Asset Allocation for 2024

We argued for lower 10yr U.S./EZ government bond yields; higher equities and lower USD for our end 2024 forecasts in the September Outlook (here). Are we still on track for this profile over the next 13 months?

Figure 1: Key Asset Market Forecasts for 13 months to End 2024 (%)

Source: Continuum Economics Note: Asset views in absolute total returns from levels on November 21 (e.g., 0 = -5 to +5%, +1 = 5-10%, +2 = 10% plus).

November has seen a countertrend to the surge in 10yr government bond yields seen in September and October, as the higher for longer narrative has given way to speculation about 2024 rate cuts in DM countries now that inflation forecasts are coming closer to target. Money market futures have pushed to fully discounting 75bps from the Fed, ECB and BOE by end 2024. The bias in the fixed income market is too push for more in the near-term, which could see a further temporary decline in 10yr government bond yields. However, caution is warranted in the next few months for a number of reasons.

1. Central banks need to be confident on 2% inflation prospects. Having been so badly wrong footed in 2022, DM central banks want to see headline inflation coming down but also be confident that the forward looking forecast is for inflation to get close to 2%. The Fed has not yet seen enough in the inflation figures to provide this confidence, especially as the economy has proved resilient in 2023 and we only see a slowdown to around 1.3% growth in 2024 (here). We feel that this means that the Fed will not be rushed into easing and will likely deliver the 1 cut in Q3 2024, with a total of 50bps coming in H2. The Fed will feel more comfortable to ease in 2025 by 100bps (Figure 2) – we recently highlighted this with our long-term forecasts 2025-28 (here). Over the winter, the Fed will likely lean against early rate cut speculation and this is already restraining 2yr yields and will likely mean that 10yr U.S. government bond yields will find it difficult to sustainably decline (Figure 2).
2. U.S. yield curve disinversion. Fed rate cuts will likely led to 10yr U.S. Treasury declines by end 2024 and end 2025 (Figure 2), but the traditional yield curve disinversion will be at play and will eventually produce a positive shaped yield curve (here). Additionally, supply pressures will remain in the U.S. market with the large budget deficit and Fed QT likely to be sustained through Q3 2024 at the current pace, but could then go to a slower pace as bank liquidity tightens. End 2024 yield view will also be influenced by the prospect of a debt ceiling drama in early 2025, with a genuine risk that a number of rating agencies could downgrade the U.S. in 2025.Total return for 10yr U.S. Treasuries will likely be around 7% through end 2024 (Figure 1).

Figure 2: 2024 and 2025 Forecasts for Fed Funds, 2yr and 10yr Bund Yields (%)

Source: Continuum Economics

• Overvalued U.S. Equity market. 12mth forward price/earnings ratio in itself and versus nominal and 10yr real bond yields (Figure 3) suggests that the U.S. equity market remains overvalued.Since we feel that 10yr yields will now only sustainably come down slowly, the bullish equity trade will likely be premature. The winter could see a frustrating time in U.S. equities, both as 2024 corporate earnings prospects are trimmed and the Fed try to temper rate cut talk. A correction lower to 4350 is feasible, before a H2 rally to 4800 on the S&P500 by end 2024. For end 2025, we forecast 5300 helped by more noticeable Fed rate cuts and a continued economic expansion.

Figure 3: S&P500 12mth Forward P/E Ratio and U.S. 10yr Real Bond Yield (%)

Source: Datastream/Continuum Economics (using 10yr breakeven inflation for real bond yields)

Should asset allocators look for better returns elsewhere? We see the USD declining against DM currencies through 2024, but the process will likely be slow against most currencies. We are looking for the ECB and BOE to cut in Q2 2024, as both economies suffer a recession and central banks macro forecasts are trimmed and allow 75bps cuts in interest rates to be delivered in 2024. Though ECB communications appear a long way from such a profile, it is worth remembering that the ECB has been prone to U turns in the past (Figure 4). The more pragmatic BOE (Figure 5) can communicate better than the ECB, but will want to see CPI headline and wage inflation coming down over the next 3-5 months before preparing the way for the 1 rate cut. The BOE should also provide more visibility than the ECB through its inflation forecasting process using market rates, which can endorse or temper rate cut expectations. In FX terms, we forecast 1.15 on EUR/USD by end 2024.

