Macro
This week, Jay Powell has surprised everyone and gave a festive giveaway to global markets. For the first time, he confirmed the assessment that the inflation is easing and going in the right direction. The meeting was mostly centred on the Summary of Economic Projections (SEP, also known as “the dot plot”), which changed the median 2024 FED funds projection from 5.1% to 4.6%. This translates to a median forecast of 3 rate cuts 2024 for 75 bps. This dovish December FOMC meeting marks the end of the monetary tightening cycle, with many analysts calling it a “FED Pivot Party”.
Even the biggest secessionists started to display reserved optimism about the FED’s accomplishment with regard to managing declining inflation. The FED was late to hike the rate, but they worked one of the most challenging macro environments and cooled off multi-decade high inflation without breaking the economy. The labour market remains tight, with unemployment remaining steady at 3.7%. An increased supply of workers accompanies strong job creation. In his speech, Powell Mentioned that growth in economic activity has slowed and emphasized that future decisions will be based on incoming data, the evolving outlook, and risk balance.
Economists have pushed their forecast of the global growth slowdown to 2024, as the 2023 outlook has significantly improved. Global growth is expected to decline slightly, while US growth will halve from 2.2% in 2023 to 1.2% in 2024. More severe revision of the US growth number compared to the rest of the developed markets and the overall global economy is related to a significant reduction in unprecedented stimulus observed over the last three years, including:
- Federal debt increased due to the fiscal stimulus, and outlays increased.
- M2 money supply
- FED balance sheet expansion
- Commercial bank deposits
- Tax receipts
Rates
Rel yields are a barometer of market cheapness, and with over 250 bps of real yields for most of the curve back in October, it represented a remarkable opportunity after years of negative real yields. Real yields still look attractive, from 230 bps for the short end to 175 bps for the long end.
After Jay Powell’s speech, markets started anticipating a turnaround from the historical, two-year-long tightening cycle and a forceful interest rate cut in 2024. The market expects 6 to 7 rate cuts next year, which means they expect the FED to cut rates at almost all of their 8 FOMC meetings. This bullish stance on bonds could be overdone, especially at the short end of the curve, where 2Y discounts 165 bps by January and 150 bps by December.
Many investors expect that yields may still go up from below 4%, but overall, it’s the beginning of a new bull market for bonds. A lot of juice has already been squeezed out of the duration trade, but yields remain attractive.
Despite the market being very optimistic about the rate cuts, there might be fewer cuts later in a year than consensus expectations.
Credit
Corporate IG credit space is exceptionally well balanced from the earning perspective and, therefore, does not pose too much risk. This cannot be said about the Corporate HY credit space, which has a significant quality dispersion.
Cyclicals and industrials look very expensive from the perspective of tight spreads during the economic slowdown, and their cash flows will be significantly affected by market conditions. Thus, it may be better to underweight the cyclical exposure where the soft landing has been priced. In case of a tail risk of recession, balance sheets with higher debt, lower earnings, and lower savings will get hit first. The process will continue and gradually start to impact the higher-quality BS. At lower FICO borrowers, delinquencies are already beginning to pick up rapidly.
On the other hand, banks look quite attractive because their spreads are relatively elevated. They have greater flexibility to deal with unrealized losses, and those losses will shrink once interest rates start coming down. The same goes for insurance, utilities, food, and beverages, which will help add a more defensive stance to the portfolio and focus on industries with more stable revenues.
Equities
Since the low in October, when the S&P 500 went shortly below its 200 DMA, we have had a rapid year-end rally, with an upside breakout above 4,600 points and increased breadth. Based on the RSI momentum indicator (Relative Strength Index), we have overbought conditions (RSI >70) for the highest proportion of stocks since 2020. Over 60% of all stocks are currently above their 200 DMA.
The perspective of peak tightening and expectations of upcoming rate cuts have allowed mid-size tech stocks to perform exceptionally well. The optimism upsurge was focused on names related to Artificial Intelligence. However, expected rate cuts also lead to bullish development for regional banks, which bounced off the lows and now reached 6M highs.
Furthermore, the rally is stimulated by the easing of financial conditions. The Bloomberg Financial Condition Index hit its highest level since the start of 2022, thanks to falling yields, tight credit spreads, and a weaker dollar.
Equities are pricing in soft landing as investors see confirmation from the robust consumer demand. Top-line revenue growth for small to mid businesses is in the mid-single-digit range, consistent with the nominal GDP growth rate.