Markets Update - December '23

Like what you're reading? Share us with a friend.

IN THIS PUBLICATION:

• November marked one of the most significant reversals of investor positioning in recent years.

• Volatility is now at the lowest level since January 2020.

• Wall Street 2024 outlooks generally advise moving out of cash, adding duration risk, and expect limited upside to equity markets after the recent move.

Life After the Big Melt-Up

In aggregate, US stocks, cash, long-term treasuries, and high-yield bonds, saw the biggest monthly rally since 2008 this past November.

Jim Bianco put the magnitude of the rally into context by saying that “November’s record easing of financial conditions was the equivalent of 90 bps of Fed cuts.”

Where We Are Now:

• Before the melt-up, and as we laid out in our October Research piece, Wall Street was significantly short both bonds and equities. This meant there was a huge amount of potential demand that would turn equity and bond positioning around if the market started to move higher (the definition of a short squeeze or melt-up).

• That happened, and post melt up, positioning in equities has turned bullish, with Wall Street now being net long US equities after the largest monthly buying of US equities that Goldman’s Scott Rubner has ever seen. 

• Global equity funds saw the largest volume of inflow in 18 months – this means that retail is also coming in to support the market.

• On the bond side, positioning is still short, but the size of the short position (was the largest ever in October) has halved over the last month reaching $178bn globally.

• As Goldman put it: “GS Research Sentiment Indicator (SI) has gone from flat / slightly negative to "stretched" in a short period of time. The Sentiment Indicator tracks investor positioning across the more than 80% of the US equity market that is owned by institutional, retail and foreign investors.”

• Volatility has collapsed and is now at its lowest level since January 2020.

• All of this bullishness has continued this past week as Central Bankers (especially the Fed) came in more dovish than expected.

• The Fed’s dot plot caused most of Wall Street to believe that the Fed Put is now in place - which logically led the Nasdaq 100 to new all-time highs. As per John Authers: “Three months ago, 10 members thought the fed funds rate would still be above 5% by the end of next year. Now only three think that. The median estimate has dropped by a full 50 basis points, and there is one outlier who thinks that it will drop below 4%. The members also seem confident that there’s no recession coming next year.”

Looking Ahead:

• The market is now expecting the first rate cut to happen in March 2024, 8 months after the last rate hike. That’s broadly in line with the last four hiking cycles, where the first rate cut happened on average almost 9 months after the last rate hike.

• In the short term, the flow of funds into and out of mutual funds carries a lot of weight for the direction of the market, and we saw this weight being thrown around in October, which was the year-end for $1.8 trillion worth of mutual funds.

• Year-end typically sees funds selling their positions that are lagging to harvest tax benefits. The second half of December will see mutual funds totaling $1.5 trillion in assets reporting their year-end as well – so for the same tax harvesting reason, this could be a significant headwind.

• Longer term, the Fed’s balance sheet is down by $1.2 trillion since April 2021, but still has $3.6 trillion to go to unwind the COVID-led increase in total assets. More importantly, we saw a breakdown this year in the correlation between the Fed’s balance sheet and the performance of tech, in a stark reminder of why past performance is never indicative of future results. The closing of the gap is something to watch for in 2024.

There’s a lot of good news baked into market prices right now… What is Wall Street expecting out of 2024? (We’ve included most of the reports summarized below in our Research Library - you’ll be able to access that through our referral program, so keep an eye out for that).

Goldman Sachs

• Believes a soft landing has been achieved, and the odds for a recession in 2024 are no higher than for a typical year. This view, however, is mostly already baked into today's prices, so they expect modest returns for equities, credit, and bonds. Commodities are their preferred asset, with significant upside risk to oil prices given geopolitical uncertainty.

• The return of real yield is here to stay, and this will force more disciplined capital allocation (yeah, right…). But weaker inflation should still allow for a milder version of the “Fed put” to take place (rates should still settle higher than inflation unless the economy underperforms).

• There’s a preference for US assets given their resilience in a higher rates environment and stronger economic growth.

• Goldman likes adding duration risk into 2024, especially after two years of negative bond returns. “Longer-dated yields above the cash rate would make the case for adding duration simpler, so the market may need to reach that point before sustained buying emerges, particularly if worries about the fiscal outlook require a larger premium than we expect.”

• On the equities side, they recommend a barbell approach: a mix of Magnificent 7 companies (outperform in a world of higher for longer rates, which given the latest FOMC meeting may not actually be the case) and high-quality companies that trade at reasonable valuations and that should be rewarded if the economy picks up (read cyclical names).

JP Morgan

• Contrary to Goldman, they’re a bit more skeptical about the soft landing narrative – and their year-end S&P 500 target price reflects that. They believe that the resilience of the economy is mostly due to the lagged effects of monetary policy and that even rate cuts won’t help the economy in 2024.

