Wed. Jul 17th, 2024

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Good morning. The S&P 500 is within a per cent or two of taking out the all-time high it set in late 2021. Most bond funds are likely to end the year with gains, too. Unhedged is, as a result, full of the holiday spirit. Let us know how you’re feeling: robert.armstrong.

Five questions for 2024

This time last year, Unhedged was in the grip of a bad forecasting error: we were firmly in the recession-in-’23 camp. What was the cause of our mistake? A lot of the trouble was down to two related problems. We were hypnotised by the inverted yield curve, historically the most reliable of recession indicators. And we were in the grips of an account of inflation as largely demand-driven; it is increasingly clear now that supply was more important. Whatever our reasons (excuses?), most of our speculations about 2023 turned out to be badly wrong. So we stagger towards 2024 with renewed humbleness.

Let us begin, therefore, with questions rather than answers. What follows is five of them that we think will be defining for markets in 2024. Some are generic questions that are important every year; others are more specific to the current moment. We are very keen to hear your answers to each, and what you would add to the list.

What will the mix of growth and policy be? This is the big, obvious one. The market seems to think its porridge will be just the right temperature next year: growth, though slower, will remain positive through the year, and there will be lots of interest rate cuts. The Bloomberg consensus for real GDP growth is 1.2 per cent, but the recent wild rally in risk assets suggests that investors are hoping for something a bit higher now that the Federal Reserve plans take its foot off the brakes. Meanwhile, the futures market says that the fed funds rate — now parked in the 5.25 per cent to 5.5 per cent range — will be below 4 per cent by the end of next year. That’s five or six rate cuts, assuming the bank goes 25 basis points at a time. 

Is the market too giddy? Regular readers will know we like to beak down questions like this by sticking them into a matrix:

If you believe we will land in box D — solid growth and oodles of rate cuts — then by all means heap on the risk. But given the history of inflation re-accelerating, and the Fed’s awareness of that history, it seems to us that D is the least likely outcome. If growth is trending around, say, 2 per cent despite firm policy, why would the Fed be in a rush to cut, and risk throwing away a hard-won victory over inflation?

Box A strikes us as relatively unlikely for symmetrical reasons: if growth falls much below 1 per cent, the labour market will probably be softening, and the Fed will feel at liberty to bring rates down. We like boxes B and C. 

Will the long end follow the short end down, and why? We can debate how much short rates will come down, but it seems pretty clear that they will fall. The long end has already taken a big step down — the 10-year Treasury yield has fallen by a percentage point, to a bit under 4 per cent — but the next move is anyone’s guess. If the long end continues to fall because long-term inflation expectations continue to decline towards pre-pandemic levels, it should be happy days for risk assets, particularly if the short end falls even more and de-inverts the curve, extinguishing one of the few risk indicators still flashing red. But obviously no one will applaud a bond rally that is triggered by a recession. A very tentative guess: fiscal concerns will put a floor under the 10-year yield that only a recession can crash through.

Will the Magnificent 7 continue to be the dominant source of returns in US stock markets? Anyone who runs a portfolio of stocks and aims to beat the index has to deal with this question. The answer depends in part on what you think the Magnificent 7 essentially is, as an asset class. A high-duration play? Non-cyclical, defensive growth? A momentum play? A bubble? But at Unhedged, we think the answer might not have much to do with the macro environment or which investment factors are in favour. The stocks have become expensive, and they have to keep beating earnings expectations to keep working.  

Can defensive companies make a comeback? The worst-performing sectors of the S&P 500 this year — other than energy, which has been hit by low oil prices — have been utilities, healthcare, and consumer staples. Part of this is down to a hangover from 2022, where the defensives outperformed a horrific market. Still, in a year where uncertainty was high, and at a moment where growth is slowing, the very weak showing by defensive stocks is remarkable (at least to us). One would expect this in the recovery phase of an economic cycle, but is that where we are?

Do investors move, en masse, out of cash? We at Unhedged never fall for the “money on the sidelines” fallacy. Money, properly speaking, never goes into or out of stocks or bonds: cash and securities are exchanged, but neither disappears (in the normal course of buying and selling). The amount of “money on the sidelines” never changes. But when investors attempt, collectively, to move away from cash, that drives asset prices up. And there is a lot of money in short-term instruments, earning 4 per cent or more. Assets in money market funds alone have gone from $5bn to $6bn since the end of 2022. If those move into risky and/or longer-duration assets, that will matter. An interesting piece in Bloomberg yesterday, written by Liz Capo McCormick and my former colleague Mike Mackenzie, suggested that the consensus move may be into slightly longer instruments such as two-year Treasuries, which locks in 4 per cent yields a bit longer. But will investors, attempting to rebalance away from cash, reach for more risk than that? They sure have been in the past six weeks or so.

Again, we are keen to hear what you think are the big questions for 2024. Send them along, along with the answers, if you happen to have them.

One good read

Should we pay Supreme Court justices more?

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