Macro assumptions - Part 1 of 3 Asset Allocation thoughts for 2024

TOPICS covered: 2024 Asset Allocation Macro thoughts……..Over the coming 3 weeks, we’ll cover macro drivers, asset allocation and finally, granular breakdown of the portfolio components.........Inflation is not an issue in 2024.........Interest rates have peaked…..’Structural employment’ means we are unlikely to see a severe rise in unemployment…Growth muted in 24 leading to outperformance of the magnificent seven in H1 followed by a switch to cyclicals into H2 as investors begin to discount a recovery and falling rates…….Strong performance likely from the long dated government bonds as the yield curve normalises……USD weakness……commodities recover (except Oil)……China stays weak……consumers falter but remain upright (ie employed)

Over the next three weeks (similar to last year’s playbook) we will turn our attention to 2024 asset allocation strategy. Once into next year, each quarter we will attempt to tactically rebalance to take account of changing circumstances. This week we will attempt to look at the key macro factors that will affect 2024 and reflect on the potential impact on our allocation strategy. Next week we will break the macro views into allocation assumption by asset class and jurisdiction and in the third week of this series, we will delve deeper into the allocation strategy in terms of granularity and weight assumptions.

As discussed in last year’s series, our portfolio strategy in terms of the assets that represent the allocation process break into a number of pots depending on the investor appetite for risk, style and investment complexity. In every case, we have attempted to create asymmetric returns by imposing a hedging discipline based on a proprietary score-card system that attempts to call oversold/overbought conditions and hedges the portfolio using Index Futures as and when signals merit an action. In terms of the portfolios, we create both global direct balanced portfolios where direct is a reference to individual stocks and bonds bought/sold and ‘passive/aggressive’ portfolios where we use ETFs (passive) to represent our strategy exposure (aggressive). Where we believe that the ETF strategy does not fully represent our investment aims (eg many European ETFs are overweight legacy/cyclical sectors), we will take a hybrid approach and invest directly.

?INFLATION

Let’s begin controversially. Inflation is ‘dead’. Barring new economic/geo-political crises (Huge assumption in the current global landscape!), inflationary pressures witnessed since the Covid period have largely played themselves out. Durable goods prices have been in deflationary mode for more than a year. Freight and logistics costs have fallen back to pre-Covid period. Commodity and energy prices have largely retraced and food prices have stabilised. We still see inflation in the services and consumer space but this has more to do with ‘profiteering’ by companies attempting to instil a sense of purchasing urgency in the minds of the consumer than a genuine attempt to protect their cost base from higher input costs. Consumers are already getting wise to this ploy and striking against the most egregious perpetrators. By Q1/Q2 of 2024, even this consumer level inflation should be largely expunged from the system.

The biggest single contributor to the CPI data in any developed economy is shelter. In the US home ownership and therefore mortgage payments remain the single biggest cost of most households. Whilst home ownership in the US has declined in the last few years, it still accounts for 66% of all dwellers. 34% and a rising percentage have turned to renting. The US has a largely unique approach to home ownership finance. The vast majority of households finance their mortgages through long term (mostly 30 year) deals at fixed rates. A large proportion of US mortgages were re-financed or taken out prior to the current interest rate cycle run. In other words, not only do current high interest rates not feature in the regular household expenditure in terms of mortgage repayments BUT more crucially, from an inflation perspective, is largely a non-contributing factor.

What is more of an issue in terms of inflationary pressure or otherwise, is rent. It affects more than a third of the US population and fluctuates on a demand:supply basis and better reflects the general pricing environment in an economy. The chart illustrates this perfectly. Stable rent environment in the 10 years prior to Covid were replaced with dramatically falling rents as folks were forced into isolation only to be followed by an even more dramatic rise which played a major role in driving up CPI in 2021. Since the peak in Q1 2022, rents have been falling and have settled at roughly the same level as the pre-Covid period. More importantly, rent does not appear to be playing a major character in the inflation play but rather a bit part now. With that in mind, the last major bastion of what could have been an inflationary threat is behind us.

