Investment Strategy Insights: A Pivotal Election Year Will Reshape the Global Political Landscape

Stance: Our central case for a mild slowdown this year continues to gain traction. As the probability of a recession ebbs, the US is likely to enter a disinflationary period as it moves to a mix of looser fiscal and monetary policy. The rundown of excess savings and a contraction in credit growth suggest that household demand will slow more quickly from the second quarter onward. But this will be partially countered by the sharp rise in government expenditures seen since the end of 2023, which can support growth in this year’s first half.

While rising geopolitical tensions in the Middle East have led to increased shipping costs, the higher inventory/sales ratio removes the immediate risk to prices. The unusual disconnect between the Producer Price and the Consumer Price Index (running at 3.4% year over year) suggests that December’s higher CPI print is a one-off phenomenon (also the six-month PCE-deflator average is running close to 1%). Except for wage growth, which has been propped up by the government pushing through a 5+% wage increase for its employees, all inflation factors (productivity, import prices, US dollar strength, agricultural prices, money supply, etc.) are pointing to a further slowdown in the inflation rate.

With the market anticipating six or seven Federal Reserve rate cuts in 2024, the National Financial Conditions Index (NFCI) eased further into negative territory; it now stands lower than when the Fed started hiking rates in 2022. Simultaneously, banks have eased lending standards. In the past, the Fed only started a cutting cycle when nominal GDP growth was below 5%. With the latter expected to fall to below 5% in the second quarter for the first time since first-quarter 2021, the NFCI data is supportive of a Fed rate cut in the second half.

Last year began with the 10-year note at 3.88% and ended with the note at 3.87%. A no-change year? Hardly, as rates rode a rollercoaster throughout 2023. We anticipate similar moves this year. Since Federal Reserve Chair Powell pivoted in December, announcing three rate cuts, the market has now priced in six rate cuts and the end of quantitative tightening in 2024. If that is correct, the Fed showed its hand, and other countries can fit the narrative to control the strength of their currencies relative to the US dollar, which should weaken amid a rise in commodity prices. This would be a boost to exporting countries.

The market is starting to pull back slightly from its overly optimistic expectations of an early Fed rate cut. The lowered enthusiasm is being reflected primarily in Treasury yields and is not impacting credit valuations, but there is an offset coming from signals of a reduction in balance sheet tapering. The fundamental outlook has now squarely shifted to a “perfect landing” of strong consumption, low unemployment, and moderating inflation. With expectations that the European Central Bank (ECB) also will shift toward easing and with China bottoming, investors are dismissing any downside risks. Geopolitical risks are also rising, yet the market is showing no fear.

Valuations are trading at the low end of our scenario range, with investment grade (IG) in the low-90s and high yield (HY) in the 330s. The most likely near-term catalyst for some spread widening would be a reset of rate-cut expectations closer to the Fed’s forecast. Relative-value opportunities have shifted toward areas of the market that have not rallied strongly, including geographies outside the US. Emerging market (EM) and European spreads now look more attractive than US credit. AA rated CLO spreads currently exceed BB rated HY spreads.

Perceived monetary policy divergence between the Fed and the ECB has acted as a dampener on the US dollar in recent months, notwithstanding our opinion that actual rate cuts by the Fed and the ECB will be synchronized in 2024 – and, possibly, enacted later than currently priced by financial markets. While US disinflation (as measured by the six-month average core PCE) has been greater in the last six months than previously envisaged, enabling Chair Powell to sound surprisingly dovish in December, US labor market conditions remain tight. With the US unemployment rate below 4%, the Fed may hold off cutting rates in March and start normalizing monetary policy halfway through the year, which is our base case. In comparison, we find stronger evidence for early rate cuts by the ECB given the inflation and growth trajectories in Europe. Yet the ECB so far has sounded more hawkish than the Fed, allowing the euro to strengthen temporarily. Given market positioning against the US dollar, a countertrend may develop in favor of the US dollar, as we believe the dollar was punished too hard in December and ought to move back toward 1.0500 to the euro. That level is our preferred euro/US dollar target in our “Stabilization Scenario” and in our 12-month euro/US dollar forecast. The euro/US dollar at 1.1000 matches the outcome for our “Recession Scenario.” EM carry on a real-rate basis has diminished vis-à-vis the US, indicating EM currencies will have a harder time strengthening against the US dollar in 2024. Even so, the absolute yield remains attractive, and as the combination of disinflation and credible central banks should provide stable rates, local currency debt still offers upside.

