Investment Strategy Insights: Data-Driven Fed Begins the Pivot Back Toward ‘Dual Mandate’

Stance: While labor markets are gradually slowing, they haven’t exhibited weakness sufficient to signal an early 2024 recession. December’s non-farm payrolls slightly exceeded consensus at 199,000, but a downward revision of 35,000 jobs over the past two months suggests some underlying fragility. Alternative employment data shows a mixed picture, and ADP employment data remains weak, indicating the creation of only 103,000 jobs in November. On a more positive note, jobless claims remain low, indicating minimal layoffs.

Inflation is on a downward trend, with headline inflation decreasing from 3.1% to 3.0%. The positive impact of the base effect in January and February is expected to contribute to a further decline. Additionally, the Producer Price Index (PPI) has consistently surprised to the downside, suggesting further support for a lower CPI due to supply chain normalization. Despite these trends, concerns persist about elevated levels of super core inflation.

The Federal Reserve altered its narrative, hinting at the possibility of three rate cuts in 2024. This shift was unexpected given the absence of concrete weaknesses in the US economy. The willingness to cut rates before reaching the inflation target raises the risk of potential reacceleration if cuts happen too early. However, the decline in long-term inflation expectations from the University of Michigan, from 3.2% to 2.8%, likely provides some reassurance that inflation is not deeply entrenched in the economy. Managing real rates also increases the likelihood of a stable or soft landing in 2024, as the level of restrictive policy will be less extreme. Despite the dovish stance taken by the Federal Reserve, the European Central Bank (ECB) maintained its commitment to data dependence and did not demonstrate a similar readiness to contemplate rate cuts. This stance persisted even as inflation declined more rapidly than anticipated and growth data indicated weakness.

What a quarter! The 10-year’s decline from 5.00% to 3.91% near the end of 2023 represents the largest bond market rally in history, according to Bloomberg. From June 30 to October 19, the long bond rose from 3.86% to 5.14%, or 128 basis points (bps), then fell 112 bps to 4.02%. Our take on the Powell press conference is that the Fed will cut rates no matter what the economy does, as long as inflation stays under control. The market seems to believe him. If that is correct, the Fed showed its hand, and other countries can fit the narrative to control the strength of their currencies relative to the US dollar; this should weaken while commodity prices rise, serving as a boost to exporting countries. There are many reasons the Fed pivoted, but the move represents a giant bet on future inflation, which we believe is incorrect. Expect more wild volatility going forward.

The all-everything rally following the Fed’s December heralding of three rate cuts in 2024 is a bit puzzling, given that markets had already priced in five cuts for the new year. Strong yearend technicals added fuel to the fire, and credit spreads tightened materially. The fundamental outlook has now squarely shifted to a “perfect landing” marked by strong consumption, low unemployment, and moderating inflation. With expectations that the ECB will shift from its no-change policy toward easing and that China’s downturn is bottoming, investors are dismissing any downside risks.

Valuations are now trading through our expected range, with investment grade (IG) in the low 90s and high yield (HY) in the 330s. Given our expectations for an economic deceleration and soft landing, which should result in spreads widening from current levels, we are downgrading our CS primarily on tight valuations.

The relative-value opportunity has shifted toward areas of the market that have not rallied as strongly, including regions outside the US. Emerging market (EM) and European spreads now look more attractive versus US credit. AA rated CLO spreads currently exceed spreads on BB rated HY.

The Fed’s continued dovish narrative has put the US dollar on the back foot recently, helped by the waning but not altogether gone notion of US economic exceptionalism. Other G10 currencies were not offering much of a fundamental alternative into year-end, suggesting technical flows will determine the US dollar’s direction in the short term.

We maintain our 12-month forecast for the euro/US dollar at 1.05. We expect that growth in the eurozone touched a cyclical bottom in fourth-quarter 2023. This, combined with incremental monetary easing in 2024, should provide a floor under the euro, but this is not a catalyst for a sustainable rally. Given the quick rate of disinflation in the block, we maintain that the ECB is more likely to cut sooner than the Fed. We acknowledge that the delta of cuts by the Fed will be larger than the ECB’s, reducing the interest rate differential. But we see the number of Fed cuts being priced by the current market as excessive. A more realistic path for monetary policy will keep the US dollar in the driver’s seat for 2024. However, should the US economy begin to slow faster than the current data suggest, we may need to revise our euro/US dollar forecast higher to 1.10.

The Bank of Japan has strongly hinted at exiting yield curve control, which would pave the way for higher yields and a firmer yen. However, we continue to see capital flows as unfavorable, mitigating this strength.

EM carry on a real-rates basis has diminished relative to the US dollar, which should indicate more of a challenge for EM foreign exchange versus the dollar in 2024 than in 2023. However, local market assets still appear attractive in nominal yield terms, and when combined with our forward-looking view on disinflation and central-bank rate cuts, we see a strong case for local markets.

