How high for how long?

As we farewell 2023, the key question in 2024 remains how high and how long central banks keep interest rates elevated. At this stage, the outlook appears more favourable for bonds in the year ahead. Our Chief Investment Office explains further.

Our view

Following October’s capitulation, equities rose sharply and bond yields tumbled. The US 10-year yield has fallen more than 80 basis points from its peak in late October and the S&P 500 has climbed more than 10 per cent over a similar timeframe – extreme in any context.

The moves were premised on growing expectations that central banks have finished tightening monetary policy. And despite Fed Chair Jerome Powell’s recent efforts to push back on the potential for rate cuts, markets are now pricing for five from the Fed over 2024 – starting in H1.

While the equity moves over November were significant, in our view, there are a few catalysts that could continue to support equities in the near-term.

Inflation is trending lower, economic data is continuing to deteriorate and yields are declining (for now). There remains scope for PE expansion should yields decline further ahead of central bank cuts.
Seasonality is typically a strong support for equities over the final month of the year. Despite the November rally there is little historical evidence to suggest a strong November detracts markedly from December’s potential.
Although investors have become more bullish and inflows to equity market funds have increased, positioning remains relatively light (particularly in some segments of the market) and sentiment closer to neutral.

Further out, however, we continue to be more confident of the outlook for bonds relative to equities. Similarly, this is for a few key reasons.

The US consumer appears vulnerable in the year ahead. Credit card balances have risen sharply over the past two years, pandemic savings are declining, unemployment is rising and so too are credit card delinquencies. Given consumer spending accounts for roughly 70 per cent of US GDP this could spell trouble for corporates in the year ahead.
Against this backdrop, analysts are still expecting double-digit earnings growth for the S&P 500 next year. Taking into consideration a slower economic backdrop, rising unemployment and disinflation, it is difficult to reconcile where this earnings growth comes from and therefore leaves little room for disappointment when earnings are released.
Unless inflation reaccelerates, we expect to have seen a peak in yields this cycle. Moreover, if growth continues to decline and central banks turn toward rate cuts then this is typically an environment in which bonds perform well and equities (at least initially) stumble.

So, can central banks deliver immaculate disinflation and the much-vaunted soft landing? Much will depend on where their priorities lie. At present, it still seems inflation is front of mind for policymakers. While economic growth is falling and unemployment is turning, with inflation remaining above target, it may be premature to suggest rate cuts will materialise over the first half of next year.

The market is pricing for more than 100 basis points of easing in 2024 – we are less convinced. For this to transpire we would likely need to see a much sharper downturn than is currently expected and for economic growth to become the focus once more.

Rather, we believe the Fed will err on the side of caution and keep policy restrictive for longer. At this stage of the cycle, assessing the level of necessary tightening becomes an incredibly difficult task. We continue to believe the risk of overtightening remains acute.

Even with a potential Santa rally, equities are expensive across most segments of the market and with bonds offering significant carry, the case to shift overweight risk assets remains unconvincing.

Fear the cut, not the pause

Trading days from first Fed rate cut to S&P 500 market low vs. S&P 500 per cent change from first Fed cut to market low.

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Source: Strategas

What this means for our diversified portfolios

With the potential for equities to climb further in the near-term, but with less conviction over the medium-term, we seek to increase exposure to those segments that have underperformed the broader market by wide margins this year and/or where positioning and sentiment remains particularly downtrodden.

In the event of a near-term pullback these segments may be less susceptible to an unexpected slide while holding potential for greater participation in rallies should they transpire, as equity managers shift away from the more expensive sectors of the market that have already rallied strongly.

Within portfolios we have increased our exposure to both global real estate investment trusts (GREITs) and listed infrastructure, taking both positions back to benchmark. On a 12-month basis, GREITs and listed infrastructure trail global share markets by more than 15 per cent. Elevated yields have weighed heavily on both segments this year. With valuations remaining relatively attractive, sentiment weak and a likely peak in the rate cycle being reached, we have elected to take both positions back to benchmark this month.

Similarly, the Australian market – where we have remained underweight for most of the year – trails global shares by more than 10 per cent over 2023. Within the domestic market, positioning in the Materials sector remains particularly light. Here, we look for any near-term pullbacks as a potential opportunity to lift our position closer to benchmark.

Overall, we remain positioned defensively across portfolios with global and domestic bonds our preferred exposures as we farewell 2023.