Investment Strategy Insights: What Could Go Wrong (or Right) in 2024

Stance: At the start of November, economic data indicated being at a crossroads. Throughout the summer, there were signs of imminent economic weakening, but exceptionally robust data in October raised questions about whether that would come to pass. As November progressed, however, data began supporting summer’s gradual weakening thesis.

In the labor market, non-farm payrolls increased by 150,000 jobs, but that came with downward revisions of over 100,000 for the preceding two months. While initial jobless claims remained near all-time lows, continuing jobless claims suggested increasing difficulty in finding employment. Inflation fell below expectations, but concerns lingered regarding trends in super core inflation, leaving the speed at which inflation might decrease an open question. Although retail sales remained strong, there was a rise in consumer defaults while concerns persisted about the level of remaining savings.

In Europe, the absence of a supportive fiscal backdrop, which fueled US growth, has posed challenges this year. However, like last winter, fears of an extremely harsh economic downturn seem overblown due to excess savings on both consumer and corporate balance sheets and Europe’s rigid labor market. Additionally, the European Central Bank began hiking interest rates later than the Federal Reserve and only achieved positive real rates in the fall. This implies that the impact of tighter monetary policy in Europe is only just beginning to be felt.

From last month, when we were bullish on the 10-year at 5%, we have moved to neutral as the 10- year hovers at 4.45% – a rarity in recent years. We anticipate a range of 4.50% to 5.00%, but with the possibility of it going much higher than 5.00%. The day before the Hamas attack, the 10-year was at 4.80%. We expect more volatility through year-end.

Recent economic data, including indications of softening inflation, have buoyed support for a “perfect landing” economic scenario. With weaker, but not too weak, economic performance providing a pathway for central banks to shift toward easing in 2024, we saw strong rallies in rates and credit spreads in November. Our fundamental outlook for credit is in sync with a soft-landing scenario; we expect decelerating earnings growth and rising defaults, but at levels below market expectations. Spread valuations, however, are now trading at the tight end of the range for such an outcome. High yield (HY) spreads have rallied 50 basis points (bps) to below +400 once again and investment grade (IG) spreads are below +110. The stronger valuations have led us to downgrade our CS by 0.25.

Despite our more defensive score, we maintain our asset class bias and preference for leveraged finance over IG over the next 12 months, as we expect the current yield advantage to more than offset the expected spread widening under a stronger base case. We have become relatively more negative on European fundamentals and therefore maintain our tilt toward the US, albeit marginally. Last month, we advocated for adding fixed-rate exposure versus floating-rate, but with the rally in fixed-rate credit this month, we now would hold off on any further shifts. In emerging markets (EM), China is showing signs of bottoming, and that may finally remove the negative sentiment on broader Asia/EM such that technicals may be trending more positively.

The Fed-peak narrative has put the US dollar on the backfoot in recent weeks. Other G10 currencies are not offering much of an alternative into year-end, suggesting that technicals and flows will determine the US dollar’s direction in the short term. The recent move higher in the euro/ US dollar suggests the path of least resistance is for a mildly stronger euro; however, this is not yet justified by the underlying strength of the US economy.

The third-quarter theme of US growth exceptionalism is likely to prevail in coming months, keeping the US dollar in the driver’s seat. Into 2024, however, the euro could find unexpected support from signs that China’s economy hit a cyclical bottom in the third quarter, and Germany may soon follow.

We believe the US Treasury was unnerved by the rapid rise of 10-year yields to above 5% and decided to reduce issuance in a clear shift of intent, which also may have prevented the euro/US dollar relationship from testing lower levels. Equally, sticky inflation in both the US and Europe may hinder central banks from sounding dovish, thereby confining Treasury yields to range trading. While US rates have experienced elevated volatility, foreign exchange moves have been measured. We expect the euro/US dollar to remain below the highs of 2023 and eventually revisit our 12-month forecast of 1.0500 as the US dollar continues to benefit from a mix of loose fiscal policy and contractionary monetary policy.

Looking ahead, growth and rate differentials will continue to dictate the path of the US dollar, indicating that the three-month outlook (our “Extensions” scenario) can be very different from the 12-month outlook (our “Stabilization” scenario), with a strong dollar in the first half followed by some weakness, translating into a neutral bias. Meanwhile, EM currencies have experienced a renaissance after US Treasury yields dipped back below 5%, negating concerns about market access in the dollar-debt market and refocusing market participants’ attention on the attractive real yields and remarkable resilience of most EM countries and currencies this year.

We see remarkable resilience in the EM corporate debt universe. Our stress testing suggests that JPMorgan’s default rate expectations for 2024 are inflated, with regional default expectations in our investable universe significantly lower and of little concern. Local currency channels will play a big part as a funding alternative, particularly in Asia and Latin America, and by screening the EM universe we can avoid many risky jurisdictions and names. Overall, we feel confident in debunking the myth of high refinancing risk in 2024 and 2025, even in scenarios where interest rates remain “higher for longer.”

