The Federal Reserve (Fed) decision to cut U.S. rates by 50 basis points and signal an ongoing cutting cycle marks an important shift in the economic landscape. From a single-minded focus on bringing down inflation, we now see a clear Fed emphasis on its dual mandate, and specifically on maintaining a strong labor market.
In our view, the post-pandemic cycle has been idiosyncratic, with inflation pressure building earlier in the cycle than is typical, and wage growth remaining contained despite full employment and wider price pressures. The fall in the cost of borrowing over the next two years will likely extend, and potentially normalize, the business cycle. That, in turn, supports a risk-on tone and a preference for overweights to credit and equity in our portfolios.
Corporate confidence, which is fragile despite strong cash flow and decent balance sheets, has scope to improve as rates fall. Consumer activity has moderated but remains robust even as unemployment has ticked up from its lows. Overall, we anticipate growth moderating to a trend-like pace of roughly 2% in the next two to three quarters, and inflation returning to target by mid-2025.
This apparently benign outcome does have risks. The strong pace of growth of the last 12 months, spurred by a jump in labor supply, was widely seen as unsustainable — prompting many investors to anticipate a more widespread slowing in the second half of 2024. But as cooling in labor data has materialized, so too have concerns that momentum will deteriorate sharply, leading to sub-trend growth or even recession. We disagree.
In our view, the imbalances and excesses that feed recessions — overleverage, excess confidence, capital misallocation, etc. — are largely absent in today’s U.S. economy. Simply put, the inflation burst that drove interest rates to restrictive levels occurred quite early in the cycle, and well before imbalances had time to build to dangerous levels. We acknowledge that a slower pace of growth and the modest cooling of the jobs market leaves the economy more vulnerable to exogenous shocks, even though the lack of imbalances mitigates the risk of endogenous shocks in the U.S.
Globally, the picture is more mixed. European activity remains sluggish, with few signs of a rebound in the goods cycle. Weakness in Chinese demand and high domestic real interest rates are dampening any rebound in activity and weigh on trade with the industrially geared, exporting economies in Europe and Asia. Consumers in these regions are insulated by high savings and low unemployment. But the upside case for a global economy, catalyzed by a recovery in the goods cycle, looks unlikely to materialize until further into 2025.
With topside growth risks muted, and the downside risks to the economy mollified by the Fed’s cutting cycle, we have growing confidence in our view of cycle extension and trend-like growth. While this environment is broadly supportive of risk, we expect returns to be more modest than they were over the last two years. An economy that is moderating to a trend-like pace will not likely spur unfettered animal spirits among investors. In addition, valuations in many assets are becoming a constraint, even as earnings and cash flows can be expected to grow in line with economic activity.
Still, this is no time to be calling a market top. Since 1970, the U.S. economy has experienced 41 non-recession years; S&P 500 total returns were negative in only five of those years. If history is any guide, when the economy is growing, stocks are likely to advance almost nine times out of 10.
The questions for asset allocators will be how to balance risk exposure across equity markets, credit markets and bond markets, and how to capture policy differentials across the global economy. In our view, equity exposure should remain focused primarily on the U.S.; despite rich valuations, credit is well supported by high all-in yields, and aggregate bond exposure close to neutral is appropriate, given the policy environment.
We remain overweight stocks, with a marked preference for U.S. equities. With economic growth moderating and margins at peak levels, we expect S&P 500 earnings growth to slow from 11% this year to 8% in 2025. And with valuations of roughly 21x forward earnings, we anticipate more pedestrian gains for the index over the next couple of quarters. Should the goods cycle come to life in 2025, as we expect, we see upside risks to this view. Moreover, we believe that corporate balance sheets and cash flows remain supportive, so we maintain an “add on weakness” mentality for equities.
Much is made of concentration in U.S. equities, but the mega-cap tech complex features distinct structural advantages, in our view. Widespread adoption of artificial intelligence is in its early stages, national self-interest creates a competitive moat for the tech sector, and free cash flow returns for the largest tech firms are compounding at around 25% a year. Thus, we believe that the sector remains an upside risk to our estimates of index level margins and earnings throughout 2025.
Internationally, we favor Japanese and emerging markets (EM) ex-China equities but take a skeptical view of European and Chinese equities. In Japan, despite recent volatility and a stronger yen, the earnings outlook for Japanese firms, together with improvements in corporate governance, point to further upside. EM ex-China equities have attractive tech exposure, improving earnings trends, and are supported by the Fed’s cutting cycle. By contrast, the exposure of eurozone equities to the soft industrial cycle probably caps returns. Chinese equities, although cheap in valuation terms, are likely held back by the disinflationary trends that are taking hold in the country.
Across all geographies, we see ample room for stock picking to add meaningful alpha. The shift in monetary policy will likely usher in investment and, in time, cyclical rotation that are best captured via our end managers. In our less-preferred regions, too, we look for exposure to high-quality companies, even though we want to minimize our index level exposure.
Optically, U.S. high yield (HY) credit spreads are relatively tight at ca. 300 basis points but we believe that they can tighten further as the cycle extends and defaults continue to trend lower. All-in yields of around 7% in U.S. HY are also compelling and strong demand in the primary market continues to underpin returns for the asset class. Credit investors’ biggest concern will always be the risk of slipping into recession. Since we do not currently see the ingredients for a recession, we believe that over the next two to three quarters, credit offers equity-like returns while sitting higher up the capital stack.
Bonds are caught in the middle of several market crosscurrents. The easing cycle and moderating growth support a duration overweight. So, too, does the fall in stock-bond correlation, which suggests bonds can play a renewed hedging role in portfolios. However, U.S. 10-year yields of 3.75% are not compelling with inflation still above target, and we see limited slack in the labor market. Should the cycle extend, as we expect, yields nearer 4% would appear appropriate. As a result, we are neutral on duration, but see opportunities to lean long in core Europe, where growth is more sluggish, and in the shorter end of the U.S. curve, where the impact of lower rates is most pronounced.
A different pace of policy easing across the major economies will have ripples in the FX market. While the dollar is rich by most metrics, we believe that the growth differentials continue to support the currency. Meanwhile, the euro could come under pressure from soft growth and a dovish European Central Bank, while the Bank of Japan’s policy tightening supports the yen. A neutral to mildly constructive tilt on USD, combined with a tactical short EUR/long JPY, is therefore our favored currency stance.
In sum, our conviction in a return to trend-like growth, and an extension of the cycle, is growing. We anticipate positive if moderate returns from risk assets as the Fed gradually eases policy, but expect to see any dips in risk assets bought quite quickly. Risks to the global economy continue to emanate from weakness in the goods cycle, but for now we believe that the consumer remains robust enough to support activity. Upside risks to our view may have been pushed out to 2025, but with the Fed in play we also believe that the economy, and markets, have solid foundations.
