New year brings new market challenges
by Todd JablonskiMr. Jablonski is Global Head of Multi-Asset Investing and Quant at Principal Asset Management. Visit https://www.principalam.com/.
It was only a year ago that many investors were beginning to batten down the hatches. Expectations for slowing equity fundamentals, limited interest rate risk, and additional strains on speculative credit in 2023 prompted them to go underweight on equities and overweight on fixed income.
Boy, were they surprised! The widely anticipated recession failed to materialize and the fears of a rapid deterioration in credit wound up being mostly a false alarm. Indeed, the US economy has vastly outperformed forecasts despite higher rates and tightening financial conditions.
The GDP / Capital Markets Surprise
What does this mean for 2024? We have no crystal ball, of course, but the outlook has some new complexities.
To lay the groundwork for 2024, we must first review some of the unexpected developments in 2023. For example, consensus forecasts in October 2022 called for flat-to-positive-1% GDP growth in the first nine months of 2023. The reality, however, is that real GDP growth was just above 2% in the first two quarters of 2023 and nearly 5% in the year’s third quarter. Inflation has come down, though not far enough for inflation-wary Fed governors who are keeping higher rates in their quivers. Plus, interest rate risk has been quite high, while credit risk has generally been rewarded.
Surprises also were abundant in 2023’s capital markets, led by the S&P 500’s year-to-date gain 10.7% (data as of 10/31/23) that was driven by a small cohort of recognizable technology-focused companies. This performance came despite broad negative sentiment about the economy, ongoing global conflicts, and a continued rise in long-term interest rates.
Although some of the pessimism has subsided, big questions remain on the minds of investors. Are concerns about a recession abated or just delayed? Will the Fed need to keep raising rates to get inflation down to its desired target of 2.0-2.5%? How will changes in the economic outlook affect current investments?
Additionally, non-market factors, such as global disruption and unrest from war in the Middle East and Ukraine, can weigh heavily on markets. The upcoming U.S. presidential election will carry significant implications for the economy and overall policy. AI, cybersecurity, and cryptocurrency will continue to attract regulatory scrutiny, with widespread consequences for the markets.
Investment Strategies For 2024
Despite these uncertainties (and there are always uncertainties!), there are several investment strategies worth considering based on the outlook:
Rely On Strategic Diversification
Investors would be wise to limit tactical risk until the macro dissonance retreats. Instead, maximize diversification and pursuit of issue selection returns. The ambiguity meter can tick quite high quite quickly. As a result, we are neutral among equities, fixed income, and alternatives today in our multi-asset views, preferring to take advantage of long strategic asset allocation, and active issue selection returns. While we don’t think a recession is imminent, we believe a further economic slowdown is on the horizon and will ultimately culminate in a recession. We will closely watch the direction of the inverted yield curve – a reliable indicator of a recession. Simply put, we are saving our dry powder for another day.
Watch For Rare Entry Points
Investors should be prepared to make a move if unforeseen events provide unanticipated market opportunities. A lack of rate cuts next year, expanding conflict in Europe and the Middle East, and Fed-market participant misalignment sit at the top of my list of risks that are capable of drawing down equity prices and widening credit spreads. Fundamental expectations at the end of October were fairly healthy, but that, of course, is subject to swift change. Worldwide and US sales growth is forecast to accelerate from 0% and +2%, respectively, in 2023 to +5% for both in 2024. S&P 500 earnings growth is currently forecast to accelerate from +1% in 2023, to +12% in 2024. That said, there is room for fundamental disappointment if the higher rates do eventually slow the US economy. In the case of any significant downward pressure in equities and other risk assets in 2024, I’d have a plan in place to overweight risk assets and participate in the recovery. Of course, stick to your risk parameters. Latin American equities and US equities have already achieved extremely low valuations and could be some the first groups to rebound in sentiment.
Don’t Expect Policy Rescue In 2024
The question of when the Fed will start to cut rates is one of great debate. Indeed, it is possible that the Fed doesn’t cut rates at all in 2024, especially if inflation remains stubborn. Fiscal policy spending worldwide could slow as rising debt levels and interest rates challenge borrowers.
Keep Track Of Corporate Balance Sheets
As of now, the relatively high quality of investment grade corporate bonds means they should outperform the rest of the credit space and treasuries. After the recent bond sell-off, investment grade yields have risen to their highest level since the Great Financial Crisis. With the economy currently resilient and the expected downturn likely only shallow, default risk should remain contained and supported by healthy balance sheets. In fact, the longer rates remain elevated, the sharper the focus and larger the appetite of yield buyers, which, in turn, begets bond buying.
Make Subtle Asset Allocation Enhancements
This can have a big impact on portfolio risk exposure and can also diversify return drivers. We tactically prefer investment grade corporate credit over treasuries; US large caps over US small caps, Japan equities over Europe equities, and Brazil equities over China equities. Valuation dispersions and macro variability will no doubt produce additional opportunities throughout 2024. These smaller views, in concert in portfolio construction, can enhance returns and refine portfolio exposures, especially when complemented by active implementation.
Don’t Forget About Dividend Stocks…
For investors willing to search for investment opportunities in the value equity space, dividend-paying US stocks are an intriguing income option in 2024. Over the past several years, dividend payers have lagged the broad market as select AI-influenced growth narratives have moved the market higher. The fast pace of rising US interest rates has also held them back. Looking at 2024, peak policy rates may arrive and give a breather to rising long-term rate pressures, allowing yield-generating, dividend-paying stocks to add value to portfolios.
…And Emerging Markets, Too.
We keep our emerging market debt exposure at a slight overweight as a means to generate income. While we have concerns about the global growth outlook, we expect further US dollar weakness and decelerating global inflation will add important tailwinds to the emerging market regions. Central banks in some emerging market countries are already cutting rates or will soon start to do so.
While every year brings new challenges, 2024 already looks like it will be filled with uncertainty on both economic and political fronts. The best advice for investors? Rely on strategic diversification, watch for rare entry points, and don’t expect policy rescue in 2024.