
If we had to choose one indicator to watch over the next few months, it would be weekly initial jobless claims. These will provide the clearest real-time guidance on whether the U.S. economy is rebalancing or drifting towards recession. Initial jobless claims sustained above 260,000 per week would be a red flag that a more painful adjustment is underway. Conversely, jobless claims that remain below this level would be a sign that tight Fed policy hasn’t crashed the economy.
Key indicator: U.S. weekly initial jobless claims
“Diversified, 60/40 portfolios have delivered positive returns in most presidential-election years - something we expect is on track again in 2024.”
- Paul Eitelman, Senior Director, Chief Investment Strategist, North America
U.S. elections
We are into the home stretch of the U.S. election cycle with very competitive races for president and control of Congress.
The democratic system of government in the U.S. which features checks and balances across the executive, legislative and judicial branches, makes it hard for individuals and parties to enact sweeping change. As a result, and over many decades, the impact of politics on U.S. markets has been limited. U.S. stocks, for example, have trended higher no matter which political party held office. And diversified, 60/40 portfolios have delivered positive returns in most presidential-election years - something we expect is on track again in 2024. Long-term investors are advised to keep it simple and stick to their strategic plan.
Impact of U.S. presidential elections on markets
“We think the unwind in the Japanese yen carry trade is now largely complete.”
– Alex Cousley, Director, Senior Investment Strategist
Yen carry trade unwinds
The Japanese yen has been very cheap and oversold for some time: one of the factors driving this was the prevalence of a carry trade in the currency. A carry trade is where an investor borrows money in a currency with low interest rates and invests that money in another currency with higher yields or a higher expected return. This trade relies on a stable or depreciating currency and low volatility, given it typically involves a lot of leverage.
In late July 2024, this trade was hit by two catalysts which led to a dramatic increase in volatility. First, the Bank of Japan surprised markets by raising rates, and this led to a repricing of Japanese bond yields. Second, the U.S. July jobs report indicated a soft economy, which led to a repricing lower of U.S. bond yields.
The chart below shows this dynamic using the differential between the two-year U.S. and Japanese bond yields. The slide in rate differentials led to a large appreciation in the yen against the U.S. dollar. The impact on Japanese equities was dramatic, with the Tokyo Stock Price Index falling 20% over three days in the first week of August. A stronger yen reflects tighter domestic financial conditions and is a challenge to exporters.
U.S. dollar/Japanese yen yield spreads
“European stocks are attractively valued and should perform well if earnings recover in line with the economy.”
–Andrew Pease
Regional snapshots
Eurozone
The outlook for the eurozone economies continues to brighten as industrial activity picks up, bank lending growth improves, and inflation tracks toward the European Central Bank’s (ECB) comfort zone. The ECB delivered its first 25-basis-point (bps) rate cut in early June and the market anticipates a further 100 bps of easing over the next 12 months.
The recent European parliamentary elections have generated some political turmoil due to the success of right-wing populist parties. The decision by France’s President Emmanuel Macron to call an election in the national assembly (where the government is formed) has created fears that one of Europe’s largest economies could soon be governed by the far right. This has helped trigger a near 4.5% sell-off in eurozone equities as investors worry about the prospect of unfunded tax cuts against the backdrop of high government debt levels. These fears seem overdone, however. France’s two-stage electoral process means a far-right win is not assured. Furthermore, the example of Italian Prime Minister Giorgia Meloni shows that European populist parties can behave responsibly once in power.
We believe European stocks are attractively valued relative to U.S. stocks and can rebound once the political drama subsides and as earnings expectations are upgraded in line with improving economic conditions.
United Kingdom
The UK outlook is beginning to improve, albeit from a low base. Consumer and business confidence are rebounding and there are signs that house prices are beginning to recover. Core inflation, however, is proving sticky, and at 3.9% is preventing the Bank of England from signalling near-term rate cuts. Interest rate markets have priced 100 basis points of Bank of England (BoE) easing over the next 12 months, which seems realistic given inflation should get closer to the BOE’s 2% target over the next year.
Prime Minister Rishi Sunak has called an election for July 4, which current public opinion polls indicate is set to be resoundingly won by the Labour Party led by Keir Starmer. The Labour Party is running a cautious campaign, promising that there will not be substantial changes to taxation and government spending.
The FTSE 100 Index is relatively attractive with a 12-month-ahead price-to-earnings ratio of 11.4 times and a 3.5% dividend yield. UK gilts are attractively valued with a 10-year yield at 4.1%.
