By Thomas O. Herrick
Chief Market Strategist, Managing Director
- Constructive on stocks. Incorporate a balanced growth and value allocation.
- Epic disinflation trend remains in place.
- Time for Small Cap equity exposure.
- Lean into Treasury bond duration.
- Opportunity in Agency Mortgage-Backed Securities.
- Derivatives-based Hedged Equity solutions limit drawdown with the ability to create income.
Much as in 2023, we are constructive in our outlook for stocks and bonds in 2024. 2023 to date has seen the S&P 500 Index gain 20.52%, albeit with intermittent narrowness, as much of the increase can be attributed to heavyweight technology companies. The Bloomberg US Aggregate Bond index has also posted gains this year, picking up 0.46%. Bonds fought against spiking yields through September and October but have rallied significantly in the last thirty days.
In the near term, yield levels remain the key macro input to risk assets. The 10-year Treasury benchmark long-duration yield poses a lot of competition to equities at levels approaching 5%, which we endured in the early fall. Higher yields have reflected “higher for longer” Fed rhetoric, stronger than anticipated GDP growth, and supply/demand concerns. The dynamic has shifted considerably with the 10-year yield currently 4.47%.
Our viewpoint is that yields have reversed their long secular post-Global Financial Crisis downtrend but are overstretched at levels beyond a 4% 10-year. Steep moves higher, such as we saw recently, exhaust themselves and are unsustainable. Consequently, we see yields lower over the next nine or so months. That yield outlook is supported by dis-inflation. Lower inflation leads to lower yields, which leads to improved risk asset prices. Within long-term trends, such as the new yield uptrend, counter moves and consolidations occur, which can last months or years. During yield uptrends, stock and bond performance is highly correlated, emphasizing the importance of additional portfolio diversification.
Source: Fairlead Strategies
Federal Reserve monetary policy remains the all-important economic factor for markets. The Fed has maintained its Fed funds rate increase campaign up to this point. At the same time, we have experienced an epic disinflation trend over the last 12 months. The reversal in money supply growth drives that trend. Money supply growth provides an effective lead indicator of a large increase and decrease in the CPI and PCE. Money supply (M2) increased dramatically during the pandemic but, over the last 12 months, has been consistently negative for the first time since data collection began in 1959. The typical rate of M2 growth is about 6%. Operating with about a 12-month lag, this supports a continuation of the disinflation trend. Further supporting lower inflation is the declining shelter component data still within the incremental, slow-moving CPI pipeline. Shelter is the largest component of CPI and has accounted for more than 70% of monthly gains in the overall index for six months. This component is easing, but there is a lot more ease to come as historic amounts of new apartment supply hit the market over the next six months. Continuing the disinflation trend allows the Fed room to halt its rate rise campaign, which is now widely expected, and opens the potential for rate cuts in 2024. While rate cuts are premature, lower inflation, while the Fed stays on hold, is de facto tightening. Consequently, Fed funds must go marginally lower just to maintain the current dynamic.
Source: FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/graph/?g=13lDl
Portfolio Positioning Recommendations
- Within equities, maintain a balanced approach to allocation between growth and value. Maintaining exposure to growth was one of our best recommendations for 2023, and we repeat it here. Long-duration growth stocks are typically potent performers around yield decline.
- Equity performance has been quite narrow in 2023. We are seeing early signs of breadth expansion, which is key for sustainable uptrends in the major averages. Within equities, small caps have been out of favor for an extended period. This dispersion in performance is unsustainable long-term going forward. Within the context of a diversified portfolio, ensure ample small-cap exposure. Our regression analysis of small versus large company stocks leads to a conclusion that small caps may outperform large caps by twice as much over a period of years. Smaller company stocks are also typically outsized beneficiaries of lower yields.
Source: Source: BofA US Equity & Quant Strategy, FactSet
- Within fixed income, we continue to recommend a focus on Treasuries, leaning into duration when the 10-year is over 4%. We are at the end of the rate hike cycle; this is the time to lengthen duration. The “T-bill and chill” crowd that has piled into ultra-short maturities will deal with a ton of re-investment risk going forward. Our viewpoint of an overstretched 10-year yield and lower CPI prints supports this recommendation.
- Additionally, within fixed income, we also recommend exposure to agency mortgage-backed bonds. For a long time, US mortgage-backed paper was not attractive. In a low-yield world, it was among the lowest-yielding paper. Now, the sector, which comes with implicit government backing, reflects very large spreads to risk-free rates. Pre-payment risk, normally a large consideration in mortgage-backed bonds, is minimal as the bulk of mortgage holders are locked in at sub-4% rates. This group is very unlikely to give up those generationally low rates. Moreover, if they pre-pay in the current environment, borrowers will be pre-paying at par while most of these loans are trading at discounts.
- Finally, we repeat our long-held recommendation that investors seeking equity participation with less risk diversify into hedging strategies. Derivatives-based hedging strategies turned in another good year in 2023, capturing the bulk of equity market upside while maintaining a constant downside hedge in the event of market declines. The CSP Global Hedged Equity strategy is up 11.40% this year and has captured 102% of the equity market, defined as the MSCI ACWI Index, return over the last three years2. Hedging strategies can also be useful in meeting investor income needs.
Source: Bank of America, Morgan Stanley, Yieldbook and Bloomberg. As of September 2023.
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1 All data through November 24, 2023.
2 CSP Global Hedged Equity: 1-year return 11.11%, 5-year return 7.45%, since inception 5.71%. Inception date: May 31, 2017.
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