2023 felt like a very volatile and stressful year. Despite the volatility, markets delivered healthy returns across most asset classes for the year. If you checked your portfolio every December, you would have missed the rollercoaster in between. US government bonds, while falling almost 8% from the April high to the October low, delivered +4% in local currency price terms for the year. Credit was no calmer, with high yield spreads blowing out over 100bps twice throughout the year. Despite a plethora of bank runs, culminating in a regional banking crisis in the US and the loss of Credit Suisse globally, investment grade credit rallied around 8% and high yield over 13% over the year. US equities suffered an earnings recession in the first two quarters of 2023, experienced a correction of more than 10% intra-year, but managed to deliver an astounding 26% return over the whole year. What was all the worry for?
Most of the stress came from investor sentiment pivoting seemingly every quarter, from “recession is nigh”, to “soft landing achieved”, to “higher for longer” and back again. However, the biggest pivot of all came from the US Federal Reserve (Fed), with Jerome Powell delivering an early Christmas present for market participants. Most “Fed watchers”, including ourselves, expected Powell to use the December meeting to push back against the recent easing of financial conditions and re-iterate the need for cash rates to remain restrictive, and talk down market expectations for cuts until inflation had meaningfully come back down to target. Instead the Fed has effectively declared victory over inflation, with a big shift in the quarterly update of their economic and Fed funds rate projections.
The previous projections in September showed the majority of members expected one more rate increase by the end of 2023. Now the committee expects to cut rates by 75 basis points (bps) in 2024, with inflation falling to 2.1% by year end whilst avoiding a recession. Chairman Powell’s press conference, following the meeting, delivered further confirmation that the Fed was now focused on the potential for weaker growth, not higher inflation, as policy was now “well into restrictive territory” and the Fed would need to start cutting rates well before inflation reached their 2% target as failing to do so would risk slowing activity too much. As this was a significant shift from the previous “higher for longer” narrative the market reaction was swift and over the course of the press conference 2-year and 10-year US treasury yields fell by 30bps and 20bps, respectively, and the US dollar (USD) weakened by 2%.
However, the market may have gotten ahead of themselves. The market is now pricing in 150bps worth of cuts in 2024, double the Fed’s estimate of 75bps, which we think is too aggressive. In reality, the market is pricing in a probability the Fed cuts 75bps as expected, but also the scenarios where the Fed doesn’t cut at all, or cuts aggressively into a recession. These probabilities will continue to shift in 2024. Bonds can still rally from here in a hard landing, but this is no longer our base case. The easing of financial conditions and the pre-emptive pivot from the Fed increases the probability of a soft landing, limiting the need for the Fed to cut so aggressively. We believe the magnitude and timing of these cuts will be watered down in 2024, but primarily from growth holding up better than expected as opposed to another imminent bout of inflation.
While markets might wobble if these extra cuts get removed from the market, this should remain positive for risk assets. Most importantly, Powell has revealed his reaction function. This is an important shift as the market had expected him to be more like Paul Volcker than Arthur Burns. There is a growing risk he will become the latter, with inflation potentially increasing in the long-term, perhaps even delivering the double hump by 2025, but for now this dovish pivot will be positive for risk assets.
That said, positioning and sentiment has shifted meaningfully. In the depths of October, deep pessimism and shedding of positioning set the market up for a short squeeze higher. Since then, systematic strategies like momentum trading funds have flipped from almost max short to max long, and sentiment is approaching exuberance. Therefore we have become tactically cautious as a pullback would be expected and healthy. But between now and the next Fed meeting, there will be little to derail momentum and retail participation likely has further room to run as we enter 2024. We therefore remain neutral on equities, but importantly have shifted under the surface. Previously we were medium-term bearish but short-term bullish on sentiment, now we are more cautious on a short-term pullback, but believe the Fed pivot has improved the chance of a soft landing.
Given our views on aggressive pricing, it is tempting to turn bearish on duration, however, we are buyers on weakness. We do not believe we will be heading back to the highs in yields we saw in October 2023, but likely will trade in a range as we wait to see where inflation finds its floor. A very rough rule of thumb would be 3.5% to 4.5% for the US 10-year yield. With yields now at 3.9% in the US, we are neutral in this new range.
Similarly, it is tempting to take profit on credit given how tight spreads have become while fundamentals are deteriorating. Interest cover has fallen sharply from the highs of 2022, but only back down to levels last seen in 2019, when credit spreads were significantly tighter. Defaults continue to tick up, but the easing of financial conditions will help issuers refinance at more attractive pricing in 2024. While the chance of a soft-landing increases, we are happy to take the carry in credit. Spreads may widen and be more volatile going forward, but we do not believe they will widen significantly in the short term. In the meantime, we look for other areas of the market that still look cheap, like securitised credit. Increased bond volatility has made higher coupon mortgage-backed securities look quite attractive, especially relative to investment grade corporates. We also like emerging market local currency bonds, which will benefit from falling inflation, falling US treasury yields and a weaker USD. This should give emerging market central banks room to cut in 2024.
The dovish pivot has changed our view on currencies. USD remains the only hedge in town if inflation comes back, but for now we place more weight on a soft landing. In this scenario, the USD moves from the right-hand side of the “dollar smile” to the midpoint, which is the worst environment for the USD. We have therefore downgraded USD to negative and prefer cyclical currencies like the AUD and emerging market (EM) currencies. We have upgraded the JPY on the expectation of yield convergence, more from US yields falling than the BoJ losing control. That said, we believe the BoJ will look to change their stance in the first quarter of 2024 once we get past the wage negotiations.
Portfolio positioning shifts
We held our higher delta-adjusted equity weight unchanged at around 30% over December, but given our subtle shift in view, adjusted our positioning under the surface. We took profit on our S&P 500 calls which were a tactical trade to profit from a short squeeze higher and instead converted this position to outright equities. This increases our non-delta adjusted equities by 4% to 31%. However, we bought a 5% notional March put-spread which protects the portfolio from a fall in US equities from 4600 to 4100, reducing our delta-adjusted position back to 30%.
Given the aggressive move in bonds, we reduced our fund duration by three quarters of a year to target 2yrs at the fund level. Most of this reduction has come from the front end of the curve, split across the US, Australia and Germany. We prefer steeper curves in the US. Conversely, we prefer to be flatter in Australian curves. The market expects over 50bps of cuts from the RBA, but as inflation is only projected to come down to 2.9% by 2025, there is little room for an inflation setback. The stage 3 tax cuts are expected to be delivered in July 2024 and would be the equivalent of 50bps of easing, so it seems unlikely the RBA will cut ahead of this unless the economy was teetering on the brink of recession. We expect them to wait and see far longer than the market is anticipating, so have sold our 3-year bonds in favour of 10-year bonds.
In FX, we have reduced our USD exposure from 5% to 3%, buying 1% in AUD and 1% in EM currencies. We added 2% to JPY but against EUR and CHF to reduce the carry cost. Despite our downgrade and reduction in exposure, we reiterate the need for some USD in portfolios as a hedge against risk assets.