The end of last year saw the Federal Reserve (Fed) finally pivot towards an easier policy stance – signaling that rate cuts were in the cards for 2024 — a view that was reinforced at the March meeting. As it has become clear that policy rates have likely peaked for this cycle, risk assets have performed well, with equities moving to all-time-highs and credit spreads approaching their cycle tights.

We anticipate U.S. real GDP growth of around 2% for 2024 — a touch above trend and in line with the current pace. Inflation is set to cool gradually, with headline CPI reaching the low 2s by year- end. This should in turn prompt the Fed to deliver two or three rate cuts this year, likely starting at the June meeting. Globally, we expect activity in Europe to pick up from a low base, offsetting the slight drag from moderating U.S. growth.

This environment supports a pro-risk stance. In our multi-asset portfolios, we overweight credit and equity. Meanwhile we are neutral duration as bonds will likely trade in a range, but the promise of rate cuts probably caps the risk of bond yields moving sharply higher.

With interest rates set to decline this year we underweight cash, managing the negative carry of this position through targeted trades in credit and FX. Differences in policy timing and growth rates across the globe also create meaningful relative value opportunities, as well as greater potential to capture security selection alpha via our end managers. 

We acknowledge one key risk to this benign base case: inflation becomes “sticky” at current levels, or worse still, reaccelerates. This would give the Fed and other central banks reason to delay rate cuts, or in the very worst-case return to a more hawkish policy setting. While recent U.S. inflation prints surprised to the upside, we believe that the most important drivers of inflation, notably shelter, are trending lower. Nevertheless, we continue to closely watch labor markets for any signs of a pick-up in wage inflation which has, so far, remained muted.

As investors have repriced economic risk from looming recession to soft landing, the S&P 500 has rallied more than 1,000 points since October. While the business cycle probably has some way to run, the economy is not in early cycle. As a result, we expect more modest earnings growth and valuation expansion, but remain constructive on stocks over the intermediate term.

In the shorter run, it may be the case that technical momentum and excessive optimism over the pace of rate cuts could have pushed stocks a little too far, too fast. To be clear, we see ample room for positive earnings growth over the next year or two, but we also see signs that recent price momentum may fade. Thus, we slightly trim equity overweights, at the margin, with a view to using any consolidation to take risk up once again.

We continue to find attractive relative value and stock selection opportunities across equity markets and favor tilts toward high quality, cash compounding names. The recent broadening of market leadership away from the mega-cap technology sector is encouraging for both the long-run market trend and the potential for active alpha. On a regional basis we prefer the U.S. and Japan, but we also note an improved outlook for emerging markets (EM) ex-China. While Europe offers some attractive stock selection opportunities, the region screens less well than some others.

Credit spreads have tightened in line with the rally in equity markets. But while the technical factors that drive equity markets look stretched, some of the key technical factors for credit — notably investor appetite for new supply — remain supportive. If equity markets consolidate, credit spreads may widen a little; but new issues are attracting strong demand and requiring limited concessions to investors. This suggests that credit will probably hold up well in our core economic scenario.

Returns from credit at this stage are likely to come mostly from coupon carry rather than spread tightening. The source of return may seem pedestrian, but in a portfolio context, credit can play an important role. Allocators can use credit to manage negative carry positions such as our underweight to cash. Within the credit complex, we favor shorter dated U.S. high yield, non-agency mortgages, and securitized credit.

The potential for riskless rates to fall as policy rates decline lends further support for credit and leads us to play duration from the long side. Ahead of the first Fed cut we see the 10-year U.S. Treasury trading between 3.75% and 4.50%. That said, despite recent price action taking us to the top end of this range, we remain neutral on duration, as the carry penalty of 17 bps per year is offset by just a 25 bps rally in yields.  

We do not anticipate a sharp dip in U.S. yields, absent a significant weakening of growth. Instead, we see more opportunity in relative value positions in government bonds, alongside more actively trading the ranges. We prefer the U.S., core and peripheral eurozone, and Australia; Canada and Japan are our favored underweights.

Policy rates of 5.5% in USD and 4% in Europe continue to encourage some investors to consider simply sitting in cash. This is far from a riskless trade. True, holding cash does avoid some elements of market risk. But at the same time a cash position carries significant reinvestment risk. We believe that given good opportunities for both beta and alpha in all the main asset classes, cash becomes a default underweight — though it is critical to manage the associated negative carry.

As policy rates begin to fall around mid-year, we also anticipate that rates volatility will decline further. Volatility in other asset markets is already in line with average levels observed during economic expansions. While we could see short-lived spikes in volatility should stocks consolidate, we believe that cross-asset volatility will remain generally subdued this year.

Together with further declines in inflation, this volatility environment also suggests that cross-asset correlations could fall modestly. Although we do not foresee a reversion to negative stock-bond correlation, any dip in correlation will further strengthen diversification opportunities for asset allocators.

In sum, an environment of moderating growth and inflation, policy rate cuts and continued low volatility supports a risk-on stance. As any investor will attest, markets can overextend at times, and in the short term we may see some evidence of this pattern in stocks. Nevertheless, we maintain high conviction that we are in an environment that is broadly supportive for risk taking, and so continue to look for opportunities to add to positions on any consolidation.

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