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Too early for a victory lap

As we head into 2024, the market narrative has shifted towards prospects of a soft landing for economies as inflation eases from pandemic highs. However, the authors argue it is too early for central banks to declare outright victory over inflation. While economies have demonstrated resilience to higher rates so far, this is better explained by the long and variable lags of monetary policy transmission rather than economies being less rate sensitive.

The authors expect central banks to remain cautious about declaring victory over inflation and anticipate rate cuts in 2024 are unlikely to pre-empt economic weakness. Therefore, interest rates could fall later than currently expected by markets. However, once rate cuts do occur, they may fall further than predicted as central banks eventually err on the side of easing too late rather than too early.

Long and variable lags

Anyone forming a view for 2024 needs to consider whether interest rates still bite economies. If economies can cope, risk assets should benefit but core bonds may underperform if markets continue pricing in lower rates. However, if the resilience seen in 2023 reflects typical long and variable lags in monetary policy transmission, investors should focus on the insurance provided by high quality bonds and be cautious of risk assets as rate cuts materialize.

While private sector debt levels and existing mortgage debt terms provide some insulation, signs interest rates are biting can be seen in rising consumer interest payments and delinquencies in auto and credit card loans. Refinancing costs for corporate debt starting in 2025 also pose risks.

Fiscal spending back in vogue

Expansionary fiscal policy has cushioned the impact of higher rates, through tax breaks, stimulus programs, and Europe’s recovery fund. However, governments will need to address unsustainable deficit and debt levels. The US deficit of 6% of GDP with low unemployment suggests tax cuts are unlikely.

R-star gazing

Whether bond yields rise further depends on what is learned about R-star, the neutral interest rate consistent with stable inflation and full employment. If economies remain resilient or inflation fails to fall, rate hikes or slower rate cuts may pressure yields higher. However, signs of economies cracking under current policy rates, as the authors expect, would see attention turn to rate cutting, sending bond yields lower.

Locking in yields

The authors argue investors should focus on locking in yields currently available in core bond markets. While yields are below cash rates, this represents an insurance premium that will pay out if recession hits with greater force than anticipated.

Within fixed income, the authors prefer investment grade over high yield given the wall of higher cost refinancing corporate debt faces in coming years. They also see opportunities in emerging market local currency debt and higher quality sovereigns in Europe.

Equities: problems at margins

Equity markets are reasonably valued but not cheap, particularly accounting for cautious earnings outlooks and low difference between stock and bond yields. The authors advocate quality stocks, income strategies, and a balanced approach across growth and value styles.

European valuations look compelling relative to the US, where further outperformance relies on mega caps delivering elevated earnings. UK stocks offer defensive characteristics through dividends and exposure to the energy sector. Japanese benchmarks have rallied on buybacks but further upside is uncertain. China valuations reflect macro challenges.

Targeted alternatives for targeted risks

With stock/bond correlations less reliably negative, the authors argue for augmenting bonds’ diversification role with real assets, commodities, and hedge funds to protect against inflation shocks. Public alternatives like REITs and commodity strategies, as well as liquid hedge fund strategies, could also help in stagflationary scenarios where both stocks and bonds fall.

Cash rates are a mirage

While cash looks tempting given high short-term rates, these are unlikely to persist. In a soft landing, parts of the stock market could outperform. In a mild recession, as the authors expect, core bonds would outperform as rates fall. Stagflation remains difficult, but selected alternatives could outperform cash. Over the long-run, equities and bonds strongly outperform cash in real terms.

Scenarios and risks

The report outlines scenarios for mild recessions, goldilocks growth, a soft landing and stagflation, outlining corresponding market implications. Political risks in 2024 include elections in the US, UK, EU, Taiwan, India and more which could impact markets. However, differentiating economic performance based on governing parties has proven difficult over the long-run.

In summary, the report advocates locking in bond yields given rates have likely peaked, focusing on quality stocks, and augmenting bonds’ diversification role with targeted alternatives to protect against different economic outcomes in a world of higher inflation volatility. It argues current cash rates are a mirage and markets are too early in calling victory over inflation.