Macro Monthly: Broadening out | 蜜豆视频 United Kingdom

Macro Monthly

Broadening out

We continue to see a high probability of a soft landing and expect a broadening out of equity market performance in early 2024.

Market Updates 07 Jan 2024 8 min read

Authors

Evan Brown Luke Kawa

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Highlights

A still healthy nominal growth environment is now being underpinned by an easing of financial conditions. This is supportive of cheaper, cyclical, and smaller companies.
We anticipate a rebound in the global goods cycle, which should support equites in Europe and EM ex China.
We think equities can perform without lower bond yields in 2024, consistent with a reduction in the recently high stock-bond correlation.

The core call from our 2024 outlook is that with a soft landing for the global economy well within reach, stocks should have more upside than bonds. We reject the view that positioning should turn more defensive because the expansion is getting longer in the tooth. On the contrary, the economy is supported by solid fundamentals and improving sentiment among households as well as businesses. And, in our view, the outlook for risk assets is bolstered by the nearly $6 trillion in money market funds, some of which may head in search of higher potential returns as central banks begin to lower cash rates.

Importantly, given resilient growth and the potential for a rebound in the goods sector, we believe breadth in the US equity market is poised to broaden beyond megacap tech into more cyclical sectors and indexes, such as midcaps. We also see room for Europe and emerging markets excluding China to perform well in the new year.

The case for broader US equity performance

The substantial slowdown in the US economy that most prognosticators have been expecting has not happened, and we see little evidence that a sharp weakening is at the doorstep. A simple story has been the most powerful for understanding US economic resilience: the return to positive real income growth has meant healthy consumer spending. Six-month annualized core inflation has slowed from a peak of 6.8% in March 2022 to 1.9%, below the Fed鈥檚 target. This provides not just support for real incomes, but has allowed the Fed to entertain rate cuts simply due to low inflation as opposed to slower growth. As such, positive real income dynamics are being reinforced by an improvement in financial conditions that should help support business investment and the housing market.

A soft landing means a 鈥榬efresh鈥� of the business cycle. This should allow room for more cyclical areas of the market, such as small to medium-sized companies to catch up with largest ones.

In our view, US mid-cap stocks offer attractive exposure to this enduring expansion. This segment of the market is more cyclical and tends to perform well during periods of solid activity and decelerating inflation. The performance relative to large caps largely lagged the听improvement in real growth that took place during 2023, suggesting there is attractive catch-up potential. Improving earnings breadth among large cap equities should be a positive leading indicator for the S&P Midcap 400, which is a much less concentrated index than the S&P 500.

Midcaps also trade at a lower valuation vs. their pre-pandemic 12-month forward price-to-earnings ratio, and at an even larger discount relative to large-cap US stocks. Historically, they have tended to trade at more expensive multiples than their bigger peers.听

Exhibit 1: Midcaps cheap vs. history and large caps

Source: 蜜豆视频 Asset Management, Bloomberg, Macrobond. As of January 2024.

Graph showing that S&P 400 midcap trading cheaper than S&P 500 and S&P 400

Manufacturing rebound

While we expect another year of US economic resilience, we are also optimistic on the prospect of a goods sector recovery that may help other more cyclically-oriented regions.

Commentary from corporate earnings calls suggest the worst of the drag from inventory destocking is behind us. In addition, the US ISM Manufacturing PMI has been below 50 (the level that divides expansion from contraction) for 14 consecutive months. This is the longest such streak since the bursting of the Technology-Media-Telecom bubble at the dawn of the new millennium. As real incomes and real spending continue to rise, we would expect this to catalyze a positive inflection for global factory activity.

The European economy, which is more levered to manufacturing, would be a key beneficiary. Sentiment indexes on the outlook for economic growth are turning up, which tends to be a leading indicator of higher earnings per share estimates for European corporates. The improvement in sentiment is being matched by some underlying components of manufacturing purchasing managers鈥� indexes. In particular, the difference between the new orders subcomponent and the inventories subcomponent has increased (Exhibit 3), which should bode well for future production. And like US midcaps, European stocks generally are inexpensive vs. history and US large caps.

Separately, leading indicators in EM ex China are pointing to an improving outlook for corporate earnings. Korean exports jumped to a 17-month high in December, amid rising demand for semiconductors and higher selling prices.

Exhibit 2:听Past the peak of inventory destocking

Mentions of "destocking" on quarterly conference calls in different sectors

Source: 蜜豆视频 Asset Management, Bloomberg. As of Q4 2023.

Graph shows number of mentions of "destocking" on quarterly conference calls in different sectors in Q4 2022, Q1 2023, Q2 2023, Q3 2023, Q4 2023 with materials being the highest.听

Asset allocation

As discussed in our 2024 outlook, we see solid nominal activity, bolstered further by the recent easing of financial conditions, as supportive for earnings and equities. This resilience in underlying economic growth suggests not as much central bank easing as the market is currently pricing is necessary for further equity gains.

Cross-asset performance over the last two years has been defined by highly positive stock-bond correlation. This high correlation is typical in an environment of high inflation and inflation volatility. Historically, when inflation starts to settle below 3%, as we believe it is now doing, the stock-bond correlation becomes much less positive. This reinforces our call that stocks can perform well without needing support from lower bond yields. Rather, yields can stay range-bound to higher, while economic optimism should be sufficient to support more equity breadth.

