Many feared recession in 2023. Instead, the U.S. economy growth rate actually accelerated — clocking in at 3.1% after posting a 0.7% growth rate in 2022. This stronger growth and continued labor market tightness have led investors to reset expectations for Fed policy. Markets now expect the first cut in May (we think June) and four rate cuts in all of 2024 (we think three). We believe less monetary easing; expected U.S. consumption moderation; and feeble Chinese/European recoveries will slow growth in 2024. We remain slightly underweight risk, seeing more value in high yield bonds than global equities.

Since the Fed’s last rate hike (July 26 of last year), U.S. economic activity has accelerated with real economic growth averaging 4.1% in the second half of 2023 (versus 2.2% in the first half). More recently, the labor market has also reaccelerated — adding 353k jobs in January on top of the 333k added in December (versus an average of 204k in the six months before that). Refreshed growth and strong labor markets have also refreshed worries over inflation — notably the core services ex-housing inflation (a current focus of the Fed), which remains elevated at 3.3% over a year ago. We expect U.S. real economic growth will downshift to a 1.5-1.8% range (just below potential) and anticipate labor market strength will slowly fade — both in terms of demand (as judged by the continued steady reduction in job openings) and supply (as recent immigration growth slows). The resulting consumption headwind joins the downward gravitational pull of struggling European/ Chinese economies and the slight drag from less helpful central bankers than previously expected.

Fed and other central bank rate cuts are still expected this year, but Fed Chair Jerome Powell took a March rate cut off the table and other Fed speakers have pushed back against the rate cut euphoria that gripped markets late last year. Core inflation continues its steady return to the Fed’s 2% target, with core prices 2.9% higher than a year ago (and only 1.9% higher over the last six months, annualized). But a major assist came from flat year-over-year goods prices; this can’t be counted on again, especially given escalating risks to global shipping. We continue to believe the Fed will tread cautiously — in a data-dependent manner — and still expect the first Fed rate cut in June and three total rate cuts for all of 2024.

High yield  remains our biggest tactical overweight — mostly funded through developed market equities. As the “least risky” risk asset, high yield can provide a lower risk — and less expensive (see chart) — way to participate in any further upside to the equity rally.

— Dan Phillips, CFA – Director, Asset Allocation Strategy

Exhibit 1:  HIGH YIELD REMAINS ATTRACTIVELY PRICED

Higher interest rates have put high yield into a new, more attractive range of valuations relative to equities.

Interest Rates

Market participants were focused on the conclusion of the Fed meeting on January 31, with most of the price action in fixed income markets spurred by the outcome of the meeting and Chair Powell’s press conference. Also released was the U.S. Treasury Department’s Quarterly Refunding Announcement (QRA) , which was in line with the market’s expectations and didn’t move markets much — a welcome relief given previous less-constructive releases.

The previous two QRA’s contained small changes relative to market expectations, and were at least part of the notable rise and subsequent fall of long-end U.S. Treasury yields in the second half of 2023. January’s announcement matched the increases announced in November — an additional $1–3 billion per month added to auction sizes across the yield curve. Importantly, the QRA affirmed previous guidance that this would be the last round of increases anticipated for the remainder of the year. For money market investors, the QRA also affirmed the outstanding stock of T-Bills would likely remain above the 20% top of the recommended range, but signaled net issuance of T-Bills is expected to decline by $100–150 billion in the second quarter. All said, the QRA has removed some uncertainty for fixed income markets.

EXHIBIT 2: Up and Down

The 10-year Treasury yield is decently off its 2023 peak.

• More certainty surrounding future Treasury issuance and confirmation of no more planned increases have helped remove some uncertainty for interest rates.  
 
• The 10-year Treasury yield had fallen ~120 basis points from its 2023 peak, but it has retraced ~25 bps of that year-to-date alongside solid economic data.   
 
• While we expect slightly less rate cuts than do markets, we see balanced risks to intermediate-term yields after the current rise. We maintain a neutral duration view.  

