Asset Allocation: Uncertain 3 Months, But Bullish Equities 2024

Market Implications: The swing towards 2024 economic recovery, plus a peak in the policy cycle, will likely power a rotation towards equity markets (Figure 1). Long-dated government bond yields will likely only see small positive returns as starting yields are partially offset by capital losses. Scope exists for 4700 on the S&P500 by end 2024, with some outperformance by UK/Japan equities but EZ equities performing in line with the U.S. In EM, we prefer China (cheap valuations/reasonable growth and a pro-growth policy from President Xi) and Brazil (rate cutting cycle and too much pessimism on fiscal policy currently discounted).These markets can outperform DM equity markets.

Figure 1: Asset Allocation for 19 Months to end-2024

Source: Continuum Economics. Note: Asset views in absolute total returns from levels on May 186 (e.g., 0 = -5 to +5%, +1 = 5-10%, +2 = 10% plus).

Growth, Inflation and Policy Prospects After the U.S. Debt Ceiling Drama 

Global asset allocation tactically over the next 3 months depends on the outcome of the U.S. debt ceiling negotiations to avoid a worst case shock to the world economy. We have recently highlighted that the central scenario is a negotiated deal (Figure 2) and that a temporary default is currently a 10% scenario (here). If Biden bypasses Congress then it can also avoid a default, but would be trickier for risk assets as uncertainty would exist over whether such a move was legal or sustainable. If a deal is reached then attention will switch to other issues.

Figure 2: U.S. Debt Ceiling Scenario Analysis for Financial Markets

Source: Continuum Economics

A 2^nd issue is the Ukraine war with the anticipation of a Ukraine offensive in eastern Ukraine in the coming weeks. This could see Ukraine regaining some territories and potentially paving the way towards ceasefire discussions later in the year. However, though we expect the Ukraine war to grind to a stalemate, the road from hopes of a ceasefire to a credible peace deal is a long one. Our view remains that sanctions on Russia will not be relaxed until a credible peace deal is seen and this is not our central scenario (Figure 3).

In terms of other shocks, we remain of the view that a China invasion of Taiwan over the next 5 years is a low probability, as Chinas military is not yet strong enough for a major seaborne invasion to succeed (here). President Xi is instead focused on sustaining China economic recovery for two key reasons. Firstly, a rebound in growth helps smooth the transition towards a more domestically focused economy that is resilient to external shocks. Secondly, reasonable economic growth helps to bring the total debt/GDP ratio lower and avoid China running into a debt trap in future years, which would undermine stability (here). We have recently downgraded the 2023 and 2024 growth outlooks to 5.5% and 4.9% (here), but regard this as reasonable.

Figure 3: Ukraine War Scenarios 

Source: Continuum Economics 

A final shock would be the BOJ abandoning QE with yield curve control. However, this would be too much of an interest rate shock to the Japanese economy, and BOJ governor Ueda is conservative in nature. We forecast that headline and core inflation rates should move lower in H2 and this should mean one final adjustment to a 0.75% 10yr JGB yield cap (here). This is a tactical rather than strategic issue for asset allocators. 

Instead, the big issue for asset allocation is economic/inflation and policy prospects. In the U.S. we have fine-tuned our growth view and now see a stagnant period of growth Q3/Q4 2023. The regional bank crisis contributes to this, but we do not foresee a broad credit crunch and hard landing (here). We have also lowered our CPI/PCE headline inflation forecasts in light of lower energy prices and fading food inflation, but we have revised the core PCE trajectory higher to 4.3% for 2023 and 2.8% for 2024 (versus the March Outlook forecasts of 3.8% and 2.7%) (Figure 4). The Fed can be confident that core inflation Yr/Yr will come down as monthly rises in shelter ease, given the lagged feedthrough of the slowing of the housing market (though this may not as larger as previous thought, with residential property holding up in 2023 ytd).

Figure 4: U.S. Headline and Core PCE inflation (%) 

Source: Continuum Economics forecasts 

The problem for the Fed is core PCE services ex shelter, where wage inflation is a large influence and the economic slowdown we are forecasting is not large enough to mean that the Fed can be confident that wage inflation will come down enough to be consistent with a 2% inflation target. We have highlighted our concern that getting from 3% core PCE inflation to 2% will be hard and may not be achieved in 2024. 

In some ways the Fed has acknowledged these concerns over hitting a 2% target with its forward guidance that Fed Funds will need to remain high in the remainder of 2023. We do feel that the slowdown in core PCE inflation and inflation developments generally will allow the Fed to start cutting rates in 2024, but we have penciled in only 75bps due to these lingering core inflation pressures (Figure 5).

Long-dated Government Bond Yields choppy but Then Back up 

Our end 2023 and end 2024 forecasts are unchanged (Figure 5) versus the March outlook and 2yr yield forecast is marginally higher reflecting the dilemma that the Fed faced on the core PCE inflation trajectory. Our big asset allocation story remains that economic recovery will kick in 2024. Out of a bottom of a U.S. recession/stagnation the normal trend is towards yield curve inversion swing to a flat then positive curve. We see this occurring through until end 2024, with 10yr yields rising to 4.00% by end 2023 and remaining elevated at 3.95% end 2024.

Figure 5: Fed Funds and Government Bond Yield Forecasts (%) 

Source: Continuum Economics forecasts 

This big picture swing in the yield curve is also our major call in the EZ (Figure 6).We see 2023 GDP growth at 0.1%, as the drop in imports is unlikely to be sustained (here) and this can hurt GDP alongside the lagged effects of ECB tightening (policy rates/TLTRO and QT) and less helpful credit conditions (here). 2024 growth will be slow as the effects of ECB tightening will still feedthrough and acts as a headwind to the early stage of recovery (Figure 7). Even so, the worst economic news will have passed, while we see the ECB cutting policy rates by 75bps in 2024, both to support the recovery and as headline and core inflation come back towards the ECB’s 2% inflation target. We remain of the view that labor market conditions are less overheated in EZ than the U.S. with a lower vacancy/unemployed ratio and a better labor supply response post COVID. This can help to bring wage inflation down, while weak growth squeezes profit margins (here) – while food inflation should also ease (here).

