The Horizon

Over the course of 2023, we experienced many crosscurrents in the market and economic landscape. Although recession concerns have abated amid resilient economic data, growth is expected to moderate this year. We see the start of a transition from one economic and business cycle regime to another one that would involve more normal interaction between asset classes and more opportunities for investors. In this edition of The Horizon, we highlight the impacts of the next phase of this inflationary regime, our expectations for the Fixed Income market and our outlook for various Equity sectors as we enter the new year.

In “A Refresher for the Next Phase of Inflation”¹ from our weekly Capital Market Outlook report, we discuss the impact of inflation on the macroeconomic landscape and the potential opportunities that lie ahead for investors this year based on the new regime. Following the aftermath of pandemic-induced supply side disruptions, inflation levels continued to accelerate, hitting multidecade highs, suggesting that the increase in prices was not as transitory as initially expected. 

While inflation eventually eased from its peak once the Federal Reserve (Fed) embarked on an aggressive monetary policy tightening campaign in 2022, there appears to have been a structural upending of the previous environment of low inflation and low rates towards a regime of above-average price levels. The Fed has explicitly targeted 2% annual inflation growth since 2012 and updated their policy framework in 2020 to include average inflation targeting, where the goal is 2% inflation ‘over time’. As inflation has run significantly higher than their target the last few years, inflation would theoretically need to fall below target for a period to achieve that average. We maintain high conviction that the Fed is at or close to the end of the rate-hiking cycle, a view that is corroborated by a plethora of economic and market data, as well as comments from policy makers themselves. This would likely seal a structurally higher inflationary environment relative to the last decade. Typically, the macroeconomic backdrop improves after inflation peaks and begins to move lower as inflationary risks diminish and consumers may have capacity to spend. Looking at various asset classes on a two-year forward return basis from the inflationary peak, performance begins to shift with areas like Small-cap outperforming Large-cap and Value outperforming Growth. While U.S. Equities historically outperformed, International and Emerging Market Equities also progressed relatively well. Fixed Income has tended to perform better after inflation has peaked than when it is accelerating. As portfolio performance can be influenced by inflation outcomes, alongside other factors, the volatility and uncertainty of different inflationary regimes emphasize the need for diversification of assets.

The impact of higher interest rates has created a challenging environment for Fixed Income performance. However, as discussed above, it now seems the Fed is at the end of its cycle of hiking interest rates, with the market expecting five rate cuts later this year, helping to avert a recession with an economic ‘soft landing’. In light of this, we are favorable on Fixed Income in 2024. We provide an update on various sub-asset classes in our Fixed Income Spotlight report, “Cross-sector Year Ahead Outlook.”² While the Fed has done enough for now, there is still a significant amount of monetary policy tightening in the pipeline that is subject to an unknowable lag. Additionally, history suggests that high inflation periods typically involve multiple spikes. Taking this into consideration, our strategy is informed by both our economic and rate views, but not beholden to them. We remain slightly long duration, not excessively long. This balances our outlook that the end of the rate-hike cycle is here against the unexpected (but historically likely) outcome of another inflationary spike. Looking more closely at sub-asset classes in the space, we recommend maintaining a slight overweight to Mortgage-backed Securities (MBS). We see the easing of interest rate volatility and larger MBS spreads as bringing a beneficial entry point for the asset class as this would provide a level of cushion against an adverse economic or exogenous event not seen since the Great Financial Crisis (GFC). We remain slightly underweight both Investment-grade (IG) corporates and High Yield, as we are advocating for an up-in-quality lean. This view is mainly due to less attractive valuations on a spread basis, which are not yet discounting the risk of a recession in 2024 or 2025. When looking at credit risk premiums as a percentage of total yield, they are at the lowest levels since before the 2008/2009 GFC. Due to this, forward excess returns are skewed to the downside. We are more supportive of Treasurys and other high-quality Fixed Income solutions. We maintain a neutral weighting for the U.S. IG Tax-exempt sector based on expectations that technical and fundamental conditions will remain supportive. Ultimately, we believe the risk/reward balance is favorable for longer-term investors to have Fixed Income exposure heading into 2024.

In our year-end Equity Spotlight report “Naughty or Nice? Parsing Equity Sector Behavior & Outlook,”³ we examine a handful of sectors within the S&P 500 Index and explore why, going into 2024, we are more or less constructive towards them. On our ‘quite nice’ list, we emphasize Healthcare and Energy, two sectors we remain overweight in. With regard to Healthcare, we are bullish on the prospects for 2024 despite a modestly negative performance in 2023. One reason for this optimism is revisions to 2024 estimated earnings per share (EPS) expectations that transpired during the second half of 2023. Additionally, if we are moving towards the end of one economic cycle, historically the Healthcare sector tends to be more resilient and defensive in nature during this transition. Innovation remains an important aspect within the research and development phase, which is propelling funding and bringing in more investors. When considering Energy, elevated oil prices could drive higher-than-anticipated cash flows and earnings in the upcoming quarters. The current environment of solid but slowing energy demand, tight global supplies, OPEC+ supply cuts, limited spare capacity, risk of potential global disruptions and a decline in capital expenditures and long-cycle energy investments are all supportive for Energy names. Concerning other sectors, some, such as Communication Services, are ‘just nice enough’. In 2023, this was one of the best-performing sectors in the index, mainly because of its exposure to a few of the Magnificent 7 stocks. Internet companies have outperformed due to hype around generative artificial intelligence, while media firms remain caught up in the battle of the streaming wars as advertisers have had to expand to multiple platforms. Retailers continue to suffer from rising costs and slowing sales. Ultimately, we are more constructive on this sector due to three factors: valuation multiples were largely de-risked in 2022, earnings estimates were reduced and broad cost-reduction plans could generate possible earnings upside. While we continue to anticipate a choppy market environment given elevated headline risk, we believe the next few months will bring the beginning of a long rotation in Equities. This implies a more positive outlook in areas that have notably lagged, as mentioned above, and areas that are well placed for a substantive rally later this year.

Overall, we anticipate a soft landing for 2024, meaning economic growth will likely slow and the labor market weaken, but we do not see a deeper downturn unfolding. In light of this, we continue to advocate an appropriately balanced, diversified portfolio, with exposure to both Equities and Fixed Income, and suggest investors start the year fully invested, which we believe is more likely to lead to longer-term financial success.