An evolving consensus

Talk, talk, talk

To paraphrase Benjamin Franklin, nothing is certain in life except death, taxes, and endless discussions about the timing of the first interest rate cut. If we could harness the energy generated by those discussions, the climate problem would be solved. From pricing a 90% chance of a rate cut in the US in March, markets have shifted to a less sure 50% probability. Instead, market pricing is 100% certain of a cut in May and rates are priced to fall to 4.0% by the end of the year. So, the theme of lower rates remains a core investment thesis for 2024, but we must pay respect to the scenario that rate cuts might be much less in size and frequency than the euphoria of late 2023 would have had us believe.

USA, oh yeah

Another thesis for 2024 is the continued exceptionalism of the US. The economy grew at an annualised “real” growth rate of 3.3% in the fourth quarter (Q4). That is 2.5% for the year. In nominal terms, the US expanded at a pace of 6.26% compared to above 9% in 2022 and above 10% in 2021. In current dollar terms, the US economy is 28% bigger today compared to the end of 2020. No wonder equities have done well (10% annualised total return over the last three years), and the dollar is strong. Most visitors from Europe to the US return home with the impression that America is booming. It has defied forecasts and the expectation that the Federal Reserve’s (Fed) monetary policy would generate a recession. Unless the data suggests a major change in trend, what necessity is there for significantly lower interest rates?

What is real?

At this stage, a scenario of fine-tuning might turn out to be the right one for the Fed. Core consumer price inflation was running at just a tad under 4.0% in Q4 2023. That is double what the Fed would like. However, it is down from the 6.6% peak in September 2022 while the Fed Funds Rate is 225 basis points (bp) higher. The implication is that real short-term interest rates stand at 1.6% compared to -6% when the Fed embarked on its tightening process. That is the highest since before the global financial crisis and real rates are set to move higher as core inflation falls further in the next few months. If the Fed thinks the level of real rates is too high, then it may feel the need to make some adjustment. But, and many of you would not like to hear this, it might be more fundamentally appropriate to have real short rates at close to 2.0% when the economy is still operating at full capacity. Prior to the 2008-2009 crisis, real short rates were in a range of 0%-4%. In the 1990s, when the US economy had an extended period of sustained growth, inflation-adjusted short-term interest rates were between 3% and 4%.

Normal

Adapting to a normalised interest rate world is also a key investment theme. Interest rates markets price US dollar rates to fall to 3.75%-4.0% and European rates to 2.25%-2.5% on a five-year view. In my view there is something of a recency bias in the way markets think – we recently went through a decade or more of financial repression and negative real interest rates – and that means there is a risk of too much being priced in. In practical terms, this suggests there is not a great deal of room for medium-to-longer-term bond yields to fall much further from current levels. If I go back to my basic model that fits 10-year Treasury yields to the medium-term average of nominal GDP growth, the market is close to fair value. Nominal growth in the US is expected to be around 4.0% in 2024, higher in the first half. If the Fed goes cautiously, then medium-term yields are likely to be range-bound. For the US Treasury market, the implied total return is likely to be around 4%-5%.

Take credit

Living with higher rates is a theme and a necessity for investors. Higher rates are only possible because, at least in the US, the economy is stronger than forecasters have expected. The implication is that the real equilibrium interest rate is higher. It means higher returns on interest-bearing assets and it is why I like credit as an asset class for 2024. The combination of an economy growing at a steady rate and being able to withstand the current level of rates is good for credit. In both the US and Europe, the yield on investment grade indices is quite close to cash rates or the yield on short-term Treasury bills. So, the question of whether investors should take on credit and duration risk in the credit markets when the running return on cash is the same, is a valid one. My argument is to think about the optionality. If official rates are lower, there is no capital gains on cash, just lower remuneration. If, however, this leads to lower bond yields, investors will benefit from capital gains. Credit markets offer more scope for sustained returns at current levels because of the compounding effect. In euro and sterling credit markets, credit offers 130-150bp more than the government bond yield in the four-year to 10-year part of the market. High yield bonds offer even more and excess returns can be achieved by taking less duration risk than in the investment grade market.

