2024 Outlook: Allview Face-Off Roundtable

Frank Cooke: I’m Frank Cooke, head of International Solutions with the Systematic Edge team, and you’re listening to On the Trading Desk®. Joining me today are Allspring’s very own Danny Sarnowski, portfolio specialist for the Plus Fixed Income team, and Ozo Jaculewicz, associate portfolio manager for the Discovery Growth Equity team. We'll be talking about our 2024 predictions for markets and beyond. Thanks for being here, gentlemen.

Ozo Jaculewicz: My pleasure, Frank.

Danny Sarnowski: Great to be here.

Frank: All right, I want to start where we left off last time. We met in June of this year. We had some predictions. And you know what? We actually did pretty well. Looking at inflation, Danny, you and I had it below 3% at the end of the year and I think that's what's going to happen. Ozo, you had above 3%, so you could actually still be correct. I think we had around 70% hit rate in total. So, I'll take that. Ozo, your calls on equities were spot on. You were overweight equities. You had growth over value. So, yeah, well done.

Ozo: Well, thanks, Frank. Most of my gains happened in the last few weeks, so I would say better late than never.

Danny: And I would just remind everyone that the books for 2023 are not yet closed. So, Frank, you and I still have a chance to edge Ozo out.

Frank: All right. So, let's start off on the macro side of things. Since we last spoke, we've had one more rate hike from the Fed (Federal Reserve). That was in July. We've been on hold since then. Fed fund futures are now pricing in four cuts next year. So, with inflation currently at 3.2%, what are we thinking for an inflation prediction for the end of 2024? And do we think the market has it about right with those four rate cuts? Danny, what do you think?

Danny: I think the trend is going to remain in place. So, I'd expect inflation to be below 3% but above 2% by the end of the year. I think it will be a bumpy ride—as we've already had—though, the trend will remain in place. But I think the market, as always, is slightly ahead of the Fed. I think over the last several months, we've seen an important shift in Fed rhetoric from the drumbeat of “the risk is that we don't do enough in raising policy rates” to a much more balanced view and a vigilant focus on “are we doing too much?” And, so, I do think that, from our perspective, means we think the Fed is at the terminal rate and the Fed themselves think they're going to have to cut rates or plan to cut rates next year. But the market might be a little bit ahead of where the Fed ultimately ends up.

Frank: Yeah, I think soft landing seems to have become kind of a consensus view and people are predicting core inflation to be within that 2.0% to 2.5% range. I think there's also a bear case out there where we have a genuine recession. Inflation stays well above central bank targets. It could be sort of a stagflation-type scenario. I think, on the Systematic Edge team, we're somewhere in the middle of that. So, I think disinflation will continue to progress, but not as rapidly as the market is predicting. So, I agree with you on that sort of 2.5% to 3.0% by the end of next year. I think unemployment increases, but not by much. So, I think we're looking at a growth disappointment or maybe a mild recession. So, that would be the view from the Systematic Edge team right now. Maybe two cuts instead of four?

Danny: Well, I think it's important to remember that the Fed is going to be data dependent. And by the time they have that data in the rearview mirror, I think we're getting through the first couple of quarters of the year and I don't think they're going to want to try and front run. Even one quarter of negative GDP (gross domestic product) is unlikely to prompt them to start cutting. So, it's a function of what does the data look like and where are we at? What trends are in place before they'd guide policy lower?

Ozo: Four rate cuts seem a bit unrealistic. I think that's somewhat of an optimistic or soothing elixir from some investors who want to feel like there's a bullish sort of outcome. We'd have to have inflation close to or below the 2% target and we might be looking at a real contraction, if not a recession, if we're talking about four rate cuts. Quick story, Frank, my mom worked in the commercial fishing industry and she would fish in the Bering Sea up in Alaska. And she would face these huge 30- and 40-foot swells. It was like that TV show, The Deadliest Catch. And she’d come back and tell me, “I thought the boat was going to sink.” And if you think about the U.S. economy, especially the last few years, you have the end of the COVID stimulus, historic rise in inflation, a rapid tightening policy by the Fed, and also a banking crisis. The economy has proven to be pretty resilient and sturdy, like a boat, through all of those shocks. One of the main things people have gotten wrong is that consumers are probably a little less interest rate sensitive than they were in previous cycles. I'm not saying that the sun's going to come out and we have smooth waters and there's plentiful fish for everyone. It will be choppy and we may face recession fears, but I just think that environment of all those rate cuts underestimates the resilience of the U.S. economy.

Frank: Thanks, Ozo. So, shifting gears with all this talk of rates, where does that leave us on fixed income? With yields where they are now, is it time to consider reducing equity allocations and increasing fixed income allocations? Danny?

