Tap Dancing on Thin Ice
Market performance in November and December reversed the more negative trend of prior months (and much of 2023) with market participants taking the view that the interest rate hiking cycle is over after US. Federal Reserve officials publicly adopted a more dovish stance, prioritized the avoidance of economic downturn and triggering a US recession. Although US officials anticipate a decline in inflation, they have been puzzled by the delayed reflection of this trend in official statistics.

Throughout December, investor confidence grew, buoyed by the notion that interest rates have peaked. The US 10-year yield started near 5% but has now fallen to 4.3%, marking the most significant month-over-month drop since December 2008. Despite this, the MOVE index, akin to the VIX (or Volatility) index for equities, remains elevated, indicating persistent uncertainty regarding rate direction. We believe interest rate and economic outlooks will continue to fluctuate until inflation stabilizes between 2-3%.
Assuming positive investor sentiment persists and the likelihood of a 'soft landing' for the US economy strengthens, we anticipate a convergence in the broader market's performance with the dominant tech names that have prevailed this year.

Notably, the S&P 500 Equal Weighted Index increased by just 3.8% YTD.  The rally was dominated by a narrow set of companies, coined the "Magnificent 7" (META, AAPL, NVDA, MSFT, AMZN, TSLA, GOOG), which presently comprise nearly 28% of the index.  These are some of the world’s greatest companies, driven further by AI speculation in 2023, ended up backstopping a market that really just treaded water most of the year.

Although Nasdaq and S&P 500 did rebound, the Russell 2000 that is made up of small and medium sized companies and seen as more reflective of the broader US economy has encountered an extended period of decline, with signs indicating that the recent surge in stock prices might be losing steam. 

Consumer sentiment persists in a pessimistic tone despite positive shifts in inflation and unemployment. Studies indicate that consumer sentiment is heavily influenced by metrics such as inflation and unemployment. However, there remains a notable disparity between economic indicators and public perception. Notably, such discrepancies have historically emerged DURING periods of recessions.  We remain cautious coming into the New Year with regard to a market weight position in equities, and are mindful of consensus estimates for the SP500 at 5100 putting current return expectations from fixed income assets nearly at par.

At home, Morgan Stanley has set a 12-month target of 7350 for the ASX200 index, projecting a rise of 3.5%, inclusive of potential dividends and franking credits. This optimistic outlook for capital growth coincides with expectations of an economic slowdown. Presently our market hinges significantly on two pivotal factors: inflation metrics and the forthcoming interest rate framework.

A robust Australian economy would yield a 2.25% GDP growth rate, with unemployment peaking at 4.25%—25 basis points below government projections. Under this scenario, interest rates would persist at elevated levels for an extended duration. The primary focus of the Reserve Bank of Australia (RBA) currently revolves around curbing inflation, which stood at 5.4% in the 3rd quarter and will make the RBA uncomfortable until they see inflation stability in the 2%-3% range.  Until we see that, we do not expect rate cuts.  We do note there are encouraging signs in the US suggesting a potential decline in inflation to below 3% could occur in 2024.

What we are looking out for in 2024

• Continued influence on markets from US Treasury Management of their balance sheet – the growing US Deficit, disappearance of the usual buyers of Treasury Bonds, and current market expectations of what the Treasury will raise versus the actuality of what they need to raise (in our view currently a difference of $0.3 Trillion) will undoubtedly influence markets during 2024. We expect longer term rates, particularly the 10-year bond rate to move back up towards 5% to reflect an appropriate term risk premium.
• Central Banks to cut short term rates – this has started in New Zealand and will, in our view, move to the US and eventually Australia as household liquidity reserves built up during Covid decline and pressures on housing supply, consumer sentiment and a rise in unemployment force Central Banks into reacting to a policy mistake of chasing an inflation bogey-man that was driven more by what we would term non-discretionary expenditure in the latter part of the inflation spike than discretionary. Exposure to securities that will benefit from cuts at the bottom end of the yield curve will benefit the most. We believe that this action must occur to revert the yield curve and return the banking sector (with this comment more relevant to the US than Australia) to a position of profitability.
• Confirmation of a (double dip) Earnings Recession – as a more reliable measure of activity than GDP or Gross Domestic Product, we expect to see that the economic measures of income declined. Herein lies the nuanced position between a soft landing (mild recession) and something more sinister. Cuts need to be sufficient to revert the yield curve, provide sufficient liquidity for market participants to refinance debt, particularly in stressed commercial property positions and free up debt capital for small to medium business to continue investment into capital equipment and the productivity boom that was evident in certain sectors post Covid. 
• A tale of two halves – we noted in our last update that we expected a rally into Christmas on rate sentiment. This has happened, but we do not expect it to last… however it could persist. Ultimately though, we expect the equity market to move relative to the pricing of 10-year rates in the bond market and our maths suggest that yields need to rise (and values fall). Only earnings reports from companies that blow market expectations out of the water would change this in our view. A US presidential election that is likely to add a material level of geo-political risk to the world is also likely to add volatility. Catalysts for more broad ownership of equities will emerge later in the year and likely be more broadly bought on a resolution of the US election. 
• Inflation – our view is that Central Banks start to change their rhetoric or move the goal posts – we have stated before that purely based on demographics and the structure of housing markets in Western Economies, that inflation will be higher this decade. This remains our view. 
• Industrial Relations and unemployment will be a factor - rising use of AI, increasing small business failures, rising union political influence will undoubtedly influence the next 12 months. Unemployment as an outcome is the second trigger for mortgage default rates and both owner occupied, and investor default rates (past 90 days due) are at highs related to 2007 (at the onset of the GFC). 
• Currency – predictions on currency are a mugs’ game, but it is something we get asked about a lot. Differentials in interest rate policy influence this as does the balance of what an economy produces. In recent years, the US Dollar, always a safe haven currency in times of volatility, has also become a petro-currency (as the world weans itself off carbon, the US has increased its production of oil and gas at a time that net importers such as China and Europe are forced to pay more and the markets for Russian natural gas have declined). Our premise for AUD investors, is that the Australian Dollar will appreciate against the USD modestly over the next 12 months largely pricing an interest rate cycle that will lead to cuts in short term rates in the US much earlier than Australia.
• A good read from the RBA – for those that want a deeper dive, we recommend reading this report from the RBA. It is an excellent synopsis of what our Central Bankers are concerned with domestically and abroad without being tarnished by an illiterate media or the politics of the day. Click here.