The bull to continue?

Lower rates remain possible, which will reduce the relative attractiveness of cash to credit, particularly short duration credit in both the investment grade and high yield markets. However, we must adapt to a world of higher interest rates (and bond yields) compared to recent years, which argues for a higher weighting towards fixed income in general, with a focus on income generation. At the same time, a strong US economy may be more durable in a ‘super Goldilocks soft landing’ kind of way. That is good for credit, but it may also be good for equities too. The S&P 500 hit a new record high this week. Most equity markets are up a little so far in January but the stand-out is the US Information Technology (IT) sector with a total return of 7%. In US Q4 earnings results, the IT sector has so far published growth in earnings of over 6% compared to -1.9% for the market. Artificial intelligence (AI) was not last year’s story, it is a multi-year one and will continue to mean that overweighting the US technology sector could potentially remain a winning strategy. For equities overall it is more challenging. Earnings expectations for 2024 have come down but lower nominal growth means it is harder to generate strong earnings growth. Hence more of a balance between bonds and equities.

Themes and risks

As I said at the beginning there is so much chatter about what might happen, and I have just added to it. In the absence of a crystal ball, I like focusing on income in the bond market, including in high yield which should continue to deliver strong total returns in a manageable default cycle, quality earnings in equities with dividend exposure in Europe and the UK, and growth exposure to US technology stocks. I am sure all readers are thinking a lot about the downside risks coming, mostly, from geopolitical events or, to a lesser extent, from policy mistakes (too tight monetary, too loose fiscal). Geopolitical events can disrupt global trade and prices and hit investor sentiment. Trump 2.0 will pose challenges to US inflation, interest rates and the government borrowing outlook, not to mention create uncertainties in global diplomatic circles. Reducing all these uncertainties to an investment decision today is impossible but we must remain sensitive to those economies, sectors and companies that could be directly in the line of some fall-out from an escalation of conflict in Ukraine or the Middle East, or a ramping up of populism and protectionism.

What if things could only get better?

We think about downside risks. Eh, come on, it is a new year. Do you want to play the ‘Fantasy Good Times’ game? What might surprise to the upside? Let us start with the outlook for inflation. Look at what is happening to producer prices. The US producer price final demand index was up just 1.0% compared to a year ago. In many Eurozone countries, producer price inflation is negative. Once the slower moving components of inflation indices – like housing – move lower we could quickly get to headline rates falling to central bank targets. Might inflation surprise on the downside? If so, rate cuts could be more meaningful than what I have suggested above. This could then encourage flows out of money market funds into risk assets, leading to a new leg of the equity bull market. All against a backdrop of solid economic growth.

We may need to be a bit fanciful here. What if the Democrats produce an alternative to Joe Biden to ensure Donald Trump does not win in November? That might lead to a less inward-looking America, helping the US intervene in Ukraine and the Middle East in a positive, diplomatic way. Even relations with China could improve, given China needs to deliver some good news to its populace. Improved US/China relations are surely better for world stability and prosperity and there is a common need to cooperate on managing the boom in AI. Closer to home (for me at least), a change in government in the UK looks likely. It would be great if that were followed by a more positive stance towards the European Union (EU) with the aim of reversing some of the legislation that has made it more difficult for UK firms to access the single market. The Labour Party has not committed to re-joining the EU, but a lot could be done that might be positive for the UK’s economic outlook and the UK’s equity market. Another, perhaps, more likely upside is a recovery in China coming on the back of more stimulus and a gradual improvement in consumer confidence. China’s stock market has been awful. A better performance there could be one of the surprises for 2024.

Bad is more expensive than good

The chances of any of this happening are slim. But we cannot rule out non-linearities on the positive side as well as the downside. A put option on the S&P 500 at a strike of 3,800 in one-years’ time currently costs more than three times the cost of a call option at a strike of 6,000. The market is willing to pay more for downside protection than upside potential. Good scenarios are priced more cheaply because they are expected to be less likely. Like Manchester United winning a trophy any time soon! Hope springs eternal!

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 26 January 2024). Past performance should not be seen as a guide to future returns.