• They expect the economy, when it turns, to do so quickly. “Averaging the last 12 recessions, US GDP growth in the quarter prior to a recession was 3% in real terms and 7% in nominal terms. Forecasting the direction of economies is hard, but forecasting the timing of a recession is even harder.” They expect the Fed to start cutting rates later than what consensus does, but once that happens, the pace will be more accelerated than what consensus has baked in.

• They are worried about consensus forecasting margins rising back to record highs in the US and staying close to record highs in Europe and the UK. For that reason, they have a preference for companies that can really defend those margins (this should not be limited to tech, but also includes industrials and financials).

• They like European stock exposure relative to the US given the 30% discount to the S&P 500 (levels last seen in the aftermath of the GFC), the fact that most of the Recovery Fund has not yet been spent (see chart below), that 60% of European revenue comes from outside of Europe, and that Europe doesn’t have concentration risks like the Magnificent 7 in the US.

• Lastly, they presented us with a neat chart that explains why cash is not the best option for 2024.

Morgan Stanley

• Mike Wilson’s bear calls for 2023 didn’t work out. To be clear and in his defense, he wasn’t wrong on earnings estimates, but rather on year-end multiple (expected it to be 17x earnings, which made sense in a world of 4%+ rates, rather than closer to 20x where it currently stands).

• Morgan Stanley prefers US exposure over Europe and Emerging Markets (like GS, and differently than JPM).

• They expect US earnings to grow in 2024 but the multiple to normalize, so equity markets should be broadly flat. They expect the equity market to broaden its sources of returns, especially in the second half of the year, which should be positive for non-Magnificent 7 companies that have lagged in 2023.

• Interestingly, Morgan Stanley is significantly underweight commodities, claiming that gold is overvalued, that oil will trade at flat prices, and that copper could be the only exception in case we see an acceleration of economic growth.

Fidelity International

• They oppose the soft-landing narrative (20% probability in their view) like JP Morgan and expect a cyclical recession in 2024 (60% probability). “The buffer of savings built up by households and the corporate sector in the pandemic is almost drained, fiscal support should narrow, and there is likely to be a pick-up in refinancing needs at a time of credit tightening across the board.”

• They like high-quality mid-cap stocks in the US that have not shared the upside of the Magnificent 7 and believe that some Emerging Markets still pose attractive opportunities (India and Indonesia are less tied to the global economic cycle).

• In Europe, they favor financials given attractive valuations and they look unfavorably to the UK given the high prevalence of energy and mining companies there (20% of the market cap), which is another way of saying that they’re also not excited about commodities.

• Lastly, they describe a cyclical recession as a goldilocks scenario for Real Estate in Europe: “A small amount of inflation is positive for real estate. Furthermore, given that property prices have already adjusted (particularly in Europe and especially in the UK), and if interest rates have peaked, then there would only be upside to come. There is already a good balance of supply and demand across European markets, meaning 2024 should prove to be a strong vintage to invest in real estate.”

UBS

• They argue that investors should reduce cash holding and move into duration assets, especially high-quality bonds. “We see value in the 1- to 10-year duration segment, and particularly the 5-year duration point. We believe this middle part of the yield curve offers an appealing combination of higher yields and greater stability than the longer end, as well as some sensitivity to falling interest rate expectations. We are somewhat more cautious on longer-term bonds due to their greater sensitivity to technical factors, including currently high Treasury supply.”

• They have a preference for EM stocks and see the UK as their least favorable geography amongst major economies. Overall, the focus of equity allocation should be on “quality” names – which, again, means companies with strong return on capital and healthy balance sheets (the opposite of what SPACs were). “Quality stocks typically have higher valuations than the overall index, but we think that quality is worth paying for in 2024.”

• They see trading opportunities within currencies (table below), expect oil to trade in a $90-$100/barrel range (so below that range is an opportunity to be long and above to be short), and gold to hit all-time highs by end of 2024 at $2,150/oz.

What all of this means is up to you – as always, there’s an argument to be made for trades in any direction. Consensus seems to be that equities upside is rather limited, that commodities offer good trading opportunities (both on the long and short side, depending on your view), and that replacing cash with duration assets might be a good idea before the Fed starts implementing cuts.

Wishing you all the best of luck for 2024.

• If you've been reading us for a while, you know we like The Daily Upside. The daily finance newsletter helps us with idea generation, without having to deal with clickbait headlines and biased commentary from another journalist - these are real-world analysts and researchers. That's why they've grown to over 1+ million readers. Highly suggest you check them out here.

Thanks for reading through! Obviously, none of this is investment advice.