Danny: Well, I think the outlook for fixed income is very strong for 2024. I think investors came into this year hoping or expecting equity-like returns out of their bond positions. And the outlook for next year is we are more likely to get bond-like returns out of our bond positions for the first time, really, since the Great Financial Crisis. And I think that's really exciting. I think we're sitting with the yield curve at a very high level and relatively flat. And to me, that means that there's a broad range of outcomes from where we sit today. And I think what fixed income investors need to think about is how they're positioned in their portfolios. I think we've seen a huge move over the last two years to the very, very front end of the curve, so investors crowding on that front end, being hyper-focused on the prospect for higher rates. And a lot of fixed income investors today are asking, “Is this the time to go to the other extreme and crowd on the very, very long end of the curve, expecting or hoping that the Fed will cut rates, as we've already talked about?” And I think, or we think, the better alternative could be to ride the curve or diversify your duration positioning. Being hyper-prepared for one specific outcome is not the same as being prepared. A Swiss army knife doesn't just have a can opener, right? It's got all sorts of tools for all sorts of jobs. And I think we're in that situation where fixed income investors can diversify their exposures, take advantage of these really attractive all-in yields, and build a lot of resiliency into the portfolio. And that should take a lot of weight off of the equities or commodities or alternatives or other portions of the portfolio because those all-in returns from fixed income should be higher than they had been in a long time. And I think that's a great, great place to start from.

Frank: Yeah, I think from a duration perspective, to Ozo’s point earlier, duration could be a great recession hedge. So, I think, from that perspective, fixed income makes a lot of sense in 2024. But more generally, the Systematic Edge team put out a thought piece recently where we looked at our capital market assumptions, our forward-looking returns over a 10-year period. We looked at what those were in December 2021 and what those are now. And in December 2021, if we cast our minds back, markets were at their top. Markets were very frothy. Valuations were quite rich. And, so, for example, our equity return assumption on the S&P 500 was around 6% over the next 10 years. But now, given what's happened with cash rates, given what's happened with volatility, which is a key input into our capital market assumptions, that whole efficient frontier, if you like, has risen up. And, actually, our return for Bloomberg Global Aggregate bonds, our return assumption over the next 10 years is just over 6%. So, for an investor that's looking to get around a 6% to 8% return, they can afford to allocate more now to fixed income than they previously could while still getting the returns that they need. Okay, let's move over to equities. Ozo, in June, we spoke about the AI phenomenon and the resulting concentration in large-cap equity indices. The markets now started to broaden out a bit, which you correctly predicted. What do you think's going to happen with equities next year? Will passive market-cap strategies continue to dominate? Or is crowding into a narrow group of stocks not such a good idea?

Ozo: Well, I really like Danny's word that he used earlier: “prepare.” I think the market is starting to broaden out. And if we really look back at the first nine months of this year, it was extreme. It's been well documented at this point, the Magnificent Seven were up about 55% through September, whereas the rest of the U.S. stock market was essentially flat. If you think about the concentration of passive benchmarks as a Richter scale, the change in the weight of the top 10 holdings of the benchmark in the first half of last year was like a 7.0 earthquake. It was the largest increase in the top 10 holdings in over 60 years. We think that is an extreme anomaly that will start to unwind and mean revert. As that happens, investors should think about diversifying and broadening out their portfolios, particularly into small- and mid-cap U.S. equities. First of all, the Magnificent Seven expanded by $3.7 trillion in the first nine months of last year. That's enough to buy the entire U.S. small mid-cap universe with some trillion left over. And SMID caps offer better earnings growth and lower valuation. Speaking of valuation, small- and mid-cap stocks are trading at over a 20-year low in relative valuation. The valuation spread between large caps and small caps hasn't been this wide in over two decades. It will likely narrow next year. And, lastly, that environment where perhaps the economy slows, but we don’t see a severe recession—rates plateau, maybe the Fed starts to cut a little bit—could lead to small caps coming back out the other side of the recovery. So, we think for those reasons—a bit of an unwind of the Mag Seven crowdedness, the relative valuations of small-/mid-cap stocks, and potentially small caps coming out as interest rates decline and there's a recovery—is why we think investors should diversify and prepare for a different tone to the markets.

Frank: I think you make very compelling arguments. Maybe I'll give the devil's advocate. So, higher for longer, were strong balance sheet companies and larger companies continue to outperform, and the AI phenomenon lives up to its promise and increases productivity, perhaps we could see that phenomenon continue. I'm not saying that's what I think. But I just wanted to give a bit of a devil's advocate there. But just on your point on small caps, I think it's, just given where valuations are, it's very exciting. It's a very exciting opportunity, I think, for 2024. So, the U.S. has outperformed in 2023, especially in equities. Will global benchmarks stage a comeback in 2024? Will they outperform U.S. benchmarks? Danny, maybe you could answer for bonds and, Ozo, maybe you could answer for equities.

Danny: Yeah, it's a great question, Frank. And I think it's really important for investors to keep that global perspective in mind. Everything that we've talked about, we spilled a ton of ink about over the last two years, has been largely focused on the Fed, what's happening here at home, our inflation rate, our monetary policy rate, but the reality is this is happening everywhere. We're not the only country seeing the highest inflation in a generation or whose central bank is working harder than they have in decades to try to restore price stability. And some of those central banks around the world will be done before the Fed, some will be done later, some will do a better job, and some will do a terrible job. And what that means for investors is risks and opportunities that start somewhere else in the world and make their way back here at home. And, so, the question of will there be great opportunities in global fixed income in 2024? I think yes. Can we say with specificity, here's a specific market that is poised to massively outperform the U.S.? I don't think so. But I think our team is focused on trying to find the most attractive relative values, and global markets will provide those sorts of opportunities throughout the next year.

Ozo: Within equities, Frank, I think I would probably stay skewed or overweight toward the U.S. I think the U.S. will likely continue to outperform. Let's just remember that, ultimately, stock prices follow earnings. And that fundamental relationship is so important to ultimately cracking through the macro noise. And within the U.S., earnings growth is powered, oftentimes by great innovations. And the United States has tremendous innovations, particularly in the technology space. We're talking about cloud computing. We're talking about the digital economy. We're talking about now AI, which is in the early phases of just building its infrastructure. We haven't even started the usage phase yet for AI. We know about the GLP-1 drugs within health care. There is robust innovation. The U.S. is not the only place these trends are happening, but there is a concentration of some of the leading companies that have the strongest earnings growth, being driven by those technological changes, that I think is important for investors to have meaningful exposure to.

Frank: Yeah, I would agree with you, Ozo. And also, the U.S. has inflation under control relative to the rest of the world, as well, developed markets-wise. Maybe I'll just highlight a few potential opportunities that we see for next year. So, I think Japanese equities are quite interesting. They're not very expensive from a forward P/E (price/earnings) perspective. And if the yen can stay weak, it could do really well. They're shifting to a more normal macro environment over there. And I think, as well, emerging market equities.  We see a discount versus developed market equities really above historical average. The U.S. dollar—has it peaked? It's starting to roll over. You've got stimulus measures in China. Maybe they could pay off. So, I think Japanese equities and emerging market equities could be interesting, but I agree with you, Ozo. The U.S. is looking strong. With the time we have left and to keep with our tradition, what will the best-performing asset classes be in 2024: 10-year Treasuries, the S&P 500 Index, the Bloomberg Commodity Index, or bitcoin? Danny, what do you think?

Danny: Well, I think I'm going to continue my prediction from last time and say bitcoin will probably be the top performer, largely driven by some of the biggest shadows hanging over that sector being removed this year. But I will say that while I expect fixed income in 2024, especially over the first half of the year, to deliver more like coupon, coupon plus sort of returns, those coupons are higher than they've been in 10, 20, and 30 years. It’s certainly above the average, so I think fixed income is an attractive spot and I think it's a place where a lot of investors are under-allocated today. And, so, while I don't expect fixed income to be the top-performing asset class next year, I think it's a great opportunity for investors to get their portfolio back in order and really reconsider those fixed income allocations. How about you, Ozo?

Ozo: Well, Danny, you won't be surprised that I'm going to stay consistent and go with the S&P 500. The main reason is I think people are underestimating the durability of earnings growth, particularly in the U.S. And I think we are looking at an environment where the economy's cooling, economic growth is slowing, and rates are plateauing and starting to come down. And I know fixed income offers attractive yields right now, but there's a real risk if you just go into T-bills and chill, you miss a big run in equities, potentially even a melt-up in equities. And in that environment, it's important to remember that stocks deliver the compounding over time that investors really need to reach their long-term objectives. So, I think I'd skew toward growth. Going back to my fishing analogy, I don't think it's going to be smooth sailing and easy. To Frank's point earlier, quality balance sheets, companies with low debt levels, free cash flow, and sustainable secular earnings growth, I think, will shine and you'll continue to see those growth-skewed equities within the S&P drive favorable returns and make my prediction look really good a year from now.

Frank: T-bills and chill, I like that one. Thanks, Ozo. You know what? I actually like all of these asset classes for next year. I think Treasuries, what we discussed earlier in terms of decent yield and a recession hedge. I think equities, yes, earnings are facing slight headwinds, but we could have real strong multiple expansion next year if we have some non-recessionary cuts. I think commodities have a place in the portfolio because of geopolitical volatility and potentially a supply shortage. But I'm going to have to agree with Danny on the bitcoin call just because we’re early in a bull market. We've got the supply halving coming in April 2024, where the number of new coins generating each day will be cut in half. And then we have that bitcoin spot ETF (exchange-traded fund) that's expected to come online in Q1 2024. But just given all of those arguments, I think it makes a strong case for having real balanced exposure across asset classes and not just relying on cash. So, I think we're running out of time. I'm Frank Cooke, head of International Solutions for Systematic Edge here at Allspring Global Investments. Thank you to Ozo and Danny. Thanks for being here today and sharing your insights.

Danny: Thanks for having me.

Ozo: Great to be here. Thank you, Frank.

Frank: And thank you for joining On the Trading Desk®.

Announcer: Visit allspringglobal.com to receive more market insights and investment perspectives from Allspring Global Investments. To hear the latest from our thought leaders on the ever-changing investment landscape, you can subscribe to the program on Apple Podcasts, Spotify, or wherever you get your podcasts. Thank you for listening and joining us on the road to investing elevated.