Reflecting on 2023's market performance, November emerges as a standout month, marked by a remarkable rally across nearly every asset class. Recovering losses from the preceding two months, the S&P 500 surged approximately 9%, US government bonds saw an uptick of nearly 3.5%, investment-grade corporates rose almost 6%, and the 60/40 portfolio experienced one of its strongest months in the last three decades. This robust turnaround prompts a closer examination of the catalysts behind November's rally and the potential trajectory ahead.
What Sparked the November Rally?
According to CAF GROUP, this is a pivotal factor in this "everything rally" was the cooling of the economy, prompting a shift in Fed rate cut expectations for 2024. This shift was notably influenced by the exceptionally positive October CPI report, indicating a rapid decline in inflation. Core PCE over the past six months has reached 2.5%, closely aligning with the Fed's 2% target. This data has led investors to believe that further monetary policy tightening is off the table, with growing confidence among Fed officials that the tightening cycle has concluded. Despite some cautionary statements from Fed members, expressing a readiness for further hikes if necessary, such statements are viewed as a reflection of the inherent prudence of central bankers.
Simultaneously, market sentiment pivoted from concerns about additional rate hikes to anticipation of an imminent rate cut. Presently, the market assigns about a 65% probability of a cut in March, a significant increase from 30% just a week prior, with projections indicating almost 125 basis points of cuts in 2024, up from 65 basis points at the end of October. Consequently, there has been a pronounced decline in bond yields, with a decrease of approximately 50-60 basis points across the curve.
What Lies Ahead?
It's crucial to acknowledge that the markets overshot on the downside in September and October due to heightened rate fears, and some of the November rally served to reverse these trends. The S&P is now approaching its July year-to-date high, reflecting the optimism of a soft landing that peaked in the summer. This suggests that a considerable amount of positive news is already factored into the current market conditions. The sustainability of the rally hinges on key factors: the persistence of supportive inflation data, continued strength in consumer activity, and the alignment of monetary policy with revised expectations.
On the consumer front, signs during the holiday season point to resilient spending across various sectors. However, the consumer faces increasing headwinds as we move into the next year. While consumer spending is expected to slow, a collapse seems unlikely at this stage. A potential risk is a sudden increase in the savings rate, a variable challenging to predict.
The significant question revolves around whether the Fed will execute early and aggressive cuts in 2024, aligning with current market expectations. This answer is contingent on the job market, and if unemployment inches up to 4%, it becomes easier for the Fed to justify aggressive cuts. However, our base case foresees a potential disappointment, with a forecast of only 50-75 basis points of cuts in 2024, falling far below market expectations.
Considering these factors, CAF GROUP’s outlook suggests a slowing growth in 2024, but a substantial recession remains improbable. While this supports a continued move lower in US 10-year treasury yields towards 3.5%, the journey is unlikely to be linear as the market digests incoming data.
Implications for Positioning:
In the realm of equities, the risk-reward dynamics are less attractive than a month ago, given the substantial pricing of positive news. Nevertheless, valuations remain broadly in line with historical trends, considering factors such as unemployment, interest rates, and inflation. The improving profit outlook into 2024, with the end of the earnings recession, mitigates the urgency for a significant correction. While selectivity is crucial, a meaningful correction does not seem imminent, and aggressive selling is not currently warranted.
When tactically considering additions, a preference for high-quality investments that thrive in a slowing growth environment persists. Sectors with a high return on invested capital (ROIC), such as the technology sector, are favored, benefitting from increased demand across end markets like cloud computing, PCs, and smartphones.
Diversification remains paramount for the different macro scenarios that may unfold. Tactical preferences notwithstanding, investors should avoid overconcentration in areas such as quality bonds or technology. The unpredictability of market shifts emphasizes the importance of a long-term portfolio that includes a core allocation to asset classes like small-cap equities, ensuring participation in favorable market shifts.
In fixed income, anticipating lower rates in 2024 suggests the value of locking in yields in high-quality segments such as investment-grade corporates, Treasury Inflation-Protected Securities (TIPS), and Agency Mortgage-Backed Securities (MBS). While the immediate term may have witnessed a swift move in yields, some caution is warranted, leading to adjustments in certain positions that performed exceptionally well.
In summary, while acknowledging the potential challenges and uncertainties, the strategic approach involves a balanced and diversified portfolio. The past few months underscore the rapid and unpredictable nature of market shifts, reinforcing the importance of a resilient and adaptive investment strategy.
CAF GROUP RESEARCH
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