United States
The U.S. economy at mid-year 2024 is on firmer footing. The labour market has painlessly rebalanced back to 2019 levels–strong but no longer overheated enough to generate significant inflation. Core personal consumption expenditures (PCE) inflation has moderated to 2.6% from a cycle-high of 5.6% and appears on track to drop toward the Federal Reserve’s goal next year. On the back of this progress, we expect the Fed to start carefully cutting rates later this year, with September the likeliest timing for the first move. Corporate earnings were robust in Q1 with growth led by the Magnificent Seven. Importantly, we also saw profits stabilise for the broader large-cap S&P 500 and small-cap Russell 2000 indices in the period.
We think it is more likely than not that the U.S. economy can avoid a recession in the year ahead, but macro uncertainty is high. The Fed has exhibited reversion aversion, demanding a high bar on the inflation data to kick off rate cuts. This leaves some risk that the gradual slowing in the cycle could extend into a downturn. Markets are priced for the expected soft landing but without the uncertainty and humility around this outcome that we also see. Equity valuations are expensive and credit spreads are tight. Our proprietary measure of market psychology shows investor optimism, but it is not at extreme levels of euphoria at mid-year that would warrant a sharp risk-off posture. Treasury yields remain extremely volatile into the combination of choppy data and a data-dependent Fed. We see good value in bonds over the medium-term; both in terms of their starting real yield and as a diversifier to more adverse economic scenarios.
Japan
Japan is the land of rising inflation expectations, after having experienced more than 20 years of near-zero inflation. The chart below shows professional forecasters are expecting inflation to be close to the Bank of Japan’s (BoJ) target next fiscal year. In March, the BoJ raised interest rates for the first time in 17 years and seems likely to raise rates further, albeit in a patient manner. The economic outlook looks decent, with manufacturing picking up and the China outlook becoming more supportive. The depreciation in the Japanese yen is supporting inbound tourism.
Japanese government bonds look unattractive on valuation, especially given rising inflation expectations. Japanese corporate earnings are expected to be robust, although equities have priced in a lot of good news. The Japanese yen screens as one of the cheapest G103 currencies but will only likely strengthen when the interest rate differential between the U.S. and Japan starts to narrow.
Core inflation forecasts: Japan
China
Chinese policymakers have become more forceful in trying to turn the nation’s property market around. They have effectively created a program that will allow local governments to purchase excess inventory in different cities. The size of this pilot program is not large, but we think this shift in the stance of policymakers is an important turning point in China’s economy. We expect it will be expanded should it prove successful.
Additionally, Chinese corporates have become more focused on governance and shareholder returns. For years, Chinese equities have suffered from dilution i.e., companies issuing more shares. We have seen an increase in buyback announcements, which will allow better economic activity to flow through more meaningfully to earnings per share. Chinese equities continue to look cheap relative to broader global and emerging market equities.
There are still risks on the horizon for China. There could be tensions with the U.S. in the leadup to the November federal government elections. There is also the risk of more aggressive action from the European Union following the dramatic growth in electric vehicle exports to Europe. These risks, along with the upcoming Chinese government plenum4 in July, need to be closely monitored by investors.
Canada
The Canadian economy has avoided recession as population growth has supported consumption and, in turn, GDP growth. However, the persistent increase in the unemployment rate (from a low of 5.4% to 6.2% over the past 12 months) and the greater than 3% contraction in the per-capita GDP since the second quarter of 2022 both indicate the economy has been weaker than the headline GDP suggests.
Given that backdrop, it makes sense that the Bank of Canada (BoC) was the first G7 central bank to ease policy, cutting its target rate by 25 bps to 4.75%. We see the potential for three additional cuts this year, so long as the disinflation trend continues. Our path for the BoC is slightly more dovish than the industry consensus view, but that's also because we are somewhat more concerned about the economy. While a recession in Canada is no longer the consensus outlook, we believe the risk of the Canadian economy slipping into a recession over the next 12 months remains above average.
Given our macroeconomic views, we maintain a positive outlook for government bonds, which are likely to benefit from economic turbulence, while being cautious about the outlook for Canadian equities.
Australia and New Zealand
Australia remains on the narrow path of avoiding recession. The consumer is under stress from the increases in the Reserve Bank of Australia’s (RBA) cash rate and variable rate mortgage interest rates. Consumer spending has slowed materially. Tax cuts will start on 1 July. It is unlikely that all the increase in disposable income will be spent, but it may provide some support, particularly to lower-income consumers. Improvement in Chinese economic activity will also be supportive.
The inflation pulse in Australia lags the rest of the world by about six months (due to a later reopening from the pandemic lockdowns), and so the RBA will likely lag major central banks to reduce rates. Our current base case is for a cut in November, but there is growing risk that the RBA may stay on hold until early 2025.
New Zealand’s economy has contracted in three of the last four quarters, illustrating the pressures that the economy is facing following the aggressive action from the Reserve Bank of New Zealand (RNBZ). The outlook remains challenging, with credit growth still soft and a large current account deficit. Despite the unemployment rate having risen more than 1% from its low, wage pressure has not abated yet. This leaves the RBNZ in an uncomfortable position. We expect that the RBNZ will commence cutting rates after the U.S. Federal Reserve.