The COP28 conference produced surprisingly strong pledges for near-term and longer-term climate change funding. Even if overly optimistic, the commitment plays directly into our cyclical and structural optimism over organic investment growth in emerging markets. Capital flows in the region of US$100 billion per year are not insignificant, considering EM gross issuance is around $120 billion-$130 billion annually. EM GDP excluding China is approximately US$24 billion. While controversial, the UAE’s role as host turned out to be a masterstroke in terms of funding commitments, which include a loss and damage fund, private sector involvement through the launch of ALTÉRRA, a flagship climate fund, and the UAE-led Africa green investment. The moves highlight the transfer of money from developed markets (DM) to EM generally, and specifically in climate finance to support mitigation (i.e., reducing emissions) and adaption through more than $700 million pledged to the loss and damage fund, which supports recovery efforts from climate events and natural disasters.

We reduced the two tail risks to zero on the back of a significant improvement in six-month-average inflation data. The improved sentiment toward “stabilization” is even more pronounced in the three months outlook. However, we believe the market pendulum has swung too far into “recession” from “extension” a month or so ago. We expect one or two Fed cuts in 2024 versus the market’s expectation of five or six. Tight valuations and low expected returns in sovereigns are the reasons we retain its underweight allocation. Longer term, EM fundamentals remain strong, with investment becoming a more prominent growth driver.

Previously, our score embodied the likelihood that inflation would stay sticky and employment at small firms would buckle amid a mild recession in which the Fed wouldn’t immediately ride to the rescue, given sticky wages and, therefore, domestically generated inflation. Now, the Fed is conspicuously talking “dual mandate,” a subtle and inexplicit way of saying that it is now of the mind to pull forward policy rate cuts even before recession has had a chance to set in. For markets, that diminishes the risk of a downturn. And should a recession develop, which we continue to expect, the Fed’s position also diminishes the risk of equity markets overreacting to a drop in cash flows based on a belief that the Fed would not act. Instead, Chair Powell’s statements made clear that a recession would lead to even faster rate cuts than those now planned — as well as the rapid end of quantitative tightening. In short, the “Fed put” is back.

While the flattish slope of our CML remains unattractive, its level is reasonable and its dispersion remains notably high. Since we expect market performance to broaden and fundamental valuations to drive markets once again, the expected headwind for risk assets may be fading. Market pricing, however, means that it is still not time to be risk-on, making a move to a more moderate posture warranted.

Labor tightness and inflation appear to be easing, which has increased market expectations for a potential soft landing. This, combined with the Fed’s stated intent to pivot to rate cuts, led to a strong year-end rally in equity markets. Consumer spending is holding up despite some slowing in the lower income brackets, and rolling de-stocking continues across various industries but seems close to ending.

At the company and industry level, the tech outlook remains muted, although de-stocking in semiconductors appears to be ending (with the exception auto/industrial semiconductors, which are still over-inventoried). Industrial sales growth has turned negative as we enter the de-stocking cycle for multi-industry companies. Healthcare spending remains solid, though investors continue to assess the impact of GLP-1 weight-loss drugs on long-term demand trends. While markets have risen recently, we are still finding investment ideas due to considerable dispersion in the economic outlook between and within regions.

Like broader markets, global EMs are seeing a rebound due to investor optimism that US rate hikes have ended and that rate cuts may begin in 2024. For the rally to be sustainable, fundamental improvements need to come through.

In China, economic indicators are mixed, with good industrial production and retail sales but weak property sales. With stock valuations at bottom levels, selection opportunities begin to emerge. The market is now absorbing the realization that Chinese e-commerce platforms will be competing in the US. Industrial companies are generally seeing good export demand, but domestic sales remain lackluster. In India, IT services companies see a slowdown in global IT spending as a key short-term headwind. Domestic demand has been mixed. Some sectors, like automobiles, have reported good results, while consumer appliances saw modest demand. In Latin America, all eyes are on Argentina, which elected a president whose initial fiery rhetoric has morphed into a more toned-down, pragmatic approach. In Mexico, regulators are set to rule soon on the Walmex anti-trust investigation. EMEA saw a boost from tentative normalization of EU relations with Hungary, where, in exchange for disbursement of funds, the government agreed to support several important Ukraine-related initiatives. Bank OTP shares rose strongly on this news.

We are in a risk-on market where previously oversold stocks are rebounding off lows. However, beyond the initial “bounce back” phase, we need to see fundamental improvement in the economy and in company earnings to create a sustainable dynamic. We continue to focus on companies with strong and improving business models, quality management, sound financial structure, and proper adherence to ESG values.

Our US Conviction Score improved slightly, while credit spreads tightened by 23 bps and the curve flattened by 17 bps. Global credit forecasts are negative, and relatively our model favors EM over DM. In DM, the model favors insurance, brokerage, and utilities and dislikes transportation and consumer goods. Among EM industries, the model likes oil and gas; it dislikes real estate, diversified, and infrastructure. Our global rates model forecasts lower yields and steeper curve globally.

The rates view expressed in our G10 model portfolio is overweight global duration but divided within regions. In North America, it is overweight the US but underweight Canada. In Europe, it is overweight France, Belgium, and Italy and underweight other EU countries and the UK. In Asia and Oceania, it is overweight Japan and underweight Australia. Along the curve, we are overweight in two-year and 20-year durations and underweight in five-, 10-, and 30-year durations.