In our House View released on Sep 28, 2023, titled "2023 Q4 Economic Outlook," we demonstrated an astute ability to forecast the course of the global economy throughout the summer. Today, we revisit our discerning analysis to delve into the underlying rationale behind an array of events unfolded during this year, and offer our perspectives on the economic developments of the United States, Japan, China, and Europe as they pertain to 2024.

Summary

• The lag in US shelter inflation, coupled with service inflation driven by robust wage growth, is anticipated to hinder the deceleration of cooling core inflation. The CPI at 3.1% faces a challenging path to reaching 2%, with a more realistic target for the Fed by the end of 2024 being a reduction in CPI to 2.5%.
• We believe that the Fed has concluded its tightening cycle in July. However, the market's anticipation of rate cuts, with an expected 150 basis points cut next year, appears excessively optimistic. We project the Fed to initiate a rate cut in Q3 2024.
• Examining eight rate-cutting cycles since 1984, the S&P 500 index has historically shown an average increase of 2% three months after the first rate cut and an 11% increase twelve months later. Yet, historical outcomes vary significantly; for instance, in 1995, the S&P 500 surged by 21% twelve months after the rate cut, while in 2007, it declined by 24%.
• Anticipating US stocks to benefit from rate cut expectations leading to the Nov 2024 election, we observe a momentum deceleration. The S&P 500 is expected to fluctuate within 4850-4950 H1 2024. Given the trend of declining US bond yields, we recommend an overweight position in bonds, adjusting portfolio duration during yield fluctuations.
• We see Japan poised to enter a rate-hiking cycle in April 2024. The narrowing of global interest rate differentials favors the yen and Japanese bond yields, maintaining our positive outlook on Japanese bank stocks.

‍US –Excessively Optimistic Market

Examination of Core Inflation

As of December 21, the S&P 500 index has seen a year-to-date cumulative increase of 22.37%, while the Nasdaq index has surged by 41.19%. This notable growth is attributed to breakthroughs in AI technology, a lenient environment triggered by the Silicon Valley bank collapse in March, and year-end cooling of inflation driving expectations of interest rate cuts next year. We believe that the Federal Reserve has already concluded its tightening cycle in July. However, market optimism towards rate cuts, particularly a 150-basis-point cut in the coming year, appears excessive. Wage growth remains a significant obstacle to cooling inflation, and we anticipate the initiation of a rate-cutting trajectory in the third quarter of 2024. A prolonged period of elevated interest rates is expected, prompting a recommendation for an overall portfolio overweight in fixed income and increased equity downside protection and hedging.

After a further cooling of the US CPI to 3.2% in October, the market swiftly shifted towards betting on a substantial rate cut by the Fed. Despite a rebound in November non-farm payrolls and core inflation data, the hawkish-to-dovish shift in the December Fed policy meeting, with a median estimate of a 75-basis-point cut in 2024 (market currently expecting 150 basis points), fueled optimism. In mid-December, Fed officials began tempering rate cut expectations for early the following year, but this did not deter the continued upward trajectory of S&P 500 as well as Nasdaq index. Institutional investors' confidence reached a two-year high, with significant capital flowing into the equity market, resulting in a two-year low in cash allocations.

As oil prices experienced significant fluctuations in the last two months due to geopolitical tensions and supply-demand dynamics, we paid our attention to the core inflation which excludes food and energy. Shelter, core goods, and services constitute the major components of the core inflation. Shelter carries the highest weight at 44%, with the latest reading still exceeding 7%. Given the lag in rental adjustments and their typical resistance to subsequent declines, shelter inflation is expected to remain elevated in the next one to two years.  

Core goods, making up 26% of overall core inflation, witnessed a rapid decline over the past year due to improvements in post-pandemic supply chain issues, particularly in the semiconductor industry. Nevertheless, the disappearance of base effects will shift core inflation dependence towards the performance of shleter and services.