Having said that, inflation per se is not dead dead. Just dead. Long term central banks’ targets of 2% inflation can now be tossed into the realms of history. As we will touch on this issue later in the unemployment segment, tight labour markets and a sway in the power of negotiation to the employee away from the employer is likely to result in secondary level inflation and keep the number firmly between 2-3% for some time to come. We can also say with a high level of certainty that inflation will remain a major issue of contention by economists next year as short-term fluctuations based on cyclical factors such as commodity prices will no doubt bring back occasional bouts of fear.

What we are basing our base case assumption on is that the major causes of inflation that have plagued global economies are no longer so prevalent. With this in mind, we believe that inflation in 2024 will continue its downward path in a relatively steady fashion allowing the Fed to focus on the interest rate environment.

?INTEREST RATES

Central banks correctly and in many cases belatedly reacted to rising inflation by raising interest rates at the fastest pace ever in recorded economic history. The traditional knee jerk reaction did take hold but only just. Economic textbooks suggest that a rise in inflation resulting from an increase in the money supply, egregious pricing, or overheated growth can be quelled through raising interest rates and increasing the cost of doing business ie create a slowing economy leading to lower pricing pressure which in turn allows for interest rates to fall and the economy to grow again. This is where we believe we are in the cycle. The US economy and the rest of G7 is in deflationary mode. Whether the Fed or other central banks react in time or not (most likely not), interest rates appear to have peaked and are likely to decline going forward.

How quickly? Most likely from Q3 24 onward. However, if the Fed drag its heals, this may occur into Q4 and early 25 and may result in a minor short lived recession in the latter part of next year. Markets tend to discount 9-12 months forward. If this is the case, risk assets should perform well into a falling rate environment. In a worse case scenario where recession hits and the Fed is late in reacting, there would be downside to risk assets but relatively short lived and most likely into Q2/Q3.

RECESSION/GROWTH

Our base case assumption is that 2024 is a year of slow, sub-par growth in developed economies. High interest rates, a spent consumer and slightly higher unemployment is likely to impact on economic growth. In this environment, structural growth stocks outperform. Companies with defensible moats, pricing power, high free cash should outgrow cyclicals. This implies a continued narrow performance of indices similar to 2023. A broadening of the market is only likely when it becomes clear and consensus that interest rates are heading lower. This should result in a switch in performance as cyclicals begin to catch a bid with the likelihood of an economic recovery into 2025. The broadening of the performance of equities in this phase may not necessarily result in index gains as the ‘magnificent seven’s ‘ underperformance vs the rest of the market acts as a dampener on indices given their significant weights.

Our worst case assumption is a recession hits Q3/Q4 on the basis that the Fed responds slowly to a loosening economy and does not reduce rates quickly enough. In this context, a recession may well be shallow and short lived. The US is likely to continue to lead on growth with developed economies 2-3 quarters behind. As we will discuss later, a weaker USD is likely to benefit EM and commodities in the latter part of next year.

UNEMPLOYMENT

We have discussed in detail in the past that we are in an era of structural ‘employment’. In terms of the impact over the next 12-18 months, the base case assumption is that we witness a slight uptick in unemployment, particularly in the service sector. We remain at full employment levels in the US as defined in economic terms. Any slack in consumer demand given the constraints on household income is likely to impact the services sector first and foremost. This is where the unemployment uptick is most likely to occur. An uptick equates to levels between 4-4.5%. In our opinion, a move toward 6% would certainly spell recession. In circumstances where ‘structural employment’ was not in place, this is where we would have headed to. For us, unemployment hitting a peak of 4-4.5% is the basis for all our assumptions in terms of a relatively benign investment environment in 2024.

BONDS

We have had an inverted yield curve for almost 2 years. The long end of the curve has been running lower than the short. This is not normal. The further out you go in your investment horizon; the more moving parts and therefore more risk is embedded into an investment decision. For this reason, the ‘normal’ yield curve would slope gently upwards from left to right. We believe that as Fed policy stabilises and begins a downward phase, so the treasury yield curve will begin to re-shape. This implies significant upside in the long end of the bond market. 2024 should be a strong year for long dated government bonds. We are already witnessing this effect with 10-year US treasury falling almost 100bps over the last month to 4.4%. There is a distinct likelihood that by this time next year, the 10 year-yield could fall nearer to 3% resulting in a significant rally in bonds.

