Macro
A year ago, economists concluded that getting inflation under control would require a spike in unemployment and a recession. During the year, inflation has come down faster than the event in the most optimistic forecast, while the economy maintained a robust growth number.
US growth was promoted by fiscal stimulus, which positively impacted consumer spending but also had substantial organic growth through increases in productivity and continuous innovation. Some economists still argue that the effects of high rates have yet to be fully realized throughout the economy, but on the other hand, a lot of this impact has been cushioned by fiscal stimulus.
The war with inflation might be over, but historically, we have seen only two or three inflationary spikes; thus, investors must stay cautious. There are a few risks to consider when judging the likelihood of returning inflation (even if this is a short-lived spike). First of all, declines in inflation were heavily reliant on good disinflation, which is not sustainable. Goods prices have declined over the last six months at a very high annualized rate of 2.5%. This level was last seen in early 2000 when globalization accelerated, putting a significant amount of additional labour supply online from China. Secondly, the big spending bills signed by Biden, such as the Inflation Reduction Act, Chips Act, and Infrastructure Act, are only starting to hit the economy next year when they can cause a spike in inflation. Furthermore, we need to be mindful of the risk of inflation coming from freight disruption caused by attacks by Yemen’s Houthi militants in the Red Sea region.
Despite those risks to inflation, we need to acknowledge that a considerable portion of inflation was indeed transitory but over a much more extended period than initially anticipated. The best example is the overall positive global supply chain trend. While the inflation normalized the critical supply chain health metrics, all came down to pre-pandemic levels, including:
- China Containerized Freight index
- New York Fed supply chain index
- The average price of transporting containers from China
- Container freight rates from China
- Vessels at LA/Long Beach Harbor
- Los Angeles/Long Beach Harbor: Container Vessels in Port at Anchor
- US goods exports
- Truck transportation costs
- North American rail traffic volumes
- Amount of time a container waits to get picked up at a marine terminal
- Inventory to sales ratio for wholesalers
Rates
Despite the discussion about the end of a tightening cycle taking place throughout the year, the range of rates was very wide, with the market moving from one extreme to the other. The market is still expecting 6 rate cuts, while the FED officials expect 3 for 2024. Rate volatility will remain elevated as long as those expectations fail to materialize and continue disappointment.
The FED would need to increase its effort to normalize and disinvest the yield curve to create a more stable environment that accommodates the increased supply of treasures.
Credit
2023 was an extremely positive year for credit investors. The year started with much pessimism, a consensus recession outlook, and credit spreads at a good value point. Over the course of the year, the recession outlook has shifted from hard-landing through soft-landing to no-landing, and as a result, credit spreads have tightened substantially. This leads to a much worse starting point for credit investors in 2024, with a less attractive entry-point valuation and less cushion for potential tail-risk credit events.
The positive development for the HY market is a limited supply while demand for issuance is maintained at a steady pace. The average duration of HY credit is falling, which makes issuers far more sensitive to interest rate changes. We are seeing much higher sensitivity at a time when the yield curve has the biggest inversion post-Voluker era. Moderating inflation and growth will be positive for credit but require more discrimination amongst the individual issuers. The yield curve, which has been heavily invested for some time now, may speak a bit more to the risks ahead, with an adverse effect of high rates being felt by smaller capital structure companies.
In 2024, we may see far more defaults. Since the spreads are now higher, credit investors must stay very selective, and good performance would require greater discrimination amongst the issuers. Defaults will come from smaller companies and those with excessive exposure to floating rates, especially since the floating rate tends to be lower quality than the fixed-rate market. Rising defaults will affect specific areas, such as leverage finance and floating-rate bonds.
If the Fed stays on its path, interest rates will eventually be cut, bringing the returns on money market instruments significantly down and forcing investors back into risky assets, but at a much higher valuation point than they currently are.
Equities
The “Soft landing”/”No landing” or “Goldilocks” narrative has set the tone for the Equity markets, and economic optimism has now been almost fully incorporated into valuations. The year ended with more positive days (132) than negative (113), with the highest return days returning far more than losses on the lowest return days. Also, while 2023 led to a full recovery in market performance, investors saw a much lower volatility than 2022. This is consistent with historical findings, which point to the fact that after a period of high volatility, equities tend to have long periods of strong performance, and price action returns to more typical market behaviour.
The excitement around AI as the new transformative technology is keeping and going to keep momentum in equities. Technology was the best sector globally this year, with IT outperforming other MSCI ACWI ex-USA Index sectors, while US IT doubled the ex-USA IT sector. Although 12M forward earnings forecasts have risen nearly the same for US and ex-US IT firms, multiple expansion was much higher in the US market as the rally was fuelled by US mega-cap tech, the biggest beneficiaries of AI technology. Magnificent 7 and friends contributed 75% of S&P 500 gains. This has significant consequences for geographical allocation, as all those US-based giants gain nearly complete control of this revolutionary technology, generating a further divide in performance compared to the rest of the global indexes.
Absolute valuations are still within the normal range but slightly stretched relative to bonds. Despite pricing in positive economic news, there is still a lot of room to grow as consumer sentiment and investors’ positioning have a lot of room to improve. As the rates recalibrate and decrease further, much capital will move back from money market instruments and bonds to the equity market.