CIO Roundtable: Peering Through the Door to 2024

We're Clearly in the Hard Landing Camp

The U.S. economy has held up remarkably well, primarily because of the excessive savings from the COVID-19 stimulus. However, we're now seeing signs of a slowdown. The combination of higher interest rates, tighter financial conditions and higher oil prices are all weighing on consumer spending as well as company margins and credit fundamentals.

Elsewhere, Germany has already entered a recession and the rest of Europe appears ready to follow. Meanwhile, China seems headed to a potential prolonged downturn.

These signs and more suggest to us that the Fed has most likely ended its hiking cycle, although one more rate increase wouldn’t surprise us. When November comes around, we believe the data will show more signs of weakening, giving the Fed enough reasons to let the full effect of higher interest rates take hold.

Hear our chief investment officers’ thoughts on what they expect will move markets, asset classes and sectors. Read key takeaways from the replay below.

Taking a Barbell Approach in Fixed Income

Against this economic and monetary policy backdrop, we’re positive on fixed income, particularly higher-quality securities. We see plenty of opportunities across the yield curve, especially compared to a couple of years ago.

Since the beginning of the year, we've been discussing a barbell strategy. We believe pairing shorter-maturity securities with longer-maturity securities offers compelling income and total return opportunities.

The Fed's aggressive rate-hike campaign has pushed yields on shorter-maturity bonds and money market securities to multiyear highs. Capturing attractive income without taking on much risk with these securities is undeniably appealing.

Longer-maturity securities have been subject to elevated volatility, which is typical in risk-cycle turning points. But when the cycle turns, we believe longer-maturity securities (particularly those with 10-year maturities) should benefit. Once yields start declining, these securities may once again offer attractive total return potential and play a stabilizing role in portfolios against broad market volatility.

High-Yield Credit Spreads Seem Too Low

While recent yields on high-yield bonds and bank loans recently approached 10%, nearly half of the yield tracks Treasury yield levels. That leaves a high-yield spread of approximately 4 percentage points, well below the historical spread on high-yield bonds.

As we look out to the next couple of years, we anticipate rising defaults and rising credit losses as the economy enters a downturn. Therefore, a credit spread of roughly 4 percentage points doesn’t adequately compensate for the higher credit risk, in our view. That's why we're cautious about buying these securities.

Instead, we generally favor higher-quality bonds in this environment. For instance, many high-quality floating-rate securities are offering yields that surpass Treasuries with lower credit risk than high-yield bonds and bank loans.

2023 Equity Market Rhyming With 2021

The spread between value and growth is at a stage we have not seen in over two decades. The refrain “reversion to the mean” is reminiscent of 2021 with high beta materially outperforming low beta in a risk-on market. It suggests to us that another reversion back to high-quality value could occur in 2024 like it did in 2022. A change in interest rates could be the catalyst.

For most of the year, equity market gains primarily reflect a group of technology stocks riding the wave of interest in artificial intelligence (AI). However, we see plenty of opportunities outside the realm of AI—such as the long-overlooked utilities sector.

After being underweight utilities for many years, we've started to build back weights. Stocks in the sector have gone from being viewed as overvalued bond proxies to being valued in their own right for their yields, defensive characteristics and potential to be beneficiaries of the shift beyond traditional energy sources.

China No Longer Carrying Emerging Markets Growth

Inflation hasn’t proven as stubborn in most emerging economies, while deflation is a rising concern in China. Consequently, many central banks have room to begin easing monetary policy, potentially propelling emerging markets’ economic growth next year.

Some central banks that aggressively raised interest rates have already started cutting them. Others are sending the message that cuts are on the horizon. That means that by early 2024 or mid-2024, we could see interest rates in emerging markets declining significantly, which along with attractive valuations is very positive. However, all eyes are still fixed on the Fed—if U.S. rates stay at high levels, then rate cuts in emerging markets will take longer.

Aside from declining interest rates, there are developments across major economies poised to unfold. For example, consumers in India are spending a lot, and there are tremendous opportunities for investments in that country. In Brazil, interest rates are declining, and consumers are starting to spend again. And the Middle East is benefiting from government changes that are opening up tourism.

China has low interest rates, but the country is not growing as expected. The rebound in demand after the pandemic lockdown has not materialized as anticipated. That said, we are finding targeted areas of growth. For example, consumers are traveling and gambling, but they're not spending much on discretionary items. We’re also seeing opportunities where there’s government support, such as the electrical vehicle space.

Investing With a Recession in Mind

Our investment teams have been anticipating an economic slowdown and positioning our portfolios accordingly. Given our outlook for recession, we believe emphasizing higher-quality equity and fixed-income securities remains warranted.

Inflation may be receding, but we don’t expect it to fall to the Fed’s target level any time soon. Therefore, we’re not counting on a quick policy pivot, and we’re still emphasizing quality and extending duration in our bond portfolios.

Though the economy and the markets have been resilient in 2023, we urge our clients to proceed cautiously.