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Yields can fall further as Fed pencils in three cuts in 2024.
US government bonds rallied further after the Federal Reserve laid the groundwork for rate cuts in 2024. While the central bank left rates on hold as expected, its latest economic projections pointed to 75 basis points of easing in 2024, up from the 50 basis points going into the meeting. Chair Jerome Powell also struck a dovish tone, stating that the Fed had even started “preliminary” discussions about easing at this month’s meeting.

The outcome contributed to a roughly 20-basis-point fall in the 10-year US Treasury yield on the day of the meeting. The yield subsequently fell below 4% for the first time since August, leaving it down close to 110 basis points since a 16-year high of 5% in late October. As of 18 December, the yield was 3.91%.

We don’t expect the pace of the rally to be sustained. Market expectations for rate cuts continue to run ahead of the Fed’s own projections, with fed funds futures pricing around 145 basis points of easing next year and a roughly 75% chance of a cut as early as the March meeting, as of 15 December. Our view is more in line with the Fed’s, and our base case is for 75 basis points. This gap raises the risk of disappointment among investors.

But while the bond rally could be bumpier going forward, we do expect it to continue as inflation declines and growth slows. The Fed’s latest projection is for GDP growth to decelerate to 1.4% next year, down from 2.6% in 2023, while core inflation drops to 2.4% in 2024-close to the central bank’s target.

Takeaway: The backdrop of slowing growth and rate cuts is favorable for quality bonds, which remain our most preferred asset class. We expect the yield on 10-year Treasuries to fall further, ending 2024 around 3.5%.

Quality stocks look set to outperform.
Stocks also got a boost from the Fed meeting, with the S&P 500 climbing to its highest level in two years. The index has now advanced for seven consecutive weeks, the longest winning streak since 2017. As of the close on 15 December, the index had gained 22.9% year-to-date, putting it less than 2% from the all-time high struck at the start of 2022. On a total return basis, the index is already at a new record high.

In our view, the policy and macroeconomic backdrop is supportive for stocks. Data continue to point to a soft landing for the US in 2024, with growth slowing sufficiently to justify Fed rate cuts, while avoiding a recession. We also expect markets to be underpinned by a roughly 9% rise in earnings per share for S&P 500 companies in 2024.

However, after such a strong rally, we now expect further upside in the broader index to be modest. US stocks are trading at a roughly 16% premium to the 15-year average 12-month forward price-to-earnings ratio, based on the MSCI index, leaving little room for further multiple expansion. The MSCI All Country World Index was trading at a 9% premium, as of 15 December.

As a result, we advise investors to focus on parts of the market that can outperform in periods of tepid economic growth, including quality stocks -issued by companies with strong returns on invested capital, resilient operating margins, and relatively low debt on their balance sheets. A proxy for these stocks, the MSCI ACWI Quality Index, has historically outperformed the MSCI ACWI by 1 percentage point over six-month periods in which growth has been slowing but staying positive.

Takeaway: While the macroeconomic and policy backdrop supports the recent stock rally, we think a lot of positive news is now priced in at the index level. We continue to favor quality stocks going into 2024. We are also most preferred on small-cap US stocks, which have lagged over the past two years and should benefit as floating rate debt becomes cheaper.

UN climate deal should speed the move away from fossil fuels.
For the first time, government leaders at the COP28 summit on climate change called for a transition away from fossil fuels to meet net-zero emissions by 2050. Expectations for a meaningful deal were low after disputes over whether to press for a “phase out” of fossil fuels, with this bolder language being removed. Instead, the almost 200 nations involved agreed to begin “transitioning away from fossil fuels in energy systems, in a just, orderly, and equitable manner.”

The impact of the deal will largely depend on its implementation and funding by individual nations and private industry. But overall, the fact that all nations eventually accepted a commitment to shift away from fossil fuels marks a turning point for emission and climate policy, in our view. The endorsement of the target to triple global renewable energy capacity from 2022 to 2030 should drive meaningful progress in decarbonizing power and should help restore market confidence in the renewable energy sector. The pledge implies a fivefold increase in annual capacity additions, according to the Centre for Research on Energy and Clean Air.

COP28 was also notable for a sharp increase in climate funding, from the UAE-led USD 30bn climate initiative to the US contribution of USD 3bn toward the Green Climate Fund targeting developing market emission reductions and climate adaptation.

Takeaway: Creating an economy free of carbon emissions and transitioning to clean fuels is a complex undertaking, requiring investments across power generation, energy infrastructure, transport, industry, buildings, along with heating and cooling systems. We think investors will gain most through exposure to a number of these themes, given the different stages of development across countries and sectors.


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