MOON - Navigating Macro Currents In 2024

2024-01-08 13:15:00 ET

Summary

• Risk assets surged to end 2023 as the Federal Reserve blessed market hopes for rate cuts. That momentum could persist for some time as inflation cools.
• Stocks slid and bond yields rose last week. Data pointing to sticky U.S. wages showed why we think market optimism on inflation may eventually be let down.
• The U.S. CPI this week will likely show falling goods prices leading inflation lower in 2024. We see supply constraints putting inflation on a rollercoaster.

Transcript

2023 ended with a more upbeat risk asset rally than we had been expecting. But we see reasons why the rally could roll on into 2024.

Yet, the shaky start to this year suggests that investors have jitters about navigating the macro currents ahead.

1) A year-end rally

The rally last year was underpinned by the Federal Reserve seeming to bless expectations for aggressive rate cuts as inflation falls.

It left equities pricing in a soft landing where inflation falls and growth holds up. That is possible - but we think it represents a big macro bet.

2) The inflation rollercoaster

We expect inflation to fall near 2% by year end as consumer spending patterns normalize and goods prices fall further. So the risk rally could extend.

Yet, as the adjustment in goods prices fades, wage gains still suggest inflation is set to rollercoaster back up near 3%, in our view.

3) Navigating macro currents

In that event, the Federal Reserve may not cut rates as sharply as markets expect, even as growth slows.

So the big question for risk assets this year is whether and when this outlook becomes clearer later on.

We’re prepared to be nimble. And we’re deliberate in managing macro risks, staying selective with our tactical views.

We favor Japan and tech in stocks, and we’re neutral long-term Treasuries.

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Risk assets ended 2023 on an upbeat note as the Fed appeared to make a big bet on inflation coming down and growth only gradually slowing. Markets interpreted the Fed's messaging as a green light for aggressive policy easing. The end-2023 rally could keep going well into 2024 as inflation cools further. Yet, the jittery start to 2024 for stocks and bonds suggests investors may be nervous about the macro outlook. We stay nimble and think macro risks need to be deliberately managed.

Volatility divergence

Notes: The chart shows the normalized level of equity and bond market volatility in standard deviations. The indexes used are the Chicago Board Options Exchange’s Volatility Index ( VIX ) and the Merrill Lynch Option Volatility Estimated Index (MOVE), which respectively measure the market pricing of one-month implied volatility in S&P 500 and U.S. Treasuries based on options.

The U.S. 10-year Treasury yield closed the year roughly where it started - at about 3.8% - masking a major round trip between 3.3% and 5%. U.S. stocks ended 2023 just below their all-time high, largely thanks to the Fed unexpectedly making a big bet for the market by seeming to endorse expectations for aggressive rate cuts at its last policy meeting of the year. That, once again, highlighted how hopes and disappointments about the Fed drove market flip-flops throughout 2023. The final rally was no different, in our view. It has left equity markets priced for a near-perfect outcome: a soft landing, where inflation falls and central banks sharply cut rates. Market pricing implies they would come to the rescue with even bigger rate cuts if growth risks emerge. That’s why we think expected bond volatility remains high (yellow line in chart) relative to subdued expected volatility in stocks (orange line).

Markets interpreted the Fed’s communications around a potential peak in U.S. interest rates as opening the door to sharp rate cuts as inflation falls. We expect inflation to ease close to 2% in 2024 as consumer spending normalizes from the pandemic and goods prices fall. So beyond the early January jitters, the risk rally could extend - until the risk of inflation resurging comes into view later this year, as we expect. Markets pricing in a perfect outcome is a big macro bet, in our view. A soft economic landing is possible, but the range of potential outcomes is wide in the new regime of greater macro and market volatility. That’s why we’re ready to be nimble and selective on our six- to 12-month tactical horizon.

An inflation rollercoaster

Case in point: Falling U.S. goods prices are dragging down inflation as pandemic-driven swings in spending unwind. Yet, a tight labor market is driving stubbornly high wage growth, as seen in the December jobs data. We think that means inflation is set to rollercoaster back up near 3% in 2025 as the goods price drag fades. We see geopolitical fragmentation bolstering inflationary pressures in coming years, too. That’s why we think the Fed may not be able to deliver the rate cuts markets expect, even with growth moderating as consumers exhaust their pandemic savings and government spending on defense and student loan forgiveness tapers off. The big question for risk assets: when they might start to reflect this outlook in 2024.

In fixed income markets, we see more volatility ahead partly as inflation’s persistence becomes clearer. Plus, we see markets grappling with where neutral rates - the interest rate that neither stimulates nor restricts economic activity - are settling after the pandemic. We think neutral rates are higher in both the U.S. and Europe, partly due to looser fiscal policy and the investment demands tied to the low-carbon transition. We also think investors could demand more compensation for the risk of owning long-term bonds given rising public debt and a more uncertain inflation outlook.

Our bottom line

We get granular to navigate macro uncertainty, favoring Japan, tech and industrials in stocks. We also went tactically neutral long-term Treasuries in October and we keep our overweight to short-term Treasuries. Yields may swing in either direction as markets keep reassessing the outlook for policy rates.

Market backdrop

The S&P 500 fell about 2% last week after the 24% surge last year, while U.S. 10-year yields climbed back to around 4% and rose more than 25 basis points from the December low. The Fed’s December meeting minutes highlighted the easing of financial conditions, adding to the risk asset jitters to start the year. The end-2023 market momentum could persist. But the December U.S. payrolls report confirmed ongoing wage pressures may ultimately disappoint the optimism on inflation.

We’re watching U.S. inflation data out this week to see if falling goods inflation will pull inflation further down in 2024 as pandemic mismatches unwind. Yet, we think tight labor markets and slowing job growth will keep inflation on a rollercoaster beyond 2024. China macro data out this week will also help gauge how subdued activity remains. China’s economy faces two key challenges: sluggish consumer spending and weak demand for its exports.

This post originally appeared on the iShares Market Insights.

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