The complex US election process and timelines provide many triggers for volatility over the course of 2024. The election’s impact will depend not just on the outcome of the presidential election but also on hotly contested Senate and House races in a few swing states. While the Fed can work independently in setting monetary policy during the first half of the year, there is a sense that fiscal policy will become the focus of attention closer to the election. What matters to markets is the rate of change rather than the level. So far, fiscal forces are a mild headwind. Taxes will be key to the 2025 outlook.

In EM, structural improvements in Mexico’s economy and waves of nearshoring indicate that Mexico’s election on 2 June will be more about policy proposals and less about personality. The question is whether candidate Claudia Sheinbaum, considered market friendly, will diverge from the AMLO days and become a reformer. The answer may ride on Sheinbaum’s support from the new Congress, which starts on 1 August. The outlook for Mexico’s corporates is subject to market-friendly policies, fiscal austerity (made more difficult by a fragmented Congress), workers’ rights and minimum wages, renewables, pragmatism on Pemex, and housing subsidies.

We kept our global macro scenarios unchanged, favoring our “Stabilization Scenario” (60%), with a slight skew toward “Recession” as a risk (25%).

Over the past six months, decreasing inflation driven by greater supply has reduced the likelihood of further rate hikes in developed markets. However, labor markets remain tight and wage pressure is not disinflating like goods and services. The Fed, which focused primarily on inflation for the past two years, emphasized its dual mandate in its December meeting. This signals a greater willingness to accelerate interest rate cuts, even without a significant easing of labor tightness.

Slowing growth ahead remains a likelihood to us, with flatlining fiscal thrusts and less savings to prop up consumption. Pre-recession rate cuts, though unusual, could soften market downturns compared to the typical uncertainty during sudden recessions.

The slope of our Capital Market Line (CML) is still flattish, with overall credit spreads and equity/illiquidity risk premiums remaining narrow, suggesting limited upside for global indices in 2024. But we see dispersion among asset classes remaining high, suggesting opportunities in specific countries, industries, and themes. We think a barbell focused on AI productivity-oriented growth on one end and successful catchup segments on the other looks poised to outperform sluggish market indices. We see the main market risk to be a potential resurgence of inflation. While not ignoring this risk, the reduction in supercore inflation in recent months led us to adjust our Risk Dial Score to a more neutral 3.2 from 3.5 in mid-December following Powell’s press conference. Our increased risk budget is directed toward the diverse opportunities emerging in 2024, rather than a continuous upward trend.

Market moves in December and January have been driven primarily by speculation around the timing of rate cuts in 2024, the bases for which are declining inflation and purchasing managers’ index (PMI) data, as well as escalating geopolitical tensions in the Middle East. The optimism comes in the face of Fed commentary that indicated rates could remain stable at their current levels for the time being. This environment has further encouraged market buying activity in anticipation of earnings upgrades as we move past inventory corrections outside of autos and industrials, which have had some auto suppliers negatively preannounce recently.

Global emerging markets have continued to rebound on reasonable valuations and investor views that US rates have peaked. In late January, the MSCI Emerging Markets Index (MXEF) was up 9.37% from its recent bottom and would require fundamental revisions for stocks to deliver sustainable upside. In some markets, especially China, estimates have been drastically reduced, perhaps too much so. Even minor upgrades to revenues will strongly flow through the profit and loss statements and lower the implied forward multiples.

Chinese macro data has shown slight improvement, especially the PMIs. The government eased off its regulatory focus on the internet gaming sector, which is a welcome development. In Latin America, all eyes remain on Argentina, which has embarked on an ambitious reform package under a new president. In EMEA, politics are coming to the fore again amid tensions between Hungary and the EU in several areas and as Poland’s new government experiences growing pains. Investors lack conviction in bottom-up fundamentals; as a result, top-down factors continue to have a disproportionate impact on markets. As the belief in March rate cuts in the US has receded, some pessimism once again has set in. In our investment decisions, we try to look as much as possible past such factors and continue to focus on companies with strong and improving business models, quality management, sound financial structures, and proper adherence to ESG values.

Our US Conviction Score improved slightly, driven by credit spread tightening of 10 basis points (bps). The curve slope is unchanged. Our global credit forecasts are negative, and our relative model favors EM over DM. In DM, industries favored by the model are brokerage, technology, and financials. It dislikes consumer goods, as well as electric and energy. Among EM industries, the model likes consumer goods and utilities and dislikes real estate and pulp and paper.

Our global rates model forecasts lower yields and a steeper curve globally. The rates view expressed in our G10 model portfolio is overweight global duration but divided within regions. In North America it is overweight the US but underweight Canada. In Europe it is overweight France, Belgium, and Italy and underweight the UK and other EU countries. In Asia and Oceania, it is overweight Japan and underweight Australia. Along the curve it is overweight in two- and 20-year durations and underweight in six-month, 10-year, and 30-year durations.