In sovereigns, rates that are higher for longer no doubt will increase the number of vulnerable credits, but Asia and the Middle East are our least vulnerable regions. Vulnerable countries (CCC rated) are already known: Senegal, Kenya, Jordan, Lebanon, Panama, and El Salvador. Sri Lanka, Egypt, and Pakistan are likely to join the list in 2024. While their external repayments warrant monitoring, the risk remains idiosyncratic rather than systemic.

Concerning our return expectations over the next 12 months, local markets stand out as the best return opportunity, followed by corporates and sovereigns, which explains this month’s score adjustment. Our scenario weightings have not changed: 50% stabilization, 25% recession, 5% stagflation, 15% extension, and 5% acceleration.

Tightening of financial conditions finally moved beyond the short end to include the entire US rates curve. Beyond rates, reduced liquidity resulting from quantitative tightening (QT) will have a much better chance of hindering growth, and if so, will also widen credit spreads and equity risk premia. Liquidity drainage is exacerbated by the ongoing trend of de-dollarization, as Japan, China, and the Global South are selling Treasuries while the Fed allows them to run off at maturity. Continued draining of liquidity spells more cracks in the financial and economic foundation as we enter 2024. As a result, we maintain our cautious Conviction Score with a negative bias.

Economic resilience has been bolstered by a stealth fiscal thrust, with job stability from this source underpinning robust consumer spending. Yet this unexpected increase in the fiscal deficit as a percentage of GDP is already showing signs of softening. If so, economic resiliency in the US may be tested. Meanwhile, in Europe, without one foot on the fiscal accelerator, growth has been relatively muted compared to the US. Keep an eye on Europe’s labor market as it responds to a dip in corporate profits, which can provide crucial insights for the US as we learn about how structural labor shortages play out in this unique cycle. Risks are further heightened by geopolitical disruptions in the Middle East, pushing oil and gold prices higher. Additionally, the geopolitical risk concerning China could increase if a stretched US military is viewed as an opportunity to open a third front (i.e., Taiwan).

On a brighter note, China’s third-quarter GDP growth beat expectations, buoyed by retail sales and modest infrastructure growth. The announcement of an increase in fiscal stimulus from 3.0% to 3.8% outside of planned meetings is positive and a sign of growing awareness of China’s growth problem. Yet this silver lining will not offset the liquidity squeeze coming in the months ahead.

We are seeing some moderation in economic drivers (inflation, wages, job growth), which allows the Fed to pause its tightening cycle rather than push harder on rates. Consumer spending is holding up despite some slowing in lower income brackets. Labor markets remain supportive, with positive but moderating job and wage growth.

Geopolitical tensions aside, the macro backdrop appears more stable. Earnings appeared to bottom in the second quarter and are set to accelerate. According to BofA Global Research,* the 2024 bottom-up consensus still needs to come down a couple of ticks, but still sees decent growth. At the company/industry level, we note the following: The tech outlook is more muted on lower IT spending and on weaker demand for PCs and smartphones, but the worst of the inventory issues seems to be behind us. Order books at industrials are slowing from high levels, and healthcare spending is solid, but the sector still faces staffing challenges as well as softness in more discretionary areas. We are still finding investment ideas in the areas of technology enablers and net-zero spending.

Global emerging markets continue to be whipsawed by interest rate fears and two wars. In China, after tentative improvement, retail sales are turning down again, which is worrying investors. Earnings have been mixed, with a big disappointment coming from a fast-food giant, where lower average tickets and wage pressure were evident. In Korea, industrials remain under pressure, but memory manufacturers continue to signal that clients are willing to accept higher chip prices.

In Latin America, Brazil delivered good earnings reports from leading companies in railroads, online retail, jewelry, pulp and paper, and telecom. In Mexico, another good quarter was reported by the leading retailers. Overall, the region’s macro improvement and competent management are evident in the results.

In EMEA, both pharma and banking leaders again delivered good results. South Africa continues to suffer from multiple problems and lack of reform. The Middle East conflict is adding to investor jitters.

It seems we are once again in a period when top-down and geopolitical events have overtaken company fundamentals, but many stocks are heavily oversold. We continue to focus on companies with strong and improving business models, quality management, a sound financial structure, and proper adherence to ESG values.

We improved our US Conviction Score due to curve steepening (+25 bps) that more than offset the widening of credit spreads by 0.09 bps. With global credit forecasts negative, our model slightly favors emerging markets over developed markets (DM). In DM industries, the model favors energy and insurance and dislikes transportation, REITs, and consumer goods. In EM, the model likes oil/ gas and financials and dislikes real estate, utilities, and diversified.

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