2yr German yields (Figure 6) are biased towards further ECB tightening, which we do not see being delivered (here) and as the ECB rotates towards 2024 easing we see 2yr yields coming down. In contrast, 10yr Bund yields will likely remain elevated. Even slow positive growth will be enough for the yield curve to become less inverted and swing to a positive yield curve during 2024.

The story is the same across DM government bond markets with the short-end being preferred and long end returns being only slightly positive as starting yield is partially offset by capital losses (Figure 1).

Figure 6: ECB Deposit Rate and Government Bond Yield Forecasts (%)

Source: Continuum Economics forecasts

Figure 7: Eurozone Forecasts (%)

Source: Continuum Economics forecasts

Equities 

What does this all mean for equities in an asset allocation framework? For the U.S. equity market valuations have run ahead too far relative to a stagnant 2023 earnings outlook and also versus 10yr real bond yields using breakeven inflation (Figure 8). Any modest shock would not really derail U.S. equities, but a major shock would leave U.S. equities vulnerable at the moment (e.g. temporary debt default that could push the S&P500 to 3500 initially Figure 2). The next three months are tricky for tactical asset allocation in equities, given the scale of the rebound from the October 2022 lows. 

However, institutional investors focused on a strategic view through until end 2024 and beyond should use any selloff on a non-critical issue as a medium-term opportunity. Though U.S. equities are overvalued, 2024 earnings prospects will increasingly become a focus in the market and 11% growth is currently projected for the S&P500 in 2024. The U.S. equity market also tends to rally hard out of the bottom of an economic slowdown. If our forecast of stagnation turns out to be a mild recession, it would be a tactical rather strategic issue for the medium-term bulls – only an unexpected moderate or large recession would derail 2024 equity market recovery prospects. We see scope for 2024 earnings growth to largely flow into a higher market rather than price/earnings multiple derating and we still forecast 4700 by end 2024 on the S&P500. The most important economic issue for the U.S. equity market is inflation rather than growth. Figure 8 provides illustration of a 2% and 3% core PCE inflation trajectory with differing 10yr real yield forecasts and our view is somewhere between these scenarios. If core inflation gets stuck at 3% it could cause a derating of valuations at some stage.

Figure 8: S&P500 12mth Fwd P/E Ratio and 10yr Real Government Bond Yield (inverted)

Source: Continuum Economics projections until end-2024 using 10yr U.S. breakeven inflation and Treasury yield forecasts 

EZ inflation has a better prospect of returning sustainably to 2% inflation than the U.S. and this is helpful for EZ equities. However, EZ equities are no longer cheap on equity only valuations, while 10yr Bund and other EZ yields will likely rise into 2024 as the era of ultra-low interest rates has passed and ECB QT causes a yield premium. Additionally, the Ukraine war will move to a stalemate rather than a credible peace deal. EZ gas prices will likely rotate higher to EUR50 (for TTF) later in the year on inventory restocking, as the big new exports from U.S. and Qatar only really change the global LNG market in 2025 (here). We see scope for around 10% gains in EZ equities until end 2024, which is similar to the U.S.

Within DM we prefer the UK equity market on valuations rerating and the BOE rotating to deliver 100bps of rate cuts to a 3.50% base rate by end 2024 (here). Additionally, the results of the BOJ policy review will likely suggest only a final adjustment to the 10yr yield cap to 0.75%, which should not adversely impact Japanese equities. Helped by the Asia and then global recovery stories, this points to 15% gains until end 2024.

Figure 9: China, India, Brazil and South Africa Equity-Real 10yr Government Bond Relatives (%)

Source: Continuum Economics. CAPE earnings yield-10yr real government bond yield (using CPI inflation). 

In EM equity markets the prospective returns are better than DM for the period to end 2024.China valuations are low relative to equity only valuations and also versus government bond yields (with no inflation pressures in China). The growth outlook is not perfect but is reasonable enough to deliver close to 15% corporate earnings growth in 2024 (here). The combination of a price/earnings multiple upgrade and corporate earnings growth can deliver 20% growth by end 2024.India can see 20% returns driven by the best earnings prospects of major markets, but the market is overvalued and the 2024 election will not be a smooth ride to victory for PM Modi. We still prefer China through end 2024 and then India on a 2-5 year view. 

Brazil is also likely to outperform DM markets. Inflation has come down enough to start the easing cycle in the autumn and this should stretch into 2025.Previous major easing cycles have been very friendly to Brazilian assets as bond yields come down. The market is also cheap on equity only valuations terms, as fund managers have been too bearish on fiscal policy and BCB independence (here). We see 20% upside by end 2024 for the Brazilian equity market. 

South Africa equities have performed reasonably YTD, but the economic and political turbulence cannot be overlooked, with rolling power cuts and the prospect of the ANC losing its majority in the 2024 election. We have recently revised down our GDP outlook for South Africa (here) and do not feel that the inflation picture will allow easing until 2024. The South African Rand and 10yr yields have shown an extra risk premium in the past month on fears that a reported arms shipment to Russia could see U.S. sanctions and cause an economic, currency and market crisis. So far the U.S. seems to want to keep South Africa on board and avoid Russia/China having too much influence. A lot of bad news is now discounted in the long-end of the bond market. However, the level of 10yr year yields is now high by recent standards and with gross government debt/GDP estimated to hit 72.3% of GDP in 2023, fiscal confidence could erode.