Cross-Asset Quarterly Outlook

March 2024*

Balancing the Short and Medium-term Signals

  • Recent activity data sends a more supportive short-term signal for global equities relative to the bonds.
  • However, we continue to hold a more cautious 12-month outlook, favouring fixed income relative to equities as growth and inflation slow, and valuations for global equities are less compelling.
  • Intra-equities, the environment is more supportive for Emerging Markets (EM) due to robust advanced semiconductor demand. We add to our OW exposure (funded by a downgrade to the UK).
  • We increased our US TIPS exposure in fixed income given the attractive real yield. We reduced our OW exposure to IG bonds as spread levels have tightened closer to previous cyclical lows.

The global economic backdrop has started the year relatively strong. The global composite PMI index has risen this year to an expansionary 52.1 level, and the improvement has been broad based. The US, Europe, and China composite PMIs rose over the past six months. Historically, positive macro momentum tends to be associated with short-term strength in equities. As a result, we believe an overly bearish stance towards equities is premature.

However, our more cautious outlook is unchanged. Valuations are unattractive for equities and high-yield (HY) credit, and there remain lingering signs of late-cycle risks that argue for maintaining our neutral equity stance. On valuations, the MSCI All Country World Index (ACWI) forward P/E is currently 18x (above its 10-year average of 16x), and the US equity earnings yield spread to the 10y US Treasury yield remains around the tightest levels since the early 2000s (chart 1). In HY credit, the Bloomberg US HY Index trades at a spread of 315bps, close to the previous cyclical lows. This spread tightening contrasts with rising corporate default rates. There is a risk that we are underestimating the resilience of the business cycle; however, there is also evidence that markets are already priced for the optimistic scenario. 

Regarding late-cycle risks, monetary lags are still feeding through the economy, and fiscal policy and excess pandemic savings should become less supportive. Also, we note that the US unemployment rate has risen over the past year, and the unemployment rate is below previous troughs. Historically, the unemployment rate is either rising or falling. Post-WWII it has never stayed flat for an extended period. Rising unemployment typically precedes a recession, and equity markets, on average, peak about six months before the onset of a recession based on data since the 1960s. Every cycle is unique, and this time may be different, but we believe a neutral equity exposure remains appropriate despite recent activity data improvement.

With this backdrop in mind, we still see opportunities. The growth in Artificial Intelligence (AI) is a structural trend, and investors should look for reasonably priced assets to gain exposure. We increased our overweight to EM equities, which include key semiconductor stocks in Taiwan and South Korea. EM earnings growth is expected to outpace DM this year, and valuations remain modest at a 12x multiple. In fixed income, US TIPS look attractive with the real yield currently trading around 1.83%. Inflation has moderated from elevated levels over the past year, and we do not expect a sharp reacceleration. Still, the 10y breakeven is around the middle of its historical range at 2.32%. It offers reasonably priced protection against two potential risks: 1) a further escalation in the Middle East region resulting in higher oil prices, and 2) the re-election of Donald Trump. The latter risk may cause markets to doubt the credibility of the Fed’s 2% inflation target if the fiscal deficit widens further and the Fed’s independence is challenged.

Chart 1: S&P 500 Earnings Yield Spread, % pts

Source: Bloomberg

Chart 2: Asset Returns, Dec-Feb, %

Source: Bloomberg

*The publication reflects asset performance up to February 29, 2024, and macro events and data releases up to March 6, 2024, unless indicated otherwise.

The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.