SHY - Putting Money To Work In 2024

2023-12-11 13:20:00 ET

Summary

• The new regime has led to greater dispersion of returns. We think this backdrop calls for managing macro risk, being selective and seeking out mispricings.
• U.S. stocks hit a new 2023 high and U.S. Treasury yields inched up on Friday after U.S. payrolls data. Market pricing of rate cuts in 2024 still looks overdone.
• We see central banks pushing back against market hopes for rate cuts at this week’s meetings. We expect structurally higher interest rates in the new regime.

Transcript

Higher interest rates and greater volatility define the new regime we’re in. In turn, that’s creating greater dispersion of returns.

We think investors will benefit from taking a more active approach to portfolios as we head into next year.

Here’s our three investment themes for 2024: number one, managing macro risk; number two, steering portfolio outcomes; and number three, harnessing mega forces.

Our first theme is managing macro risk. Production constraints mean central banks face tougher trade-offs between inflation and growth - they can’t respond to faltering growth like before. This leads to a wider set of outcomes and a more uncertain macro outlook.

We don’t think investors should wait for the macro environment to improve. Instead, they should look to neutralize macro exposures or be very deliberate about which risks they take.

Our second theme is steering portfolio outcomes. We believe the new regime rewards an active approach to portfolios. Greater volatility and dispersion of returns create space for investment expertise to shine - that involves being more dynamic with indexing and alpha-seeking strategies, while staying selective.

Our third theme is harnessing mega forces. We see five structural shifts reshaping markets and driving returns now and in the future. We think they have become important portfolio building blocks on their own.

The bottom line is: Going into 2024 in the new regime, we want to put money to work. We believe investors should take a more active approach to their portfolios and be deliberate in taking portfolio risk.

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We think the new regime of greater macro and market volatility makes this the time to grab the wheel and take an active portfolio approach. Our 2024 Global Outlook outlines how we do that. First, we are deliberate in managing macro risks. Second, we aim to capitalize on greater dispersion of returns by getting selective within asset classes, geographies and sectors. Third, we tap mega forces, the structural shifts we see driving returns and transcending the macro backdrop.

More rewards for dynamism

Past performance is not a reliable indicator of future performance. Index returns do not account for fees. It is not possible to invest directly in an index.
Notes: The chart shows monthly U.S. equity returns based on the MSCI USA in the old and new regime in three scenarios: keeping the holdings unchanged (buy-and-hold), yearly rebalances and semi-annual rebalances. Rebalances optimize portfolios for returns, diversification and risk with perfect foresight of equity sector returns in the MSCI USA index.

The new regime’s higher interest rates and greater volatility are a sea change from the Great Moderation, the four-decade period of stable growth and inflation that was capped by ultra-low rates in the wake of the financial crisis. That helped suppress macro and market volatility, stoking bull markets in both stocks and bonds - but also limiting the reward of having investment insight. We find that reward is back. The test: Imagine you could perfectly predict future U.S. equity sector returns and adjust your portfolio to capture them. That would have had little upside in the four years before the pandemic. “Buy-and-hold” strategies (the orange bar on the left chart) would have generated similar returns to portfolios allocating to outperforming sectors more frequently (the left yellow and green bars). The reward has been much greater since the pandemic, with rebalancing delivering more than double the hypothetical returns of a buy-and-hold strategy. See the gap between the orange bar and the others on the right chart.

How do we try to capitalize on this new regime? First, we focus on managing macro risk - the first of three investment themes that help us identify opportunities to generate alpha, or above-benchmark returns. Markets have been swinging between hopes for inflation to fall as growth holds up and recession fears. Yet, we think the context is that the economy has just climbed out of a pandemic-shaped hole. Plus, structural drivers such as shrinking workforces are poised to push up inflation. One macro risk we’re watching is the uneven market adjustment to structurally higher rates. The income cushion bonds provide has increased, leading us to upgrade long-term Treasuries recently to neutral on a tactical horizon. We went overweight European and UK government bonds at the same time, but have since trimmed again given the fall in yields. This more dynamic approach contrasts sharply with our previously long-held underweight in developed market long-term bonds.

Steering portfolio outcomes

Greater dispersion of returns creates space for investment expertise to shine and means security selection is likely to be more impactful - as detailed in our second theme, steering portfolio outcomes . This involves being dynamic with both indexing and alpha-seeking strategies, while staying selective and seeking out mispricings. For example, we upgraded Japanese equities twice without hedging against currency swings this year due to high compensation for the risk of holding them, strong earnings growth and shareholder-friendly corporate reforms. On sectors, we like European banks for their low valuations and positive outlook for net interest margins, as well as developed market technology.

Harnessing mega forces

Our preference for tech is supported by our third theme, harnessing mega forces, which offer opportunities uncorrelated to economic cycles. Case in point: Investor enthusiasm for digital disruption and artificial intelligence ((AI)) - one of five mega forces we track - has buoyed U.S. tech stocks and offset the drag of higher bond yields. Our expectation for high-for-longer rates would keep us underweight broad U.S. equities on a tactical, six- to 12-month horizon. Yet, adding the AI theme has taken us closer to neutral. Other mega forces present opportunities, too. Within the low-carbon transition, climate resilience - society’s ability to adapt to and withstand climate hazards - is emerging as an investment theme. And we see geopolitical fragmentation dialing up investment in strategic sectors like tech, energy and defense.

Our bottom line

The three investment themes of our outlook guide us on how to take a more active approach to investing. Mega forces help us get granular in DM stocks. And higher rates have increased the income in fixed income, boosting its appeal.

Market backdrop

The S&P 500 hit a new 2023 high, beating the record it set on Dec. 1. The U.S. jobs report for November stemmed the fall in 10-year U.S. Treasury yields - down about 75 basis points from 16-year highs - from markets pricing in multiple Fed rate cuts next year. The data showed a gradually cooling labor market, but falling unemployment and still-high wage growth aren’t consistent with inflation returning to the Fed’s 2% target. So, we don’t think the Fed will cut rates as swiftly as markets expect.

The Fed and ECB policy decisions will be the center of market attention this week. We think both central banks will push back against market expectations on how many rate cuts they’ll deliver in 2024 and how soon they will come. For the Fed, in particular, persistent inflationary pressures and loose fiscal policy will prevent it from cutting rates as swiftly as markets expect, in our view.

This post originally appeared on the iShares Market Insights.

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