After a historic run up in both equities and fixed income in 2023, what actions are you taking to best position client portfolios for the year ahead?

Economic Outlook: Slowing Growth Aided by Monetary Easing and Fiscal Spending

Soft Landing in Sight as Disinflation Opens Door for Aggressive Fed Rate Cuts in 2024:

1. Fixed income markets anticipate 6-7 cuts to the Federal Reserve benchmark rate throughout 2024.
2. Despite strong consumer spending and healthy labor markets, decelerating inflation provides pretext for Fed rate cuts.
3. Optimistic consensus outlook for U.S. earnings growth of annualized 11-12% over next two years.

Key Risks to the Disinflation Narrative:

1. Near-term supply-induced shock that arrests disinflation.
2. End demand remains strong even in the face of higher rates.
3. Housing appreciation starts to pick up with lower rates.
4. Positive fiscal spending impulse in an election year means more deficit spending and bond issuance.
5. Post-pandemic recovery in labor productivity proves to be transitory.

2024 GDP Bloomberg Consensus:

1. US: +1.3% (↓ from +2.4% projected for CY2023)
2. Europe: +0.5% (= from 0.5% projected for CY2023)
3. Japan: +0.8% (↓ from +2.0% projected for CY2023)
4. China: +4.5% (↓ from +5.2% projected for CY2023)

2023 Recap

• 2023 was a notable year with respect to not only the strength of the global equity rally coming off a dismal 2022, but in its narrowness dominated by mega cap technology stocks – the perceived beneficiaries of significant capital deployment to fund generative artificial intelligence (AI) initiatives.
• 2023 was a narrow year with respect to divergence between a handful of technology mega cap growth stocks, as proxied by the NYFANG+ Index (+96.4% in 2023), and the broader markets (S&P 500 +26.3% and S&P Small Caps +16.9%). Global markets remain more attractive versus U.S. large caps, primarily mega caps which have priced in a blue sky scenario of unmitigated spending on AI.

2024 Opportunities & Risks

• If the Fed pursues the easing campaign anticipated by the markets (6-7 rate cuts in 2024), then rate-sensitive segments such as small caps, cyclicals, financials, and real estate as well as those with marginal balance sheets would likely benefit.
• A weaker U.S. dollar makes foreign markets and hard assets (i.e. commodities) more attractive.
• Despite the year-end rally in fixed income as global interest rates dropped from late Autumn peak levels, real (inflation-adjusted) bond yields remain positive and attractive. Should the Fed pursue its rate cut campaign, then the current high rates offered by short-term vehicles such as money markets could be cut nearly in half within the next two years.
• Corporate credit risk as expressed by yield spreads above comparable government rates has declined in anticipation of a benign financing environment of lower rates but a smaller chance of an outright recession that would stress corporate balance sheets. Should the Fed pursue its rate cut campaign, then more of the yield offered by risky fixed income would compose of credit risk as opposed to base interest rates. As such, we are more cautious on corporate credit risk while still favoring structured finance (asset-backed, mortgage-backed) securities with more favorable valuations.
• Risk premiums as expressed by implied volatility from option pricing have also compressed to well below historical average levels, suggesting that investors selling volatility through covered call writing programs might consider other de-risking alternatives such as reducing overall equity allocations and/or raising cash.

Current Investment Guidance

• We maintain a neutral/cautious outlook on equities and risky fixed income due to higher valuations (lower risk premiums) that afford smaller margins of error in the event a soft landing does not occur.
• Investors should increase diversification by allocating to fixed income and equity alternatives such as real estate and commodities to reduce overall portfolio volatility in the face of a multitude of economic and monetary scenarios.
• Investors looking to put new money into the markets should consider a dollar cost averaging program and tilt towards areas of the market offering more balanced risk-reward.

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