“European stocks are attractively valued relative to U.S. stocks.”
- Andrew Pease
Asset-class preferences
Global equities have taken a breather in the second half of 2024. We have seen a rotation into value stocks at the expense of growth stocks. After a very strong first half of the year , most of the U.S. mega-cap tech stocks have lost ground since the end of June despite fundamentals remaining relatively robust. U.S. small-cap equities have outperformed in the last three months on increasing expectations of the U.S. economy achieving a soft landing and lower interest rates.
Fixed income markets have been positive as inflation has faded to the background and the focus has shifted to growth. Sovereign yields are now down for the year, and the U.S. 10-year government bond yield has fallen by 0.7% since June. Shorter-end bond yields have fallen by more, as markets have increased conviction in central bank rate cuts. Credit spreads have been volatile but remain tight.
Asset-class performance year-to-date in 2024
What’s the outlook in equity and fixed income markets?
We use our cycle, valuation, and sentiment (CVS) framework to guide investment decision making. Our base case is for a U.S. soft landing, but recession risks remain elevated given concerns about potential lags in impact of monetary policy. Equity and credit market valuations are slightly expensive, and earnings expectations indicate the market is fully pricing a soft landing. Our sentiment indicator suggests that market psychology has become more balanced after being quite optimistic two months ago. Combining these building blocks, our CVS framework points to negative asymmetry6 in equity and credit markets and highlights the diversification role that government bonds can play in a multi-asset portfolio.
COMPOSITE CONTRARIAN INDICATOR:
MARKET SENTIMENT IS OPTIMISTIC BUT NOT AT EUPHORIC EXTREME
Our asset-class preferences at the beginning of Q4 2024 include:
- The tactical opportunity set in equity regions, sectors and styles is muted in our opinion. Across global equities, the value and momentum factors appear relatively cheap but are accompanied by higher economic sensitivity and poor sentiment, respectively. We prefer to maintain a balanced exposure and allow stock selection to be the key driver of portfolio outcomes.
- Government bonds are fairly valued and offer positive asymmetry if economic growth deteriorates further - however, some of the tactical opportunity has dissipated given the rally. We expect the yield curve to steepen from here, which means the gap between the 10-year bond and the two-year bond will increase. Credit spreads are pricing in a significantly lower recession risk than our own, making them unappealing.
- Real estate and listed infrastructure are both attractively priced relative to broader equities, although the valuation gap has narrowed. Listed real estate climbed more than 15% in third quarter7 as central banks began cutting interest rates. We expect that real estate and infrastructure can serve as important diversifying assets. Oil prices have fallen as concerns about weak Chinese economic growth have resurfaced. Geopolitical tensions could cause occasional spikes in oil prices, but weak demand is likely to keep prices below any level that would cause challenges for the global economy. While the prospect of interest rate cuts usually bodes well for gold, stretched valuations relative to real rates make the near-term path less certain.
- The U.S. dollar continues to look expensive, and we expect it will likely depreciate in a soft landing. The oversold reading on the Japanese yen has unwound since August given the unravelling of the yen carry trade.
- The interest rate-cutting cycle should help provide a floor under commercial real estate and may help unlock more mergers and acquisitions (M&A) opportunities. Even so, our expectation for a gradual pace of rate cuts also means that borrowing costs will still be somewhat elevated at the end of 2024. Management teams will need to focus on operational value-add. We expect the dispersion of outcomes within the private market universe will be high, in part because of ongoing macroeconomic uncertainty. This makes manager selection crucial for achieving favourable investment outcomes.
“Our portfolio strategies are generally emphasising diversification into high macro uncertainty and emphasising security selection as the primary driver of active return.”
- Paul Eitelman, Senior Director, Chief Investment Strategist, North America
Prior issues of the Global Market Outlook
1 John Maynard Keynes was an English economist who popularised the ‘paradox of thrift’ economic theory that personal savings are a net drag on the economy during a recession.
2 A prediction market is a unique type of futures exchange that facilitates speculation on the outcome of all sorts of common events.3 The Group of Ten (G10) consists of 11 industrialised nations that meet on an annual basis or more to consult, debate, and cooperate on international finance. The member countries are Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States.
4 China's ruling Communist Party commenced its so-called third plenum on July 15, which is a major meeting held roughly once every five years to map out the general direction of the country's long-term social and economic policies.
5 The Group of Seven (G7) is an intergovernmental organisation made up of the world’s largest developed economies: France, Germany, Italy, Japan, the United States, the United Kingdom and Canada.
6Negative symmetry refers to scenarios where the downside risk outweighs the upside potential.
7As measured by the FTSE EPRA NAREIT Global Developed Index through September 10, 2024.