Thought of the day

Markets are becoming more cautious about the timing and speed of rate cuts in the US, Eurozone, and UK. The latest moves in interest rate expectations partly reflected more hawkish comments from central bankers, most recently from the European Central Bank. Bundesbank President Nagel said that it would be “a mistake to loosen our monetary policy stance too early,” and Irish central bank governor Makhlouf said that he “would not rule out today that we have to go up another rung.”

Business activity surveys have also been more positive than expected. The euro area composite Purchasing Managers’ Index reading for November rose to 47.1. While this still points to a contraction, it was better than the 46.8 expected by economists. UK survey data topped expectations by an even wider margin, with the composite index pointing to the first expansion in activity since July.

Partly as a result, investors scaled back expectations of an ECB rate cut by May from an intraday peak of 93% last week to 59% at the end of trading on Thursday. The chance of a rate cut by June from the Bank of England is down from 97% on 20 November to 36%. And the implied probability of easing from the Federal Reserve by May is down from a high of 94% last week to 56%.

The swings in market expectations for future interest rates are in line with our view that market sentiment over the timing and pace of rate cuts will continue to swing. But we believe a turning point for central bank policy is near. Against this backdrop we advise investors to:

Consider quality bonds, especially as an alternative to excessive cash holdings. Quality bonds offer high all-in yields that are unlikely to last. Attention has gradually shifted to the pace of rate cuts, making it a good time to lock in attractive rates, as both yields and the rates offered on bank deposits look likely to fall through 2024. Our forecast is for the yield on the 10-year US Treasury to decline to 3.5% by the end of 2024, from 4.48% at present, as inflation approaches the Fed’s 2% target amid slowing economic growth. Current yields should provide attractive returns, with positive returns possible even in the event of stronger growth than we currently expect and particularly in a downside scenario of a US recession.

We see value in the 1- to 10-year duration segment, and particularly 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.

Quality equities should also outperform in an environment of slowing growth and elevated valuations. The recent strong rebound in US stocks has left the S&P 500 less than 1% away from it high for 2023 and around 5% below the all-time peak struck at the start of 2022. With valuations above the 15-year average, we believe any further gains in stocks for 2024 will be driven largely by a rebound in earnings per share. As a result, we only expect relatively modest gains for 2024, with the S&P 500 ending the year around 4,700, compared to 4,556 at present.

Against a backdrop of slower growth, we believe quality stocks—from companies with strong returns on invested capital, resilient operating margins, and relatively low debt on their balance sheets—will be best positioned in 2024.

A broadly benign outlook makes it a good time to add to balanced portfolios. While we currently expect the best risk-adjusted opportunity in quality bonds, 2024 is shaping up to be a year in which cash, fixed income, equities, and alternatives will all offer positive returns. As a result, we consider it an opportune moment for investors to strengthen their core multi-asset portfolios. This diversification should also help smooth returns amid shifting opinions over the pace of rate cuts, continued geopolitical risks arising from the Israel-Hamas war, and concerns over the increasingly dysfunctional US budget process.

So, we advise investors to hold their nerve as the outlook for monetary policy continues to move. While recent data suggests that inflation is falling faster than expected, disappointments remain possible and central bankers are eager to stress their commitment to hitting their targets.