The path to slower US growth, inflation, and rates is unlikely to be smooth, making this an environment that is likely to favor quality bonds and stocks, says the UBS Chief Investment Office. (UBS)

Initial jobless claims data rose to 231,000, ahead of the 220,000 consensus forecasts and reaching the highest levels since August. Other indicators like nonfarm payrolls and the unemployment rate also point to some gradual weakening in the jobs market. Industrial production fell by a greater-than-expected 0.6% last month as strikes hit autos production, while a confidence gauge from the National Association of Homebuilders fell for the fourth month in a row in November.


US equities seem to have responded more to expectations for potential Federal Reserve easing than worries that slower growth would dent corporate earnings. This month, the S&P 500 is up around 7.5% and the 10-year US Treasury yield is down more than 50 basis points to 4.4%. Market expectations are now for nearly 100 basis points of Fed easing by its December 2024 meeting.


But the path to slower US growth, inflation, and rates is unlikely to be smooth, making this an environment that is likely to favor quality bonds and stocks:


Quality bonds still offer appealing yields and potential capital gains. We think this is an opportune time to add to high-quality bonds—specifically high grade (government) and investment grade. Current yields of around 4.4% on 5-year US Treasuries should provide attractive returns over the next 6–12 months, given our forecast for the 5-year yield to stand at 3.25%by end-next December. We foresee positive total returns across a range of scenarios, especially if US growth slows more and Fed rates fall faster than markets currently expect.


We particularly favor the 5-year duration point. We believe this middle part of the yield curve offers an appealing combination of higher yields and greater stability than the longer end, as well as some sensitivity to falling interest rate expectations. We are somewhat more cautious on longer-term bonds due to their greater sensitivity to technical factors, including currently high Treasury supply.


Now may be time to seek exposure to quality stocks. We define high-quality equities as securities of companies with strong returns on invested capital, resilient operating margins, and relatively low debt on their balance sheets. These types of businesses should be best positioned to continue to generate profits in an environment of weaker growth.


A proxy for these stocks, the MSCI ACWI Quality Index has historically outperformed the MSCI ACWI by one percentage point over six-month periods in which growth has been slowing but staying positive (as measured by the Atlanta Fed GDPNow survey)—the environment we expect in 2024.


Quality stocks have also historically outperformed in the late stages of the business cycle, including in periods of economic contraction, which should offer portfolio protection if the economy slows more than we expect. The quality tilt also aligns with our preference for US technology companies, which should be among the key beneficiaries of AI-related demand for both hardware and software.


While quality stocks typically have higher valuations than the overall index, we think that quality is worth paying for in 2024. Investors can find quality stocks within US tech, as well as stable quality-income and high-quality cyclical stocks in Europe and in select names in Asia.


Structured solutions may help investors pivot to quality while mitigating market volatility. Investors with a more bearish reading of US growth indicators may be reluctant to consider high-quality stocks. For the year ahead, we see value in certain types of structured solutions that can take advantage of high interest rates and benign equity volatility to provide some preservation of capital in a market downturn and participation in the expected gains of high-quality stocks.


Investors should be aware that changes in interest rates, implied volatility, and dividend levels can influence the pricing of structured solutions. There are additional risks borne when using structured solutions or other options-based strategies, including that the issuer fails to meet its obligations or to repay an investor’s principal at maturity.


Main contributors: Solita Marcelli, Mark Haefele, Matthew Carter, Christopher Swann, Giovanni Staunovo, Jennifer Stahmer


What to do next: Read the full report More signs of US growth softening speak to buying quality, 17 November 2023 and then visit the Year Ahead 2024 website to learn more about CIO's outlook for the next year and decade.