Trending
Written by: Cliff Corso | Advisor Asset Management
“The future ain’t what it used to be!” —Yogi Bera
Sentiment at the start of 2023 was quite dour while at the start of 2024 remains quite optimistic. 2023 didn’t play out in a dour fashion. Will 2024 also be a year when there is a “flip in the current script” as well? We think that it might. In 2023, most analysts expected a recession mid-year driven by the series of rapid rate hikes from the Fed. While 2023 started out following that script — with markets that “came in like a lamb” — things certainly went off script as markets “went out like a lion!” The powerful 4th quarter rally of 2023 pumped the annual returns of both stocks and bonds — in essence, generating the equivalent of a whole year’s worth of returns in one quarter. The main deviations from beginning expectations? A resilient economy (e.g. 4th quarter GDP printed a surprising 3.3% last week) against a backdrop of higher rates, and inflation that did come down but remains near 2x the Fed’s target.
Another key divergence? The pivot never came but…the Fed opened the door for 2024 by pumping the markets expectations at year end.
So, here we stand again, for the third year in a row with the market expecting a forceful Fed pivot lower in 2024 (roughly 5+ eases priced in as of this writing). Except now, this expected pivot is already accompanied by record-high valuations in equity indices and very snug bond spreads, which are at or near the tightest levels this cycle. This setup presupposes an “immaculate disinflation” with an economic soft-landing scenario — a very difficult feat to achieve, in our view.
At the start of the last two years, we disagreed with the market’s view that a Fed pivot would occur due to our concerns over sticky inflation. We saw challenges to achieving “the last mile” to the Fed’s 2% inflation target. How do we feel about that this year? First, we do agree that the Fed is done tightening, however, we still expect sticky inflation to keep the Fed on hold longer than is priced into the market. While the market’s hope for a pivot lower in rates was dashed each of the past two years, we do think “the third time’s the charm” in 2024…but with a large caveat. Yes, our expectation is for a mid-year pivot lower, however, one that is driven by a meaningful economic slowdown tilting into a mild recession as the toll of higher rates, spent down savings, high credit card debt, resumption of student loans and higher unemployment finally catches up with the consumer. In this scenario, rates likely move lower not due to the kindness of a slowing but solid economy (we don’t see enough disinflation for the Fed to take that risk), but rather, as spending slows, a mild recession occurs and as credit risk and equity risk premia widen in response to a faster slowdown than expected. This should widen bond spreads from tight levels and provide a headwind to equities, generally speaking. So, we see a pivot commencing later than currently priced in and sometime around mid-year, but because we are cautious on our economic outlook.
In the short term, the Fed dot plot pivot and dovish presser in December allowed the pivot party to go too far, in our opinion. Financial conditions have eased significantly, which we don’t think the Fed intended. We don’t expect the Fed to ease in March and expect this week’s press conference will walk back some of the dovishness that is embedded in the market.
Moving into the second half of 2024, history instructs that markets bottom after the first ease, which is ultimately followed by the beginning of a recovery in both the economy and markets in ensuing months. We have positioned our asset allocations below accordingly by overweighting reasonably priced quality, value and income factors within our portfolios. High quality value sectors and durable dividend payers and growers have been overlooked in the rush to AI (Alternative Intelligence). Perhaps AI trees will continue to grow to the sky, but one should not ignore the value in the wider forest surrounding seven tall trees (well, at least six are still remaining tall as one EV maker took it on the chin this week). We believe overweights in our favored sectors will result in more resilient portfolios longer term as cheaper valuations have the potential to provide a margin of safety. We also expect income to become a larger share of total return vs the past decade and a half as we move forward. With the Fed done, we think there is value in shorter and intermediate segments of fixed income and discuss what we view as the “fair value range” for longer rates. Given that and cash rates poised to fall, we believe moving some of that cash exposure into short to intermediate fixed income to mitigate the reinvestment risk exposure we now see as likely.
Here is a summary of some of our key themes for 2024:
Interest Rate Outlook
Rates have traveled a long road higher, but that does not mean they are too high. Sure, a rally in bonds would occur if a recession takes hold and the Fed lowers rates. The challenge the rates market might be underappreciating is that a mild recession may only be accompanied by a mild and short-term pivot. Why? If inflation remains sticky and above 2%, as is our view, how far would the Fed let real yields drop and for how long? Powell’s Fed is acutely aware of the mistakes of the 1970s and the risks posed by the “stop and start” pattern of that era. Would a mild recession accompanied by a forceful ease really be the best recipe to get/keep inflation at 2%? As for the longer end of the curve, we could see the 10-year Treasury rally below the 4% range for a short while until economic green shoots show up. But, if we are correct, the rally won’t have the reason nor the room to stay there very long. So, with a bit of a longer lens pointed out into late 2024/early 2025, where could long rates return to? After nearly 15 years of suppressed and market manipulated real and nominal yields, what does normal look like? We think a 4% to 5% range on the 10-year is the norm — the past 15 years have been abnormal.
