The non-predictions for 2024.
The US equity risk premium will not end 2024 narrower compared to end 2023.
The US high yield bond index will not outperform high grade bonds in 2024.
Fixed income volatility will not end 2024 higher than equity volatility.
Private equity will not outperform public equity in 2024.
MSCI India will not outperform MSCI China in 2024.
The US dollar will not underperform EM currencies in the first half of 2024.
By now many of you would have seen several outlook reports for 2024 from the sell-side or large buy-side firms. Most start with a set of forecasts on growth, inflation, and interest rates to drive their asset class and sector return estimates. The challenge with this approach is that human beings cannot see the future. Moreover, even if we could accurately forecast macro variables, earnings on a company or index, the valuation multiple could vary wildly depending on risk perceptions, discount rates and positioning. Put another way, the price determination mechanism is considerably more complex than a simple linear model of earnings and valuation.
The concept behind the “non-predictions” is an attempt to identify “what is probably wrong, rather than forecast what might go right.” Our investment approach is to take on expanded risk premium when beliefs or expectations have shifted rapidly and have become anchored on an implausible outcome. Stated differently, we assess where there is a large skew in valuation, risk compensation, positioning, and consensus beliefs rather than attempt to back an asset based purely on a forecast or view. In addition to a large valuation anomaly, our definition of a behavioural episode is when price has been driven by emotional sources of volatility, rather than fundamentals. The final element is the focus on a single story (The Economist Cover).
As we have noted previously, 2023 has been the year of the contras where swings in major macro trends have caught consensus positioning and beliefs offside. At the start of this year, the prevailing bias was bearish on the first half outlook for growth. Recession risk was feared to be in the first half. Our sense was that the risk was likely to be much later for three reasons; 1) elevated excess savings; 2) the strong fiscal impulse; and 3) the Fed’s response to the regional banking episode in Q1 (clearly that was not known in November 2022). As a result, the many investors were caught offside on long duration positions.
Throughout this year the prevailing bias transitioned from recession to “soft landing” as the dominant consensus belief following the easing in consumer price inflation and peak rate expectations by early November 2023. The 50 basis points fall in long rates has reduced tension on the equity risk premium and broad financial conditions. Of course, the shift in rate expectations has been modest (so far) because most investors believe in a “soft landing.” If the deterioration in growth, labour market conditions and profits is much deeper, the Fed will likely cut rates by 250-300 basis points next year. That would probably not be a favourable environment for risk asset prices (equities and credit). From our perch, the irony is that the odds of a harder landing have increased (not decreased) since June this year given the renewed tightening in financial conditions, lags in monetary policy transmission, reversal in the fiscal impulse and rundown in excess savings. There is also meaningful evidence of a slowdown in the US labour market.
In that context, the greatest challenge for the global risk proxy (the S&P500) next year is risk compensation relative to Treasury bond and bill yields. The earnings yield on the S&P500 is only 4.8% (at the time of writing) which is the lowest since 2005 relative to 10-year Treasury yields. Stated differently, markets are priced for a benign outlook on growth and require a meaningful earnings recovery in 2024 to warrant current valuations. As we have noted, the first 50 basis points fall in long rates reduces tension on the equity risk premium and eases broad financial conditions in a reflexive or self-reinforcing way. However, the first 50 basis points (or so) are like a drug addict’s first hit. It’s all thrills. The following 50-100 basis point drop in rates is likely to signal recession and the addict’s (stock market) descent into a long tunnel of pain. Historically, the “soft landing” or benign outcome has been the lowest probability outcome in 10 out of 12 cycles since 1957.
Risk compensation is also extremely narrow in the US high yield (junk bond) market given the lagged impact of policy tightening on macro conditions (cash flows) and the fact that many corporations had locked in or termed out debt at much lower rates. The tightening in lending standards evident in the bank senior loan officer survey also impacts credit conditions and the credit risk premium with a lag. The complacency in risk perceptions is also evident in equity and credit implied volatility compared to fixed income volatility (or the prior interest rate cycle).
As we have also noted throughout this year, the current episode is not a credit cycle like 2008, it is an asset valuation anomaly in private assets (private equity, venture capital, debt, and commercial real estate). While there has been an adjustment in some of the most over-levered or extreme liquidity beneficiaries, the mark-to-market on some private assets still appears heroic compared to the mark-to-market on public assets.
The good news in Asia is that both valuation and sentiment is already extremely pessimistic following a deep three-year bear market in the region. Pessimism is particularly evident in Chinese assets. To be fair, that has been warranted by the genuine episode in real estate, the anaemic cyclical recovery in growth and the absence of aggressive policy support. Of course, the relative valuation is now so extreme we are becoming optimistic on MSCI China relative to the United States and compared to India (within the region).
Tactically, the end of rate hikes in the United States and the (potential) transition to rate cuts suggests the odds are asymmetric (greater upside relative to downside in price) on high grade bonds and long duration Treasuries. The key variable in a disinflationary economy is that the Federal Reserve tightens by just maintaining rates on hold through a rise in real rates. In the very short term that could support the US dollar and put downward pressure on equities sensitive to the cycle (including emerging markets). Of course, if the labour market deteriorates rapidly thereafter, the probable rate cuts by the Fed will be much deeper. As we noted above, the initial move down in rates is welcomed by equities. In contrast, a much larger cut in rates would imply greater weakness in growth and profits.