Services inflation, accounting for 30%, is primarily driven by labor costs. The government's relief plans during the pandemic eventually led to excessive liquidity, resulting in a structural change in wage growth. According to an analysis report released by the Joint Economic Committee of the US Congress, from January 2021 to October 2023, the average wage and salary earnings in the US increased by nearly $15,000. Despite a decline in year-on-year wage growth from the peak of nearly 6% last year to the current 4%, it remains well above the 2010-2019 average of 2.33%. Combining robust revenue growth in the latter half of this year and a successful strike by the automotive industry union, labor market resilience may prevent a thorough cooling of inflation and lead to fluctuations next year.  

Fed Is Expected to First Cut in 2024 Q3  

Considering the aforementioned analysis, we identify wage growth as the primary impediment to the Federal Reserve achieving its 2% inflation target. The projected trajectory from 3% to 2% CPI is expected to be a protracted and convoluted process. If CPI descends to 2.5% by the end of 2024, the Federal Reserve would have achieved its objective.

In our June forecast, we anticipated “a single additional rate hike from the Fed this year, deviating from the dual hikes indicated by the dot plot. By year-end, we expect the US policy rate to land between 5.25% and 5.5%”. The subsequent forecast in September reiterated our view that “the Fed has already concluded its final interest rate hike in July. Additional rate hikes are not anticipated at the policy meetings scheduled for September, November, and December. Consequently, the policy interest rate in the United States will continue to hover within the corridor of 5.25% to 5.5% by year-end”. Our predictions, as articulated in previous Poseidon Global Economic Outlook series, have proven entirely accurate.  

Looking ahead to 2024, our take is that the market's optimism regarding the first rate cut in March, driven by a perceived deceleration in inflation, may be overly optimistic. To avoid a situation reminiscent of the CPI fluctuations observed in the 1970s, the Fed is likely to maintain elevated interest rates to monitor trends in macroeconomic data. Additionally, the outcomes of the Democratic and Republican party primaries, scheduled for disclosure in July and August, will influence the Fed's decisions. Consequently, we anticipate the Federal Reserve to initiate a rate-cutting trajectory in the third quarter to navigate economic developments effectively.  

Below, we have compiled recent customer concerns regarding interest rate cuts for readers' reference:  

Question 1: What are the prevailing market anticipations regarding interest rate reductions in the upcoming year? How does Poseidon perceive this situation?

Answer 1: The market has priced in a 150-basis-point interest rate cut by the Federal Reserve in 2024, with the average expectation for the first rate cut in March 2024 according to Bloomberg economists. However, we, as participants in Bloomberg's economist surveys, poist that core inflation in shelter and services driven by wage growth exhibits stickiness. To avoid CPI fluctuations or rebounds, we anticipate the Fed to initiate a rate-cut in 2024 Q3.  

Question 2: How have equities and bonds performed in recent times?  

Answer 2: Since mid-October, both stocks and bonds have risen simultaneously and continue to do so. The yield on the 10-year US Treasury, a key anchor for asset pricing, has decreased by 110 basis points from its peak of 4.99% to 3.89%. The price-to-earnings ratio of the S&P 500 has expanded by 10% to 19x, approaching historical highs.

Question 3: Given the current scenario, what strategic adjustments are recommended for asset allocation?  

Answer 3: Presently, optimism pervades the market, and the valuations of equities and bonds have duly accommodated this sentiment. Consideration should be given to reinforcing portfolio defenses against downturns by augmenting exposure to fixed income instruments (such as both short and long-duration investment-grade bonds, TLT ETF, etc.), FCN fixed coupon notes, 100% principal-protected long positions hedging, and neutral market strategies.

Question 4: Historically, what has been the norm for US stocks post interest rate reductions?  

Answer 4: Over the course of eight interest rate cut cycles since 1984, the S&P 500 has, on average, registered a 2% upswing three months post the first Fed rate cut and an 11% surge twelve months hence.

