- The probability of a soft landing continues to rise.
- Government bond yields continue to signal a moderation in both growth and inflation next year and credit spreads do not suggest that material stress is building in the corporate sector.
- Our estimates for U.S. and global GDP growth, inflation and interest rates imply roughly mid-single-digit growth for S&P 500 earnings in 2024. If the bottom-up consensus estimate follows the typical pattern of modest negative revisions, it should be in line with our forecast by the end of 2024.
- We remain constructive on equities and duration and in U.S. credit, prefer shorter dated, higher quality opportunities.
Market volatility has been elevated in recent weeks as better-than-expected growth and inflation data releases have coincided with Federal Reserve (Fed) statements suggesting interest rates are likely to stay higher for longer. With investor views on economic outcomes for next year increasingly dispersed, we find ourselves asking, “What is priced in?”
Different asset markets are sending a similar message: A soft landing is in the cards. As a result, we see room for a modest decline in rates, tighter spreads and higher equity markets over the coming quarters.
Rates are pointing to a soft landing
Interest rate markets seem to be pricing in an economic outcome that is in line with our base case assumption of below-trend growth and decelerating inflation in 2024. Ten-year U.S. Treasury yields have fallen more than 50 basis points (bps) from their October high of nearly 5%, driven lower by declines in both real yields and inflation expectations. To us this reflects two distinct developments.
First, the Treasury market has priced in easier Fed policy in 2024: nearly 40bps of rate cuts are expected by the middle of 2024. Second, this decline in yields likely reflects a deceleration from Q3’s robust GDP growth environment, alongside market participants’ expectation for a more muted growth backdrop next year.
However, positioning data highlight that many tactical investors remain net short Treasuries, so if any economic releases were to contradict the prevailing narrative of slowing growth and disinflation, yields could rise in the near term.
Credit spreads are not signaling material stress
The U.S. credit markets seem priced for a similar outcome. Investment grade and high yield spreads both tightened in November to levels consistent with moderate GDP growth in the coming quarters. High yield option-adjusted spreads (OAS) suggest that recession risk remains low in the next 12 months and that defaults should remain muted even as growth slows. That would be in line with our current forecast for defaults, and consistent with high yield spreads widening only modestly from where they are currently (assuming average recovery rates).
Interestingly, while both areas of the U.S. credit market seem to be sending the same message, equities have rebounded from October’s low with a bit more gusto. The S&P 500 is up 10.5% since the October low, while high yield OAS have tightened by about 50bps, for a total return of about 4.5% over this period.
Equities’ outperformance vs. bonds was driven, in part, by a move lower in Treasury yields. But it may also reflect market participants’ different states of positioning at the low: Commodity trading advisors are and have been at maximum long credit positions for some time but have been buying equities over the past two weeks, seemingly giving these funds scope to continue doing so.
Finally, looking at global credit, the message from emerging market debt is quite different from the one being sent by developed market (DM) debt. High yield emerging market debt (EMD) spreads have tightened from October highs, and high yield U.S. and European debt markets have traced a similar trend.
But while yields in the investment grade OM debt space have reversed October's upward move, investment grade EMO has been range bound. That marked difference in price action may be a signal that growth in China could remain muted for the foreseeable future.
Looking for a modest adjustment in earnings estimates
Equity market pricing has quickly moved closer to our baseline view of a soft landing.
Equity markets have been on a tear during the past few weeks. However, this rally has merely reversed equities’ earlier decline in 2H 2023. Between the start of August and the end of October, the S&P 500 and the Russell 2000 fell by 10% and 18%, respectively, reflecting an increasingly pessimistic outlook for U.S. equities. A key driver of this pessimism was rising interest rates – rather than a significant deterioration in company fundamentals – which became evident during the 3Q23 earnings season.
In the third quarter, as in the first two quarters of this year, U.S. companies again showcased more resilient margins than the market expected. S&P 500 company earnings grew for the first time in four quarters (by 4%) and excluding the energy sector, margins expanded by 25bps year-over-year. Companies’ forward guidance, relative to analysts’ consensus forecasts, were also broadly in line with prior quarters.
However, statistical analysis has helped highlight that the typical stock price reaction to changes in interest rates was four times more negative this earnings season than during the past few years. As a result, the benefit to returns from better-than-expected earnings results in Q3 was more than offset investors’ overreaction to interest rates.
Interest rates have continued to be the primary equity mover in recent weeks. Since the end of October, the S&P 500 has climbed by 10% and the Russell 2000 by 9%, alongside a 50bps decline in the U.S. 10-year Treasury yield. However, despite the sharp equity rally, we believe that market pricing for both U.S. earnings and U.S. equity valuations are not overly optimistic, considering our baseline expectation of a soft landing.
Our estimates for U.S. and global GDP growth, inflation, and interest rates imply roughly mid-single digit growth for S&P 500 earnings per share (EPS) in 2024, which is in line with the top-down consensus. In addition, if the bottom-up consensus estimate follows its typical pattern of modest negative revisions, it would also be in line with our forecast by the end of 2024 (Exhibit 1).
While the headline S&P 500 forward P/E multiple is elevated relative to history (81st percentile since 2000), it is driven in large part by a handful of mega cap technology stocks. On an equal-weighted basis, the current S&P P/E multiple is only at its 53rd percentile, which appears much more reasonable given our macroeconomic outlook.
As we approach year-end, U.S. equities could see further upside from buybacks and favorable seasonality. However, since the recent rise in prices, U.S. equities’ near-term upside potential is now clearly lower than it was a few weeks ago and risks appear more balanced.
Asset class implications
Our positive view on duration was bolstered by the recent decline in interest rates. As we expect slower growth into the end of 2023 and throughout 2024, rates should trend lower, and we maintain a modest duration overweight in our multi-asset portfolios.
As positive stock-bond correlation has persisted, we also see some opportunity in equity markets, albeit less so than prior to the November rally. Significant equity gains would need to be driven not by the mega caps alone but the broader market as it prices in a soft landing scenario. In the near term, seasonal tailwinds should be supportive. Finally, given the wide dispersion of views on growth, we see value in high quality carry and believe that spreads may even tighten modestly from here, assuming the economy slows rather than stops in the months ahead.