EARNINGS/MARGINS

There is a steep refinancing wall hitting the corporate bond market leading into 2025. Those companies with weak balance sheets will increasingly find it difficult to service debt at what will be significantly higher rates than they have been used to. The quicker the Fed reduces, the easier the toll. However, those with high levels of debt face an uncertain future. We believe that 2024 will be a deflationary year. This does not bode well for pricing in general. With this in mind, we believe that earnings growth will be muted and margins under pressure. Currently the S+P500 consensus earnings estimates are at 11.4% for 2024. This seems overly optimistic given the likelihood of low growth and low to no inflation over the next 12 months.

CURRENCIES

With the US leading developed markets lower in terms of rate setting, the USD is unlikely to perform strongly in 2024. A muted performance is our base case as falling rates are counteracted by healthier growth than the rest of G7. Emerging markets assets may well pick up on the back of a relatively weaker USD. The Euro is likely to perform well in the coming year with GBP holding steady between $1.20-1.25 as relative strength vs the USD is countered by what is likely to be difficult economic environment with persistently higher inflation than in Europe and US, stopping the Bank of England from reducing rates in a timely manner.

ENERGY/COMMODITIES

We have in past letters suggested gold is increasingly becoming marginalised as a low correlation hedging instrument as so many alternative hedging instruments now pervade financial markets. Having said, given our premise that the USD may be muted for much of 2024, the gold price as an inversely related asset, should benefit. Furthermore, much of the commodity complex should also take advantage of the weak dollar and be underwritten for much of next year with a view that economists begin to perceive a nascent recovery H2 24, the commodity complex is likely to receive a secondary bid.

Oil is proving to be a more difficult animal to predict. In an election year, the Democratic party will be keen to keep the lid on gasoline price appreciation. More releases from the Strategic Petroleum Reserve (SPF) are likely to occur as we approach the Presidential elections in November. In the meantime, OPEC appears keen not to disrupt global supplies and unlikely to cut production exclusively to drive prices. Saudi is in the process of a major transition to a post hydro-carbon economy. It wants to maintain normalised relations globally and its current muted stance on the Israel-Hamas conflict is a testament that it is not keen on using geo-politics to profiteer in the short term.

Apart from the low growth environment we feel will be the case in developed global economies in 2024 generally, China, which hitherto has been a major force in the global energy market is unlikely to play as major role as in the recent past as a marginal buyer given what is likely to be a continued slow growth economy.

CHINA

The Chinese economy is likely to remain weak for at least H1 24. The real estate market remains in financial flux and consumer demand is fragile as we’ve heard from a number of Western companies active in the region. Infrastructure spend may well be diverted towards consumers to dispel any notions of hardship. As a result, China is unlikely to make a particularly substantive contribution to global growth. In the meantime, in an election year, the US political rhetoric from both sides will reach high pitch shriek levels with various restrictions proposed to sanction and restrict trade between the West and China. Much of this will be bluster but it is likely to result in a negative sentiment amongst investors in the run-up to the election.

THE CONSUMER

A very telling factor as to the state of the US consumer has been the use of ‘Buy Now Pay Late’ (BNPL) services from the likes of Affirm. Use of BNPL rose a dramatic 72% during Black Friday/Cyber Monday week vs the previous week. This is a clear indication that the consumer is stretched. Despite decent YoY growth in sales over the period (and higher still for online sales), the consumer appears to be reigning back spending. Indeed, the recruitment site highlighted that whilst temporary job search for shopping season increased 19% YoY, the number of positions available fell 6% YoY. Walmart talked about smaller average shopping basket value despite consistent footfall.

All this suggests that the consumer is ‘down’ BUT not ‘out’. In the main, the household spend is stretched to the limit, but it doesn’t appear that the flow of income has stopped. The US consumer will become a lot more discerning in 2024 but will continue to spend areas such as Sports & Wellness, vacations and going out to eat.

PLEASE DO YOUR OWN RESEARCH. THIS IS NOT A SOLICITATION TO FOLLOW ANY OF OUR ADVICE. THIS IS MEANT FOR PROFESSIONAL INVESTORS ONLY.