Question 5: Is an upward trajectory for US stocks guaranteed following interest rate cuts?  

Answer 5: From a historical perspective, outcomes have been pretty diverse. Post the interest rate cut in 1995, the S&P 500 witnessed a commendable 21% upswing twelve months later, whereas in 2007, it experienced a notable downturn, contracting by 24%.  

Question 6: How can one assess the overarching trend of the US stock market?  

Answer 6: The crux lies in discerning whether the economy can evade a recession. In three instances out of eight interest rate cut cycles, the economy dipped into a recession post the rate cut (in 1989, 2001, and 2007), thereby precipitating a downturn in the equity market. Our contention is that the US economy exhibits resilience this year, and the labor market maintains a tight equilibrium. Consequently, we envisage the US accomplishing a soft landing, sidestepping consecutive quarters of adverse GDP growth.

Asset Allocation Ideas  

In the domain of equities, our Q4 forecast from September posited, " While broad market crash is not in our play books, we anticipate that the US stock market, notably large-cap technology stocks, will weather a correction ranging from 5% to 10% in the near term". This prognosis materialized only in part, as the S&P 500 index indeed experienced an 8.6% descent from approximately 4500 points at the onset of Q4, momentarily touching 4117 points by the close of October. However, buoyant corporate earnings during the fourth quarter, coupled with the premature advent of interest rate cut expectations, propelled the S&P 500 index to a resurgent 15% climb over the last two months, reaching 4750 points and nearing historical pinnacles. We forecast that in the lead-up to the November 2024 elections, US equities will continue to benefit from the sustained expansion in expectations of interest rate cuts. Nevertheless, as momentum decelerates, we anticipate a range-bound market oscillating between 4850 and 4950 in the first half of the coming year.

Regarding the fixed-income arena, our September prognostications demonstrated precision. " US Treasury yields have climbed throughout the whole summer, ascending to levels unseen since the aftermath of the financial crisis. An excess issuance of bonds and the attainment of a decade-high yield level have endowed investors with auspicious entry points. Although yields may conceivably ascend further in response to hawkish pronouncements from Fed officials, the extent of such ascent remains circumscribed. Our forecast suggests that, by the third quarter of the ensuing year, yields, on the whole, will commence a descent. Presently, the recommendation entails augmenting the duration of bond portfolio holdings to lock-in elevated yields and capitalizing on the tail end of the prevailing period of US dollar strength through certificates of deposit”.

Owing to the interest rate cut expectations in November, the 10-year Treasury yield plummeted by 110 basis points from its summer peak. Although the extant entry opportunity is marginally less propitious than in the autumn, we advocate maintaining an over-allocation to bonds as our premier strategy amid the backdrop of impending interest rate cuts. Given our anticipation of potential transitory CPI fluctuations and a languid environment, it is judicious to contemplate initiating positions in short-duration investment-grade bonds to harness time value or adroitly adopting fixed-term deposits for nimble maneuverability. Should yields rebound in accord with our forecast, creating a more propitious entry juncture, amplifying bond portfolio duration is an advisable course.

Additionally, one might contemplate allocating to fixed coupon notes linked to US Treasuries for augmented interest returns or delving into TLT, the US 20-year plus Treasury ETF. Since the advent of the pandemic in 2020, US long-duration bonds have sustained an unprecedented three-year descent, with TLT plummeting 50% from its peak in 2020, presently ensconced within a 40% dip ambit. In light of Federal Reserve Chairman Powell and other voting members adopting a more dovish stance at the December policy meeting, we reckon that the foundational trend of the US bond descent has undergone a fundamental metamorphosis. Within the context of interest rate cuts, a persistent upward trajectory for TLT is a high-probability eventuality.  