As shown above, when we “correct” for the period post Global Financial Crises (GFC) and look back at pre-manipulated markets and historical levels of real yields in the previous two decades (1986–2006), we see real yields averaging closer to 2%. This makes sense because in the long sweep of history, real yields normally approximate real GDP and nominal 10-year yields normally approximate nominal GDP. So, if we come out of a recession and return to “normal,” we could see 10-year nominal yields land somewhere between 4% and 5%, depending upon whether one believes inflation is 2% or 3% against a backdrop of 2% real GDP.
We would err a guess on the mid+ side of that range post-recession (and think so still, even if we are wrong and a soft landing does occur) given the challenges of growing Treasury supply (debt is now over 120% of GDP while 50% of our debt comes due over the next three years) and as some of the largest buyers of the market (the Fed and foreign governments like China and Russia) step back. By the way, if the 10-year was in that range, that is a level that can still allow for normal economic activity in our view. Again, 4 to 5% is normal; it just portends a different asset allocation as leadership likely rotates away from sectors and companies that relied on low/zero cost funding. We also see volatility remaining a bit elevated as part of a return to normal. While one might argue volatility could put a flight to quality bid into Treasuries, it may be more nuanced than that routine expectation because some of that volatility will be driven by issues like our explosive debt level.
Volatility Outlook
As for volatility, we think the days of unusually low rates hanging around for months/years is in the rearview mirror. Many sectors in equities are not priced for this expectation. Nor are markets priced for the higher volatility regime we expect. To be clear, we are not expecting a jump-step function to a high stress volume regime. But, we are expecting to live in a moderately higher volatility regime than the past couple of decades. The lower volume regime began with a rise in globalization, a rising peace dividend and unending and expanding Fiscal and Fed Puts. Going forward, Fed and Fiscal Puts may be less bazookas and more like BB guns. A changing geopolitical world is not only reordering supply chains and causing military and trade conflicts (inflationary), but also reordering political alliances leading to more uncertainty, wars, higher defense spending and added pressure on our budget. As a consequence, investors must come to grips with an investment world that is less certain and more volatile than we witnessed when we had rising globalization, freer trade, less debt burden all while wrapped in the warm bosom of Fed Puts and Fiscal bazookas.
Evolution of Strategic Asset Allocation and Return to Less Predictable Correlations
The past 20 years saw P/E (price-to-earnings) ratios expand, lifting equities as rates shrunk, while bond returns were also juiced by lower rates. This was a goldilocks scenario for the predictability of the 60/40 portfolio. With the Fed’s thumb on the bond market, stock and bond correlations were durably negative and the combination of a 60/40 portfolio worked well. The return of that combination was heady and above longer-term historic norms.
If the sticky inflation and higher volatility themes plays out as we foresee, then equity/fixed correlations likely become less stable going forward. As we can see from the chart on the right side below, in a pre-Fed Put and Fiscal bazooka GFC world, correlations often flipped positive and at a minimum portend the increasing the uncertainty of the investment outcome of the traditional model.
Source: AAM | Past performance is not indicative of future results.
Allocation Recommendations/Conclusions
Given this backdrop, we see meaningful opportunities to improve the probability of good portfolio outcomes by reframing the asset allocation model to build for steady returns through thoughtful factor construction and diversification. A portfolio focused on income generation, quality, value (which has lagged considerably providing a reasonable margin of safety), inflation mitigation and growth at a reasonable price should help increase expected returns and lower the volatility around the outcome. We see the market continuing to broaden out with leadership shifting during the year. We favor sectors like Energy, Financials (particularly large cap and Insurance), and Defense. With the Fed poised to lower rates we think it is time to move some cash into short to intermediate term fixed income. We think this allocation offers an attractive coupon with a significant margin of safety vs higher rate volatility as well as spread widening. We also look to private markets in real assets (select sectors of real estate and infrastructure) to provide diversification from public markets, mitigate inflation and grow income. We think real estate will prove to be one of the more interesting asset classes in 2024 as the rate rise train stops. We favor select REITs (Real Estate Investment Trusts) and particularly like the sectors in which secular demand remains strong such as industrial, data centers and select residential. We like private credit as well, which is offering diversification and attractive yields but recommend sticking with active management to navigate the market opportunities. Private credit also represents a large and growing asset class, and we expect that trend to continue as it becomes more “core” in overall portfolio allocations.
2024 represents the next phase of Regime Change as the Fed begins to ponder lowering rates. Sticky inflation, large deficits, slowing globalization all portend change. We look to evolve asset allocation to prepare for that change. The future maybe “ain’t what is used to be” — at least compared to the last 15 years. However, if we go back further in time to seek perspective on the future we face, it may be the case that history may not repeat itself, but it sure can rhyme!