For much of last year, we maintained overweights to US large cap equities and Japan. We continue to maintain those positions, but have broadened our overweight to include midcaps, Europe and EM ex China as we believe investors are set to embrace a refreshed cycle.听

We retain a neutral view on Chinese equities. Geopolitical uncertainty and a still substantial economic drag from the property sector may limit how much both valuations and profits can improve. It is also unclear whether the nature of some of the stimulus 鈥� targeted towards strategically important industries 鈥� will translate efficiently into profit growth rather than creating excess capacity and low margins. Earnings revisions continue to be underwhelming relative to other regions.

Regional equities that serve as our underweights include Australia and Switzerland. These two markets tend to behave more defensively, and have historically underperformed during periods when leading indicators are rebounding after a contraction and moving into expansion territory.

Exhibit 3:听European leading indicators are turning up

Source: 蜜豆视频 Asset Management, Swedbank, ZEW, Sentix, Macrobond, Bloomberg. As of December 2023.

Exhibit 3 showing European leading indicators with Zew moving upward.听

Asset Class Views

The chart below shows the views of our Asset Allocation team on overall asset class attractiveness as of 1 January 2024. The colored squares on the left provide our overall signal for global equities, rates, and credit. The rest of the ratings pertain to the relative attractiveness of certain regions within the asset classes of equities, rates, credit and currencies. Because the Asset Class Views table does not include all asset classes, the net overall signal may be somewhat negative or positive.听

Asset Class	Asset Class	Overall / relative signal	Overall / relative signal	蜜豆视频 Asset Management's viewpoint	蜜豆视频 Asset Management's viewpoint
Asset Class	Global Equities	Overall / relative signal	Overweight	蜜豆视频 Asset Management's viewpoint	Profits growing, lower rate volatility should help support multiples.听
Asset Class	US	Overall / relative signal	Overweight	蜜豆视频 Asset Management's viewpoint	Room to advance as earnings grow and rate volatility calms; expect more broadening out beyond megacap tech.
Asset Class	Europe	Overall / relative signal	Overweight	蜜豆视频 Asset Management's viewpoint	Cheap valuations and leading indicators beginning to turn up.
Asset Class	Japan	Overall / relative signal	Overweight	蜜豆视频 Asset Management's viewpoint	Still inexpensive after recent gains, with solid earnings and ongoing corporate reform. Prefer to express in FX unhedged terms.
Asset Class	Emerging Markets	Overall / relative signal	Neutral	蜜豆视频 Asset Management's viewpoint	EM ex China to perform on better global manufacturing. Property sector and geopolitics still weigh on China.
Asset Class	听	Overall / relative signal	听	蜜豆视频 Asset Management's viewpoint	听
Asset Class	Global Government Bonds	Overall / relative signal	Neutral	蜜豆视频 Asset Management's viewpoint	Disinflation offset somewhat by decent growth. A lot of easing already priced in.
Asset Class	US Treasuries	Overall / relative signal	Neutral	蜜豆视频 Asset Management's viewpoint	Growth is slowing, but downward trend in inflation may stall as well. Expect volatility to calm. Still the best hedge for recession.
Asset Class	Bunds	Overall / relative signal	Neutral	蜜豆视频 Asset Management's viewpoint	鈥淢uddle through鈥� economy and slowing inflation lays foundation for easing cycle.听
Asset Class	Gilts	Overall / relative signal	Neutral	蜜豆视频 Asset Management's viewpoint	Bank of England policy rate path meaningfully lower amid more progress on inflation.听
Asset Class	听	Overall / relative signal	听	蜜豆视频 Asset Management's viewpoint	听
Asset Class	Global Credit	Overall / relative signal	Neutral	蜜豆视频 Asset Management's viewpoint	Attractive all-in yields amid decent growth and disinflation, but limited room for spread compression.
Asset Class	Investment Grade Credit	Overall / relative signal	Overweight	蜜豆视频 Asset Management's viewpoint	Spreads relatively narrow, so risk-reward confined to carry.听
Asset Class	High Yield Credit	Overall / relative signal	Neutral	蜜豆视频 Asset Management's viewpoint	Slight preference for IG versus HY. Moving up in quality in context of broader risk-on positioning.
Asset Class	EMD Hard Currency	Overall / relative signal	Neutral	蜜豆视频 Asset Management's viewpoint	Valuations and macro data have become less supportive relative to DM credit.
Asset Class	听	Overall / relative signal	听	蜜豆视频 Asset Management's viewpoint	听
Asset Class	FX	Overall / relative signal	-	蜜豆视频 Asset Management's viewpoint	-
Asset Class	USD	Overall / relative signal	Neutral	蜜豆视频 Asset Management's viewpoint	Strong carry and resilient growth limit scope for weakness vs G10 FX. Bearish against higher carry EMFX.
Asset Class	EUR	Overall / relative signal	Underweight	蜜豆视频 Asset Management's viewpoint	Core inflation slowing quickly, along with weak growth. Expect ECB to cut before Fed.
Asset Class	JPY	Overall / relative signal	Overweight	蜜豆视频 Asset Management's viewpoint	JPY is cheap vs. USD, and the BoJ is moving towards tightening. Safe haven JPY is a good hedge against recession.
Asset Class	EM FX	Overall / relative signal	Overweight	蜜豆视频 Asset Management's viewpoint	Soft landing is a good environment for carry. Prefer MXN and BRL.
Asset Class	听	Overall / relative signal	听	蜜豆视频 Asset Management's viewpoint	听
Asset Class	Commodities	Overall / relative signal	Neutral	蜜豆视频 Asset Management's viewpoint	Prefer oil to industrial metals given low geopolitical risk premia currently in price.