‍Japan – Poised for Entering a Rate Hiking Cycle

As major DM countries have finalized rate hikes, poised for an easing cycle, Japan stands singularly positioned to embark on an interest rate hike cycle for the first time since the financial crisis. This dichotomy designates Japan as the lone exception. The contraction in interest rate differentials between Japan and overseas augurs well for the yen and Japanese bond yields, which have languished persistently for an extended period. On average, Bloomberg economists, representing prominent financial institutions on Wall Street, including Poseidon, expect Japan to adjust its monetary policy come April of the ensuing year – a timing we deem reasonable. The rationale behind this temporal alignment is multifaceted:  

• Japan's CPI has consecutively surpassed the 2% target for 19 months, eroding real wage growth and exerting a deleterious impact on residents' purchasing power. We predict a further surge in inflation, rendering an interest rate hike inexorable.
• The fund scandal involving Prime Minister Fumio Kishida has precipitated his approval rating to a nadir of 16%. Amidst a fervent contest among Liberal Democratic Party leaders, including Shigeru Ishiba, Taro Kono, and Sanae Takaichi, for the party presidency and premiership, the heightened political milieu has intensified the imperative for the BOJ to effectuate an interest rate hike.
• Governor Ueda's erudite background inclines him toward a relatively conservative stance in policy formulation, necessitating a more comprehensive evaluation of data before making pivotal decisions. We did not see a policy shift in January, involving the exit from negative interest rates or a modification of the YCC cap.
• Kuzuo Ueda took over the reins from Haruhiko Kuroda in April, and the alignment of policy adjustments one year hence accords with the customary political practice in Japan.

In our Q4 outlook from September, we articulated, " We maintain the viewpoint that the Bank of Japan is grappling with the challenge of embracing a yen depreciation to the extent of 150 against the US dollar. Therefore, starting in the fourth quarter and extending into the first quarter of next year, we anticipate a gradual sequence of policy interventions, including the cessation of the 0.5% yield reference for Japanese bonds, the abandonment of the 0% target yield for 10-year JGBs, Widening the YCC upper limit, and the termination of the negative interest rate policy. These steps will serve to support the yen and control inflationary pressures, thereby enhancing purchasing power. In this scenario, banks (we prefer MUFG & SMFG) and the financial system will continue to benefit and lead other sectors within Topix, with the yen potentially appreciating to 135-140 against the dollar by year-end”.

Concerning the yen, our discernment proved nearly exact. On December 7th, BOJ Governor Ueda, when queried in parliament about economic and monetary policy guidance, asserted that addressing monetary policy concerns would become more difficult from year-end to early next year, with multiple options available for adjusting policy rates. Concurrently, Deputy Governor Ryozo Himino hinted the day before in a press conference that the world's last negative interest rate policy might imminently conclude. Many traders commenced betting that the BOJ would exit negative interest rates within two months. Short positions on the yen were closed, and stop-loss positions were triggered. Even if the December policy meeting did not culminate in a rate hike, by the close of 2023, the yen eventually diverged from its historical low of 150 and stabilized around 142.

Concerning Japanese equities, we persist in our optimism for the top two financial entities, Mitsubishi UFJ Financial Group and Sumitomo Mitsui Financial Group, while exercising prudence in other sectors.  

• In a milieu of escalating interest rates, major Japanese banks can benefit from the ascent in net interest income, while the valuation of Japanese banks still remains subdued.
• In the past month, Japanese bank stocks have receded by 5%-10% due to the rapid descent in US Treasury yields, proffering an enticing entry opportunity. Commencing next year, we anticipate that Japanese bank stocks will ascend in tandem with the speculation on rising interest rates.
• According to our projections, the prospect of a substantial yen upswing until April is limited. Seizing the opportunity presented by the yen's historically low levels to allocate to banking stocks is recommended. In the subsequent scenario of yen appreciation, investors would have a chance to gain additional foreign exchange returns.  
• Coupled with simultaneous inclusion of TLT (US 20-year plus Treasury ETF) with Japanese bank stocks, investors can formulate a hedge within the portfolio.