Global fragility and heightened uncertainty are likely to weigh on equities. In a potentially more volatile landscape, investors should adopt a selective stance in their equity allocations.
Against a backdrop of tightening monetary policy, stubborn inflation, and mixed economic data, equity markets fared better through much of 2023 than had been anticipated. However, a continuation of that advance might be more challenging to achieve in 2024.
Given the diminished equity risk premium and the high bond yields that have resulted from the gradual removal of liquidity, investors are under less pressure to reach for “riskier” returns that had until recently been considered necessary to meet portfolio objectives.
From a big picture perspective, the consumer will be less of a growth driver as excess savings and financial stimulus fade and households feel the strain of high interest rates. In the US, for example, auto and housing have held up well but the more acute pain is likely ahead — the symptoms are already there. US household interest payments as a percentage of interest income are the highest since 1959; credit card delinquency rates at small US banks are the highest since 1992; and personal savings are in decline. And this deterioration is occurring with an unemployment rate close to 50-year lows.
A more cautious and price-conscious consumer has implications for corporate earnings. Impacted sales revenue puts further pressure on equities as profit margins shrink. Discretionary goods and services that are aligned with more cyclical market segments appear at risk — we have recently seen substantial downward revisions to 2024 earnings growth estimates.
Companies with more resilient earnings streams and stronger balance sheets are better positioned to withstand the pressures of still-tight monetary policy, rising debt, and a deterioration of consumer spending. In short, we favor Quality stocks, namely those assets which display these compelling characteristics.
The Quality style allows participation in upside growth, while also offering downside protection. The general definition of Quality is consistency of earnings, elevated profitability, and low debt levels — all easily quantifiable metrics. But there are qualitative considerations too, such as the trustworthiness of the management team, company culture, brand strength, competitive moat, strength of a business model, and catalysts that may unlock value or disrupt an incumbent.
The US Large Cap segment contains an outsized portion of sectors and companies that exhibit Quality characteristics. In the US, many of the companies that exhibit Quality characteristics were heavily “re-priced” in 2022-2023 in response to aggressive interest rate hikes. Owning Quality in 2024 should come with a caveat though, given the potential for renewed market volatility: Be selective. To avoid the more severe drawdowns, investors should consider avoiding the cheap cyclical end of the market (for now at least), while also steering clear of those narrower pockets where valuations have become stretched.
By sector, information technology, industrials, and materials are major beneficiaries of recent US legislation that provides large fiscal incentives for clean technologies and new infrastructure investment (e.g. Inflation Reduction Act, Bipartisan Infrastructure Law, and CHIPS Act). International companies with US operations as well as US companies are also eligible for these incentives.
Monetary policy tightening has impacted the broader European economy quicker than in the US due to a comparatively less supportive fiscal backdrop. Even so, the European Central Bank (ECB) appears less likely to cut rates in 2024 in the same manner we expect from the Fed. The ECB’s apparent preference is to let current rates work through the system. However, the threat of recession is rising — something the European Commission’s latest forecasts acknowledged. It noted that “high and still increasing consumer prices for most goods and services are taking a heavier toll than expected.” The provision of bank credit has slowed and the Commission sees “continued weakness in industry and fading momentum in services.”1
Although the eurozone household savings rate is still relatively strong, deterioration is evident in other areas, including domestic fixed investment. As consumers adjust spending habits, company earnings will inevitably be impacted. While profit margins have been sustained at high levels, MSCI Europe margins have typically been correlated to inflation — lower margins have often followed a peak in inflation (see Figure 2).
The pick-up in Japanese inflation has given companies who have struggled to lift prices an opportunity to now do so, potentially boosting revenue and earnings. With the “shunto” negotiations in 2024 expected to deliver higher wages (a key factor for inflation), consumers may be encouraged to spend. Alongside government spending and export growth hopes, the case for Japanese equities has improved.
Another potential driver of growth is the Tokyo Stock Exchange’s call for companies to improve corporate governance and capital efficiency, or face delisting. This could help to create higher-quality, more profitable companies and help push the market towards more sustainable growth. The benefits from this campaign have been evident in increased share buyback announcements.
Higher risk appetite amid rising Japanese yields could also support inflows into the stock market, while corporations, which sit on a large amount of cash, could look to reinvest in growth opportunities in order to keep pace with inflation.
Emerging market equities tend to outperform in “best case” environments of stable-to-rising global growth and global trade, adequate or abundant global liquidity (stable-to-declining US/global yields and inflation, stable-to-declining US dollar), and stable commodity prices. A soft landing for the US and developed markets may erase “worst case” fears, though it will not guarantee the best-case scenario either.
China’s equity market is likely bottoming, setting up a potential near-term recovery. Meanwhile, policymakers seem to be taking time to create a stimulus plan that protects the economy without exacerbating structural problems. The longer-term growth outlook remains clouded by a heavy debt burden, limited fiscal policy space, property market overhang, worsening demographics, and heightened geopolitical tensions. Real GDP growth is expected to slow from near 5% in 2023 to 3% over the next few years.
Tight monetary policy and slower economic growth dampen the outlook for equities in 2024. Amid heightened volatility, we favor selectively owning aspects of the market that exhibit characteristics of Quality investing. The US market is preferred due to its sector composition and the competitive advantage of its companies. For various structural reasons, we believe Japan should maintain its momentum of positive performance into the new year. However, investors looking for outperformance from Europe, broad emerging markets, and China will face headwinds due to the cyclical nature of their economies and deteriorating economic conditions.