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Outlook 2024: Global Target Return - volatility and active investing will define 2024

The last two years have been a rollercoaster ride for investors. The recent rate hike cycle has been the hardest and fastest in decades, upending the relative tranquillity of markets in the post-GFC era.

12-06-2023

Authors

Sebastian Mullins
Head of Multi-Asset, Australia

Bond holders have seen one of the largest and longest drawdowns in history, and global equity investors had to stomach +/-20% swings only to underperform cash.

It’s fair to say that investors are looking for some good news in 2024. Inflation has peaked and is rolling over, providing a pathway for central banks to ease monetary policy next year. It is therefore no surprise that investors are celebrating and the market is now pricing in a soft landing.

However, uncertainties are likely to persist in 2024.

Outside of a recession, interest rates could remain higher than the market is anticipating. The remarkable insensitivity of the US to rising rates is due to both households and corporates looking in low fixed rate loans in 2021. US households managed to lock in 30-year mortgages near the lows and have therefore mostly been insulated from rate rises. The share of US household debt that is floating rate is now around 10%, which is much lower than the 25% in 2008 or 40% in 1990. Corporates are no different. Less  than 15% of non-financial companies have debt maturing over the next two years. Higher quality companies issued longer dated debt in 2021 at rates below what they’re currently earning on their hefty cash piles, with some even seeing a decrease in debt servicing costs in 2023. Outside of a crack in the labour market, pre-emptive easing is premature.

Looking beyond 2024, fiscal imperatives will likely continue to drive looser fiscal policy, keeping upward pressure on inflation, while central banks remain more hawkish to try and keep inflation under control. There are many different factors at play but we think they can be grouped into three categories, namely Deglobalisation due to rising geopolitical tensions and the need for greater supply chain resilience; Decarbonisation or energy security as economies transition to a new energy mix; and Demographic constraints, where income inequality clashes with a continued reduction in workforce supply. Together, they form what we’ve called the 3D Reset. We predict that fiscal policy will be looser, governments will be increasingly protectionist, and input costs will be higher. The cost of money, the cost of labour and the cost of energy will create winners and losers, both at the corporate and state level, depending on their ability to access these resources.

Stay nimble, stay active

In this environment, investors must stay nimble and active. Higher inflation leads to higher rates which leads to higher volatility. Higher inflation causes the negative corelation between equities and bonds to breakdown, further exacerbating volatility in portfolio returns. However, more volatility offers more opportunity to active asset allocators as they can capitalise on dispersion of returns.

GTR Outlook 2024 graph

Investors should also look to be active in security selection in both equities and credit. When money was free, loss-making companies could survive on the promise of future earnings. Yet with today’s much higher cost of capital, companies will be forced to pay off their debts sooner rather than simply roll over their paper. This means identifying companies that can defend their moat and make adjustments to defend their margins. On the fixed income side, managing duration will require a more hands-on approach. Country and curve selection will be important as each economy walks the tightrope of reigning in inflation but not pushing their economies into recession.

Will the equity laggards catch up or will the generals roll over?

The extraordinary rally in equities in 2023 was driven by a mere seven stocks. The “magnificent-7” are up over 100% year to date, whereas the S&P rallied almost 20%, but the equally weighted S&P 500 is up less than 5% over the same period. Laggards such as emerging markets delivered a paltry 3% in local terms over the same period. This has caused the US equity market to look expensive relative to others. US exceptionalism has always led to a valuation premium to other markets, but even this valuation gap between the US and other markets is becoming stretched. The question for 2024 is whether the US equity market will continue its dominance or whether the laggards will catch up.

While US equities are expensive on most valuation metrics, forward looking earnings expectations are strong. Analysts expect earnings to grow just shy of 12% over next year and another 8.5% the year after, which would bring forward looking P/E ratios down to a far more attractive 17x and 16x respectively. While these earnings numbers do look optimistic, our macro driven earnings model suggests they may be achievable outside of a recession.

GTR Outlook 2024 graph

If policy makers are able to achieve a soft landing, there is scope for laggards to catch up. Earnings outside of the US have lagged, but recent earnings revisions have picked up markedly in regions like the EU and UK. Valuations and structural change make Japan attractive despite the recent rally. Even within the US, the average stock looks attractive on a valuation basis at only 15x, falling to less than 14x next year, when using the equal weight S&P as a proxy. Therefore 2024 could see a bull market under the surface as the rally extends its breadth and the other 493 stocks catch up in the US and ex-US countries climb the wall of worry.

The multi-asset portfolio is positioned for continued equity strength over the short-term as markets climb the wall of worry into the new year. In 2024 we believe there is a risk for the market to shift back to a higher for longer narrative, potentially putting pressure on equity multiples again. We will likely be reducing our overall equity positioning in early 2024. Once we see more evidence that growth is holding up, we would look re-enter via ex-US markets to capture the laggards. Conversely, if the economy continues to weaken, it will be time to finally extend duration risk, particularly in the front end.

For now, the income is back in fixed income

The volatility in sovereign bond yields was extreme in 2023. Looking at the MOVE index (the bond equivalent of the equity volatility index or VIX), 2023 saw the highest reading since 1989, excluding the GFC. While it is understandable that investors have been burnt and may have given up on the asset class, both nominal and real yields on offer are now at the highest level in 15 years. Higher inflation in the age of the 3D reset will likely limit the diversification benefit of sovereign bonds, but this higher yield improves their return contribution relative to equities, flattening the efficient frontier.

We believe investors should look to reallocate to duration. Nominal yields between 4.5-5% are attractive, as are real yields on offer from inflation linked bonds of 2-2.5%. Based on our models, sovereign bonds in the US are at fair value. With inflation and growth slowing and central banks towards the end of their hiking cycle, the headwinds should soon turn to tailwinds for bond investors, at least in the short-term. Over the medium-term investors will have to be more active in their duration management in the age of the 3D reset.

GTR Outlook 2024 graph

All in yields for credit have also improved, both from a rise in the sovereign bond yield but also from the widening of credit spreads. Investment grade credit now offers around 6-7% and high yield above 10% (USD hedged) which is significantly higher than what was on offer two years ago. These higher yields can offer protection to investors. All in yields will have to rise more than 1% in investment grade or 2.5% in high yield to wipe out the yield earned over the next 12 months. This can provide a margin of safety. Investment grade credit also looks attractive on a rock bottom spread basis, which essentially shows that current spreads are compensating investors for a recessionary level of corporate defaults.

Indeed, our current allocation favours credit as one of our preferred assets for a soft landing, potentially allowing us to collect carry as we wait for more concrete evidence of where the economy is heading. While higher yielding credit offers attractive all in yields, we believe this is a shorter-term trade. The risks of a potential slowdown and rise in defaults leads us to prefer higher quality investment grade credit over high yield more structurally.

GTR Outlook 2024 graph

Investors can also look to alternative sources of credit. Securitised credit is currently offering investors between 7-8% yields in USD, but with a higher credit rating than investment grade of AA-. This allocation benefits from a strong consumer and has no duration risk. Subordinated bank debt can also provide high yields for investors without reaching too far down the credit curve. We allocate to high quality subordinated debt from banks offering 8% in USD terms, which are floating rate and have an average credit quality of BBB. These yields are higher than the long run return from equities. In the age of 3D reset, having floating rate credit or short duration credit should benefit for now.

GTR Outlook 2024 graph

When sovereign bonds are no longer providing diversification, other assets should be considered. Using breadth of investment opportunities will be essential. For example, insurance linked securities may pay high yields but can lose money during catastrophic weather events, such as hurricanes. These assets have next to zero correlation to equities or bonds as they are unrelated to the economic cycle and instead driven by the weather or seismic events. They are currently yielding over 15% in USD terms or 12% once expected loss is removed. This asset class has outperformed the S&P 500 since the start of 2023, which makes it a high performing diversifier in portfolios.

Portfolio positioning shifts

We continued adding to risk during the start of the month. The portfolio’s equity allocation now stands at 30%, but due to option positions, this allocation could rise to 32% if the market keeps rallying into year end, or fall down to 22% if US equities fall between 5-10% from here. We increased our high yield allocation by 2% and reduced our investment grade allocation by 1%. We reduced our USD position by 5%, allocating to a mix of CNY, JPY and AUD and other EM Asian FX. The portfolio also added 0.40yrs of duration to target 2.9yrs. We added 0.75yrs to US 10yrs but sold 0.5yrs of Aus 10yrs, with the remainder added to the front end in Germany.

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Authors

Sebastian Mullins
Head of Multi-Asset, Australia

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