The Macro Picture
Market participants enter 2024 with expectations that inflation is close to being tamed and that the tight monetary policy of many central banks will ease as the year progresses. So far, the soft-landing scenario appears to be a real possibility. Geopolitical and military conflicts, along with many important elections in 2024, raise the specter of increased volatility. However, as is typically the case in election years, there is a very low likelihood that government spending is curtailed or that tax increases come to fruition in 2024. Our primary concerns are whether earnings growth in 2024 can keep up with somewhat optimistic estimates, whether there is enough liquidity available to handle any disruptions in commercial real estate or corporate defaults, and whether central banks can effectively navigate the trade-off between taming inflation and keeping the economy from stalling.
United States. In the U.S. specifically, we will be looking for these signals:
- Inflation reaching or at least continuing to move in the direction of the Fed’s 2% target level;
- Interest rates to come down meaningfully (100-200bps in 2024), thereby relieving some pressure on those that need to refinance debt;
- Ongoing Real GDP growth near 2%;
- Solid corporate earnings growth (at least 6-8%) that provides better support for equity prices. While the largest 7-10 stocks in the S&P 500 Index make equity prices seem expensive, we believe the vast number of securities in the U.S. trade at more reasonable valuations that could continue to propel markets higher in 2024.
Longer term, we must pay close attention to the U.S. government deficit and debt, particularly in a higher interest rate environment. With less budgetary flexibility, the ability to address unexpected events will become more challenging and raises the risk that the US Dollar could be devalued.
Europe and Asia. Perhaps surprisingly, several European markets outperformed the S&P 500 Index in 2023. As we look ahead to 2024, Europe will face several of the same issues as the U.S., taming inflation paramount among them. The good news is that valuations among European equities are much more favorable than their U.S. large cap peers, providing a greater opportunity to generate returns. While European markets enjoyed the strong return of tourism to boost economies, many of the industrial companies lagged, because trade with China has continued to lag even in a post-pandemic environment given the latter’s internal policy issues and challenging domestic real estate industry. Meanwhile, consumer savings rates have grown in China, suggesting demand could be a tightly coiled spring that could ultimately benefit commodity producers as well as many of the manufacturing industries in Europe. Japan is another market that offers upside relative to its modest equity prices. It is fighting the opposite battle, which is to boost inflation from very low levels. Some investors have expectations that further corporate restructuring could unlock value in that market as well. Both the European and Japanese markets, while dependent on growth coming from outside their borders, offer attractively priced equities with better yields than can be found in the U.S.
Chinese equity markets were some of the worst performing last year. The outlook remains questionable despite low equity prices as the Chinese are engaged in an ongoing trade war with the U.S., are dealing with significant economic challenges domestically, and most recently saw Taiwan elect a pro-independence leader, raising a greater hurdle to the mainland’s desire to embrace Taiwan more fully as a part of China. Most other emerging economies fared quite well last year and have attractive opportunities ahead. Restructured supply chains have created some opportunity for them, and the hope for lower interest rates in the U.S. should be a positive tailwind in the year ahead as well.
Fixed Income. In the fixed income world, interest rate risk is much more to the downside in 2024 given receding levels of inflation, making return prospects for core fixed income more attractive than they have been in several years. The main challenge investors will face is determining the appropriate duration for their portfolio to maximize returns in the year ahead as we anticipate central banks around the world to begin cutting interest rates this year.
The Micro (Bottom-up) Picture
We expect the path for the economy in 2024 is well paved as inflation has come back down to more manageable levels and continues trending towards central bank targets. Additionally, that suggests that we are likely to see interest rates come down in 2024. Our biggest concern against that backdrop is equity valuations, particularly in the large cap growth segment. Our forward looking return expectations (3-5 years) for Core Fixed Income are presently higher than for Large Cap U.S. equity.
This month we are advising clients to bring U.S. Small Cap back to target weight, trimming from an overweight position in short-duration fixed income/cash. By avoiding a recession last year and with the prognosis for rates to fall this year, we feel there is less risk on the horizon for small caps compared to last year.
We continue to prefer equities outside of U.S. Large Cap Growth, which we find to be most overvalued. That leads us to maintain our tilts in Large Cap and Developed Non-U.S. towards Value (and ideally quality, profitable companies as the case is with most active managers we use).
We maintain a very modest underweight to Emerging Markets equity because of the negative momentum currently being suffered in China, which makes up a significant portion of the MSCI EM Index.
Within stability assets, we will be watching yield curves and Fed messaging closely as 2024 progresses. We are currently barbelled in core fixed income (overweight to both short-duration and long-duration) but will evaluate when a move back to Strategic, which is more focused on the intermediate duration bonds, will be warranted.
Please contact your client advisor for the full Tactical Allocation Viewpoints report, which includes detail on Pathstone’s current recommended allocations by asset class and sub-class.
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