Portfolio Positioning Primer: 2024

By: David Marra, Managing Director

Markets are evolving rapidly, shaped by many factors from earnings and geopolitical events to inflationary pressures and the ever-present risk of recession. For wealth managers and investment advisors, these shifts create opportunities and challenges. It is essential to understand how current events impact multi-asset portfolios and what investment strategies can be implemented to optimize yield and mitigate risks.

The Global and US economies have outperformed even the most optimistic of expectations for 2023. Globally, GDP growth will likely beat consensus forecasts from a year ago by a full percentage point and US GDP growth will likely beat by two full percentage points.

The still incomplete and continuing normalization of product and labor markets provides for continued disinflation next year and a strong case for US rates having now peaked. Across most developed economies, core inflation has fallen from about 6% in 2022 to around 3% today. More disinflation is coming down the pike with core perhaps reaching between 2% to 2.5% by the end of 2024 and, if achieved, would represent nearly complete normalization.

Will High Interest Rates Cause a Recession?

A recession in 2024 seems less likely than moderate growth for the following reasons: growth tailwinds for 2024 include less drag from monetary policy, strong household income growth, a recovery in manufacturing and greater central bank willingness to cut rates as growth slows.

A looming question for investors has been: with the elevated interest rates that come with cooling the economy and inflation, does this induce a US recession? The concern is real. It appears that some parts of the Eurozone, Germany for example, may already be in recession.

A recession in 2024 seems unlikely for the following reasons: growth tailwinds for 2024 include less drag from monetary policy, strong household income growth, a recovery in manufacturing and greater central bank willingness to cut rates as growth slows, particularly if it slows markedly. None of this rules out a recession – recessions are devilishly difficult to predict – but the risks are skewed to normal levels of growth in 2024. When rates cuts do arrive, barring a recession of course, they probably won’t arrive until the second half of next year.

What is the Greatest Risk to Global Growth?

An escalation of the war in the Middle East that interrupts energy shipments could lead to sharply higher oil and gas prices that would reduce global growth.

Despite the generally optimistic picture, equity, bond, and commodity volatility all remain elevated, evidence of market participants seeing elevated macro risks. We are in a period of elevated geopolitical tensions.

An escalation of the war in the Middle East that interrupts energy shipments could lead to sharply higher oil and gas prices that would reduce global growth. The Ukraine/Russia conflict and US/China trade decoupling further elevate geopolitical uncertainty with the potential for economic spillovers that impose drags on growth.

What is the Current Investing Environment?

Rates are firmly in positive territory, real yields have climbed to normal levels, and deflationary risks appear to be very low. The investing environment looks more normal than at any point in the last 15 years.

The Global Financial Crisis (GFC) of 2007/08 established a very particular type of global economy that endured until the covid crisis.

The post-GFC environment was characterized by low inflation, near zero federal rates, and low yields that were negative in real terms. During this period the annual Federal Funds Rate averaged a mere 0.58%. Former Treasury Secretary Larry Summers coined the term “secular stagnation” to describe that era’s inescapable march toward low inflation and even lower global yields. Investors called it a liquidity trap and Japan became the liquidity trap poster child with two decades of negative real rates, deflation and growth stagnation.

Well, we’re not in Kansas anymore.

Despite a pretty bumpy ride, covid-induced global supply shocks combined with several federal helicopter money drops and the reemergence of inflation have allowed markets to break from the liquidity trap of the post-GFC era. Rates are firmly in positive territory, real yields have climbed to pre-GFC levels, and deflationary risks appear to be very low.

In fact, the investment landscape looks more normal than at any point in the last 15 years.

Real yields are back. The outlook for yields is one that investors could only dream of for most of the period since 2008. The key challenge for investors now is how to construct portfolios to earn these higher yields with the right mix of exposures to tail risks.

Assets in Play: Equities, Bonds, Credit, Commodities

In the current investment climate, with real yields on core assets nearing pre-Global Financial Crisis of 2007/2008 averages, institutional investors find themselves in an enviable position. Expected returns on equities, fixed income assets, credit, and commodities all look healthy for once in a very long time.

It’s tempting to include cash in this list but while the return on cash remains high, it is hard to see cash outperforming other asset classes over the next year and even harder to see it outperforming over a longer period.

The Tail Risk Role of Asset Classes

Each asset class provides insurance against a specific tail risk. Equities should outperform in the coming year if rates decline faster than expected or generative A.I. provides more earnings boost than is currently priced in.

Bonds are likely to outperform if the risk of recession rises, encapsulating the “higher-for-longer” tail risk, or as inflation falls. The energy sector should outperform if global growth surprises on the upside or in the event of supply disruptions due to geopolitical events.

More Balance Than Last Year

Given the potential of multiple asset classes to outperform, this suggests that a more balanced asset allocation should replace the emphasis on cash that prevailed in 2023.

For investors who are more concerned about the likelihood of recession and rate cuts, overweighting bonds and duration while underweighting equities would be sensible. For those with access to margin and worries about the risks of duration, levered positions in shorter maturity bonds can achieve a similar exposure profile.

Investors with a positive outlook on growth may find it sensible to increase their allocation to risky assets like stocks and commodities while reducing exposure to fixed-income duration.

The Case for Caution

Despite the growth obstacles posed by increased interest rates and geopolitical risks, the main reason why shifting to more balanced allocations might be premature is this: the possibility that improved growth, sustained inflation, and weakened fiscal positions will drive yields higher and valuations lower. These concerns are likely to persist in the short-term, at least until inflation subsides sufficiently to alleviate them.

Investment managers must remain vigilant and flexible, ready to adjust as market conditions evolve. As always, the goal is not just to earn a higher yield, but to do so while effectively managing risk.

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