Figure 4: Previous ECB Easing Cycles (%)

Source: Continuum Economics

Figure 5: Previous BOE Easing Cycles (%)

Source: Continuum Economics

10yr EZ and UK government bond yields already reflect the expectations that their central banks could move ahead of the Fed, with 10-2yr yield curves inverted and real 10yr bond yields using inflation expectations lower than the U.S. Thus the next couple of months could see consolidation in 10yr EZ and UK yields, though 2yr yields will fall sustainably through 2024 (we forecast 2.35% and 3.7% 2yr Bund and Gilt yield for end 2024).

EZ equities are undervalued on a 12mth fwd P/E ratio basis and more comfortable than the U.S. versus nominal and real yields, as we covered in a recent article (here). This could mean marginal outperformance versus the U.S. circa 10% versus 6% for the S&P500.However, the economic recovery in the EZ will likely be shallow and this will be a headwind. Also the outcome of the November 2024 U.S. presidential election is a swing factor. If Donald Trump is re-elected and seriously threatens to withdraw the U.S. from NATO, then European security could face an existential crisis that casts a shadow over EZ equities. EZ equities could outperform in H1 and then run out of steam.

Japanese markets are dominated by the BOJ policy stance. We feel that the BOJ will likely effectively abandon yield curve control (here) once it lifts the BOJ policy rate from -0.1% to zero in the spring. This will likely see 10yr JGB yields sustainably rising above 1% and we see 1.6% by end 2024. This is enough to mean a headwind for Japanese equities, while we also feel that the narrative of sustainably higher nominal GDP is overdone. We see Japanese equities merely rising in line with U.S. equities by end 2024. The big story will likely be the further unwinding of extreme JPY weakness, both on Fed easing and the adjustment in BOJ policy and Japanese yields. We see 125 on USD/JPY by end 2024, which is also a headwind to our Japanese equity view.

In terms of EM, a general shift lower in the USD tends to be helpful to EM equity performance and we see the major EM equity markets outperforming the U.S. through end 2024 (Figure 1). India remains the favourite EM equity market for multi-year portfolios and we see 10-15% gains by end 2024 driven by PM Modi re-election (here) and earnings momentum, but restrained by overvaluation. We see 15-20% upside for Brazil equities by end 2024 and we forecast the Brazilian central bank cutting the SELIC rate by a further 300bps to 9.25% by end 2024 (here). The fiscal situation is also coming under control, which should allow a sustainable decline in 10yr bond yields and uprating of the price/earnings ratio.

China is clearly undervalued on equity only measures and against 10yr government bonds (Figure 6).We see a 10% rally for China equities by end 2024 and mild outperformance versus the U.S., as pessimism will get less intense at some stage. Nevertheless, this is a tactical play rather than a strategic asset allocation decision. China is not addressing the negative drag from the residential property decline sufficiently. Along with population aging, we look for 4% growth in 2024 and 3% by 2027 (here).Secondly, Taiwan uncertainty continues to cause a discount for China equities valuations for global investors. With the opposition parties this weekend having failed to agree on one candidate, the opinion polls suggest that the DPP will win the presidential election race in January 2024. Though we do not see this leading to an invasion or blockade of Taiwan in the next 5 years (here), we do see this leading to an increase in grey warfare post-election that will keep tension high and restrain global investors from getting too upbeat on Chinese equities.

Figure 6: China Earnings-Bond Yield Relative Cheap Compared to Other Big EM's (%)

Source: Continuum Economics.CAPE Earnings Yield-10yr Real government bond yield