Great (rate) expectations

Future historians will debate the influence of social media or the progress in artificial intelligence, but financial historians will look back on 2022-23 as a period where expectations became reality and led markets on a rollercoaster ride. All the major recent movements in stock, bond and currency markets can be traced to changes, not in interest rates, but in expectations for interest rates.

The United States economy grew at roughly an average rate over both 2022 and 2023, but the stock market fell by 25% during 2022 on the fear of higher rates causing a recession, and then recovered in 2023 on the hope that the Federal Reserve (Fed) was ready to lower rates again. Meanwhile, bonds had their worst year on record in 2022, then two of their best months ever in late 2023. Lastly, expectations for US rates versus European rates drove the dollar versus the euro and pound.

We agree with the market’s view that US and European rates have peaked and that the Fed, the European Central Bank (ECB) and the Bank of England (BOE) will cut rates in 2024. However, we also believe that the market may be pricing in more US rate cuts than will actually happen this year. Given the danger of relaxing too soon and allowing inflation to persist, we believe the Fed may keep rates higher for longer than the market currently expects.

Will higher rates eventually cause recession?

This question has divided economists since the bear market of 2022. Some argue that the US has already experienced rolling recessions, with different parts of the economy contracting in turn. First, the housing sector slumped under higher borrowing costs, as did the manufacturing sector. However, with their COVID-19 savings and higher wages, US consumers kept on spending, and President Biden’s policies pumped more money into the system, preventing an overall slowdown.

Now in 2024, excess savings are almost spent, as is Biden’s fiscal agenda, and we see three potential paths for the US economy. Our base case is that higher rates and other uncertainties will eventually dampen activity enough to cause a mild recession. A more positive potential path is that employment and wages soften enough to keep inflation low but stay strong enough to allow the US to avoid recession. Towards the end of 2023, markets began to assume this ‘Goldilocks’ scenario.

The third path is the least likely, but the most worrying – that inflation persists or even rises again. This would leave the Fed unable to cut rates, and maybe even needing to raise them again, which would be more dangerous for the economy and would drag down both stocks and bonds. This is the scenario the Fed wants to avoid and why we believe they will be slow to cut rates.

The picture is clearer in the Eurozone. Here inflation is falling faster, the economy contracted in Q3 2023 and may already be in recession. So, we expect the ECB to be the first to cut rates in H1 2024, despite President Lagarde’s warnings. The UK situation is trickier. Although growth has flatlined rather than declined, inflation is still higher, especially in wages. Governor Bailey is wary of relaxing too soon, and the BOE may cut a little later than the market expects.

What if the market is wrong about rates?

If rate expectations are as powerful a force in 2024 as they were in 2022-23, and if we are right that the market is overestimating US rate cuts, then what will happen when the market realises this? From August through to October 2023, the stock market fell by 11% on the realisation that Fed chair Powell was serious about ‘higher for longer’.

A simple answer is that we’re long-term investors, and as long as inflation is beaten and rates eventually come down, we can handle some near-term volatility. Looking at previous 12-month periods post-Fed rate peaks, returns were typically strong (see Figure 3). Economic backgrounds were different then, and markets have already rallied since the Fed last hiked in July, but history does suggest that the return odds are stacked in favour of stocks and bonds once the Fed stops hiking.

However, the question remains – what is likely to happen if rate pricing is too optimistic? The 11% correction in the second half of 2023 involved uncertainties around both the ‘higher’ and the ‘longer’. Now the prospect of higher rates is remote and the debate is all about how much longer before rates are cut. This should mean less change in expectations this year compared to last year, and less indigestion for markets – in other words a smaller sell-off.

Why not wait in cash?

For some investors, being told there is a decent chance of a ‘small sell-off’ is enough reason to exit the market. However, the reality is that there is always a chance of a sell-off. We’re just thinking about it more now because there is an obvious macro risk in front of us. There is also a decent chance that rate cuts come as soon as expected, or sooner, and the Goldilocks rally continues.

The big difference now is that interest rates are at (in EUR) or close to (in GBP) their highest level this century, and investors are getting paid1 to wait on the side-lines. Ignoring the typical market returns post rate peaks, sitting in cash is not only psychologically safer but now offers a modest return too. Why not just wait for risky markets to drop and then buy in?

To test how realistic an investment strategy this would be, we looked at the US market from 1970 to 2023 and measured returns before, during and after every decline of 10% or more. The idea was to see how accurate we would have to be at timing the market for it to be worth trying. Over the 28 declines, we counted the frequency of success and the size of the gain or loss in returns.

Depending on your view or experiences, the results may not be surprising. We found that if your exit timing, and more importantly your re-entry, is accurate to within a month, then chances are (55-65%) that your timing strategy will be profitable. If you are accurate on both ends to within 2-3 months, then what you can expect to miss in the market would be similar to the current return on cash, and timing the market might seem worth trying.

It shouldn’t surprise readers to learn that we don’t believe we can time the market to within 1-3 months, and therefore we’re not inclined to follow such strategies. But it’s worth noting that even if our timing is less accurate than this, there were still circa 25% of times when exiting the market would have been the right move. What are the chances that 2024 is one of these episodes?

Will 2024 be a year to avoid?

The periods when exiting the market were clearly successful are perhaps the obvious ones – the oil shock and bear market in 1974, the 2000-2002 tech crash and the global financial crisis in 2008. Other marginal cases where imperfect timing was just about profitable were Black Monday in 1987, the China and energy slump of 2015, and the inflation-induced bear of 2022.

At the risk of sounding complacent, with inflation coming down and the financial system more tightly regulated, the set-up in 2024 does not resemble 1974, 2008 or 2022. If anything, the recent enthusiasm for the Magnificent Seven2 may remind some investors of the late 1990s. But while the dominance of such a small group is unusual, we note that these companies are mostly cash-rich and highly profitable. Of more concern is the recent resurgence in more speculative stocks.

To put market levels in perspective, we compare valuations with the 1990s bubble period. At over 20x forward earnings, the S&P 500 is expensive, although cheaper than it was in 2020-21. But we can see that this is led by the technology sector at 30x earnings, while the average US stock trades at roughly 18x. So the market is not cheap, but not as expensive as it looks on the surface, and nowhere near the levels of the late 1990s.

If the bear markets of 2000-02 and 2022 taught us anything, it’s that the more speculative an investment, the more it’s likely to get punished in a slowdown. While we don’t envisage another bear market in 2024, we are minded to avoid the more frothy end of the market, and anything that requires unusually strong earnings growth to justify its valuation.

Conclusion

From expectations to valuations to politics, there are plenty of reasons for investors to be cautious in 2024, and current cash rates are hard to ignore. As always, we advise clients to have enough liquidity set aside to meet their near-term capital needs. However, even at today’s rates, the odds of being able to profitably time out of markets are not attractive. Our preferred strategy for core capital remains to stick with a well-diversified portfolio and avoid unrealistically priced assets.

1Assuming that investors can access instruments that pay close to the central bank rate, such as money market funds or ultra short term government bonds.

2The Magnificent Seven are Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla