The year ahead: Three macro metrics to define an “interesting” 2024

The Chinese expression, “May you live in interesting times,” is very much intended to be a curse. And the macro environment looks set to remain very interesting in 2024. However, for investors at least, change breeds opportunity. 

In part one of our analysis of the year ahead, we highlighted two big-picture drivers to watch - a tight credit environment and the rise of artificial intelligence (AI) - and the opportunity they could potentially present for private markets investors. In part two, we turn to the macro metrics we think you should watch to guide your allocation decisions as 2024 unfolds.

There are many difficult-to-answer questions and unresolved imbalances that continue to unwind, both here in the US and across the globe. The path of the US economy remains relatively unclear, even as it keeps consistently defying widespread predictions of recession.

Coupled with a far from stable political and geopolitical backdrop, 2024 may be more interesting than markets expect. Conflicts in Ukraine and Gaza raise the odds of instability in the Middle East and Europe, as well as the specter of supply-chain disruption and energy price volatility. Meanwhile, what is likely to be a bruising US election campaign will create fresh economic uncertainty, both domestically and internationally. Expect greater volatility as November approaches.

All of that said, from a macro perspective, we identify three defining data-points to watch for investors:

• Interest rates, which we expect will start to be cut, though relative to recent decades they should remain relatively high

• Earnings growth expectations, which are still strong - but possibly too strong given an ongoing manufacturing recession and weak GDP growth expectations

• The equity-bond correlation, specifically whether equities and bonds will return to their “goldilocks zone” inverse correlation (which underpins diversification in the 60/40 portfolio)

1. Interest rates - higher for longer?

There is a marked disconnect between market and Fed expectations on interest rates. 

The market is pricing in multiple cuts in 2024 to take the Fed Funds Rate down to around 4%. The current Fed “dot plot”, in contrast, suggests a more modest path of just three 25 basis point cuts this year.

While a recession is possible, which would drive a rapid easing cycle, it is far from certain. And with inflation proving quite sticky and the Fed relatively hawkish, we think that market expectations are on the aggressive side. Slower-than-expected rate cuts will be painful to many borrowers. There are numerous businesses that will need to refinance in 2024, and many who were on fixed-rate schedules will find these rates difficult to manage. 

Further, pockets of stress - particular commercial real estate - may be unable to service debt at these rates, assuming they can find a lender. Debt service burdens get painful when rates stay high even as incomes fall. While the overall picture for household and business income seems relatively healthy, these pockets of stress are worth watching closely, as they may provide attractive entry points for opportunistic debt investors.

2. Earnings growth expectations - too optimistic?

While market expectations on interest rates appear predicated on the need for a more aggressive pivot - implying a slowdown in growth - earnings growth expectations baked into valuations remain strong.

It is difficult (if not impossible) to entirely reconcile these two realities. While the US economy and the US equity market are certainly not 1:1 - public equities are only part of the corporate picture and a chunk of revenue for many public companies originates overseas - estimates and conditions are in tension. 

Financial leverage remains muted, and the net positioning of speculative bets is negative - this generally means the risk of extreme misses to the downside is lower - but that does not mean equities will deliver the returns investors are expecting.

Analyst estimates for earnings growth this year are, historically speaking, aggressive (see chart below). Earnings growth of roughly 11% is expected, driven half by revenue growth, and half by margin growth. This level of growth in earnings is typically seen after material downturns, largely driven by the recovery from a low base. Despite the rise in rates, activity has remained strong (and often stronger than expectations), making this sort of rebound-driven uptick seem a bit far-fetched.

As briefly touched on in part one, there are several material influences that make robust earnings growth less likely:

1. China, a major source of demand for US public companies (and global growth more broadly), has entered a material economic downturn that policy intervention has done little to remedy thus far. A larger-than-previously-estimated mountain of local government debt is not helping the situation.

2. While over the next decade AI is poised to boost margins, we are likely to see net headwinds in the short term from high debt costs (see above), a relatively tight labor market, and geopolitical uncertainty.

3. Election uncertainty makes planning hard, which can dampen investment, such as Capex and real estate investment. Election year spending can sometimes be a countervailing tailwind, though it is often ineffective in reaching consumers in time to offset the pullback in fixed investment.

4. Home purchases and refinancing have moved out of reach for many Americans. This can be a significant headwind, as real estate-related borrowing is by far the biggest source of consumer credit, and a major way in which spending can outstrip income: spending = income + borrowing + dissaving (overspending).

3. Equity-bond correlation - a return to the status quo?

With the actions of the Fed a dominant driver of markets, the equity-bond correlation has flipped positive (see chart below). This is the first time this has happened in over two decades, but is not a new phenomenon. A positive correlation persisted for roughly three decades until the turn of the millennium. 

Effectively, this is to be expected when Fed action and inflation, to which equities and bonds respond in largely the same way, are bigger drivers of the economy than growth, to which equities and bonds have an inverse relationship.

The Fed certainly hopes inflation volatility will subside from here, given the picture of Fed expectations (first chart above), but volatility in central bank policy versus expectations seems unlikely to reduce materially in 2024. This means you would need a dramatic growth shock, either positive or negative, for stocks and bonds to revert to a negative (diversifying) correlation again.

This means that using bonds as an equity hedge is, at the very least, risky. With short-term rates above 5%, investors may reasonably choose to take less risk, moving to overweight cash and cash-like instruments until the risk-reward of a traditional public market portfolio looks reasonable. While this may be prudent for some, it could result in weak real returns if inflation persists but the Fed is slow to act on rates.

Given the potential opportunity cost of retreating to cash, our preferred approach would be playing “active defense” by “widening the aperture” on what constitutes an investor’s income-focused allocation. Building in some yield-focused private markets exposure can create a more resilient portfolio in these interesting times by introducing diversified sources of return and risk - even in more correlated markets.

Skating to where the puck is going

As always in investing, actually beating the market depends on anticipating what comes next. Waiting until the crowds have descended on a trade is unlikely to lead to outperformance. Paying close attention to the direction of the metrics we have identified - even better leading indicators of their direction - should help you to skate where the puck is going, rather than following the crowd. 

Getting these calls right day-to-day is fiendishly hard, which is why we  partner with managers focused on areas of expertise in which they have demonstrated the ability to source unique information and deal flow, which leads to more unique insights. 

Secondly, private markets provide a longer-term vantage point. Will it be 75 degrees on June 15 of this year? Your guess is as good as ours. But will it be hotter in June than it is today? Certainly. Private markets give us the benefit of being able to cut through some of the noise while focusing on the trends that will truly define value creation over the next decade.  

That said, there is a great deal of uncertainty in the current geopolitical environment, and a black swan event can very easily derail the best of predictions. So whether our expectations are borne out or not, proactively diversifying your portfolio into private markets makes a great deal of sense. Incorporating a wide variety of idiosyncratic sources of risk and return reduces overall exposure to any one economic trend or event and thereby reduces overall portfolio risk - which is always a good idea.

This is the second of three articles mapping our expectations for 2024 and beyond. To chat with us - or disagree with us - about anything we have raised here, please reach out to any of our team, or email advisory-services@optoinvest.com.

Part one is here.