Looking ahead into the second half of 2024 is like chasing the white rabbit – but where will it actually lead investors?
This is a clear reference to Lewis Carroll's Alice in Wonderland where the white rabbit symbolizes stresses and tensions of the time and leads its willing followers into a strange world. The difference is that we in the market have no choice. Putting this into a market context, the metaphorical white rabbit may be leading investors into an ambiguous world more so than an uncertain world.
The difference is that the market can calculate risks associated with uncertainty, but cannot with ambiguity. This presents a challenge in the second half of 2024 as we enter a world with political drivers of market movements, a key source of ambiguity. Perhaps it's already started with the election results in Mexico, India, the EU and France.
More to come with the US presidential election
The projections for trade, foreign policy, tariffs, fiscal policy and tax policy all represent ambiguity. Let's also not forget monetary policy, inflation, employment and other fundamental factors that represent uncertainty. So what can investors do in the second half of 2024?
Let's start with managing the uncertainty. As we like to say, all roads lead to inflation as the main source of uncertainty. If we can get that one right then Fed policy follows. Adding to the uncertainty are three measures of inflation which are sending signals, and I like to use a traffic light analogy as it relates to the possibility for rate cuts. I'm going to start with the Super Core inflation measure which I see as a red light. Super Core is still running hot at 4.8% and this is a no go for Fed rate cuts. The yellow light is symbolic of Core CPI year-over-year, which is cooling down to 3.4% on a year-over-year basis. It's heading lower, but it's keeping the Fed on the sidelines until they can gain more confidence. The greenlight is Core PCE which is expected to be around 2.6 - 2.7% and that's closer to the Fed's comfort zone for cutting rates.
At what point does the Fed find confidence to cut rates?
It likely stems from a weakening in the labor market. In other words, the Fed would likely go ahead with a cut despite Core CPI and Super Core, which are also remaining high. If the unemployment rate starts making steady progress higher, say if it goes to around 4.3%. Currently, the unemployment rate is at 4%. Why? Because this would signal a decline in wage inflation to come. If that happens, then the Fed will believe that inflation is not only falling, but it can become anchored. Our best guess is that this is a path we are on. That is a slowing economy with the Fed swooping in with rate cuts to make sure that the landing is actually soft.
In which case, the asset class implications for bonds are that we believe that it will be range-bound in interest rates as the yield curve is already inverted and pricing for this. We prefer high yield and bank loans as overweights, as we expect lower default risks. We will hold an overweight in Emerging Markets too. We like keeping our duration a bit short because of the inverted curve and the better carry that it provides in the front end.
With respect to equities, we see more idiosyncratic and alpha opportunities over beta. In other words, it's not just about having exposure at the index level but creating tilts where we see pockets of value. We are overall neutral, but we have concentrations in European banks and more recently in French equities. We still prefer growth over value in large to small and underweight defensive sectors in the US. As we see it, the economic uncertainty is manageable. We are neutral but with positive alpha tilts.
Managing the ambiguity
This is not an exact science, but we think the solution to ambiguity driven by politics lies in portfolio construction. That's to say we want to have ample liquidity and neutral exposure at the top down portfolio level so that we are unencumbered to act freely in response to market moves.
So how do we think about ambiguity? Well, picture a normal bell-shaped probability distribution. This is a model of calculable uncertainty. Now instead of a bell shape, draw a horizontal line. This means that all events have an equal probability. In other words, anything can happen, this is what ambiguity is OK. Now I'm exaggerating a bit, but I think the reality lies somewhere in the middle of both these illustrations.
Again, it's not an exact science. I mean, how can it be when even the supposed experts get it very wrong? Not just in terms of how people vote, but also by how elected leaders will govern despite what they say on the campaign trail. So as we just said, if the truth lies somewhere in between the fundamental distribution of uncertainty and the ambiguous one driven by political outcomes, then we solve for this by portfolio construction. A durable, well-diversified portfolio that has a neutral starting point, so it can strike out at dislocations in the market that are perhaps driven by political ambiguity and market overshoots. This is the way we are thinking about managing the risks as we head into the second half of 2024.
And if anything becomes unclear along the way, then just go ask Alice.
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