Andrew Pease

Chief Investment Strategist

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.

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

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

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.