Credit Markets

The high yield market saw very strong performance to finish the year with high yield spreads tightening 73 basis points (bps) to end 2023 at 323 bps. Despite some back-up to start the year, high yield still sits at the tighter end of the spread range over the last two years. As spreads  have tightened, bond-level dispersion has increased. As seen in the nearby chart, high yield index dispersion currently sits at its highest level in over a year. Tighter spreads have also concealed decent volatility at the individual issue level – particularly in single-Bs and consumer non-cyclicals. The technology, transportation and finance sectors have also seen increased dispersion over the last few months.

From an asset allocation perspective, the current 7.8% yield looks attractive, especially as compared to equities. High yield remains our largest tactical overweight, offering a lower risk way to maintain risk asset exposure in an uncertain market environment. From a strategy perspective, high dispersion suggests more opportunity to add value through security selection (as opposed to systematic approaches at the sector or risk-factor level). These higher dispersion levels may provide opportunities for additional return in more fundamentally active high yield strategies.

EXHIBIT 3: credit dispersion

High yield index dispersion has risen to a one-year peak.

• Tighter average credit spreads across the high yield index mask rising dispersion underneath the surface.
 
• We think high yield’s ~8% yield makes for a compelling risk-return outlook vis-à-vis the ~6% global equity earnings yield.
 
• High yield is our largest tactical overweight as we enter a lower-growth and higher-cost-of-capital environment.

Equities

Year-to-date through February 9, global equities were up 2.5%. U.S. equities have led the major regions (+4.9%), with losses in non-U.S. developed (-0.9%) and emerging market equities (-2.5%, weighed down by a ~8% loss for China). U.S. stocks have enjoyed solid economic data and continued support from the “Mag Seven” (up ~12%). With only Nvidia left to report, fourth quarter earnings for the “Mag Seven” have exceeded expectations and boosted projections for overall Q4 S&P 500 earnings growth by roughly 8%. This has led to decent results in aggregate, including year-over-year earnings growth that’s firmly into positive territory (and several percent above expectations).

With 2023 earnings largely in the rearview, attention has mostly shifted to 2024 and beyond. In an average year, calendar year earnings expectations are revised down around 9% beginning a year prior to the estimate year. Per the chart on the right, downward revisions to 2024 U.S. earnings estimates have so far been lighter than this historical trend. In other words, consensus expectations for stronger earnings growth in 2024 (~12%) vs. 2023 (~1%) have shown resilience relative to average historical trends. This has helped U.S. equity returns, but we maintain a degree of caution given historically extended valuations.

EXHIBIT 4: holding the line

2024 earnings estimates have shown some resilience.

• In a typical year, earnings estimates trend around 9% lower beginning about a year before the estimate year. 
 
• Consensus expectations for 2024 earnings growth have been trimmed less than usual so far. Investors continue to expect an earnings acceleration.  
 
• We maintain a 1% underweight to U.S. equities given relatively extended valuations and remain 3% underweight developed ex-U.S. equities as well.

Real Assets

Global listed infrastructure (GLI) is trading at the bottom end of the sector’s historical earnings multiple range. One reason for this discount may be that long duration sub-sectors such as utilities and renewables re-rated lower in the rising interest rate environment of the trailing 12-month period. With the Fed tightening cycle coming to an end and stable-to-improving global infrastructure and utilities fundamentals, it may now be time to revisit the sector. 

Historically, GLI’s diversification, inflation protection and income generation properties make it a worthwhile asset for multi-asset portfolios and a good complement to global real estate. Infrastructure assets can have attractive investment characteristics, including revenue certainty, profitability and longevity. Further, infrastructure and utilities should benefit from capital expenditure growth as the sector addresses the power and electrification requirements of the green energy transition. We remain equal weight GLI for now, but the asset class looks increasingly attractive — especially should the economy shift into a lower gear. We also maintain our equal weights to global real estate and natural resources.

EXHIBIT 5: valuation TEMPTATION

GLI valuations are well below historical median levels.

• Global listed infrastructure (GLI) valuations are about one standard-deviation below their historical median.
 
• The end of the Fed tightening cycle and slowing global economic growth could provide a nice setup for GLI.
 
• While valuations are tempting, we remain tactically neutral GLI as economic activity has shown resilience.