Will the Goldilocks market continue in 2024?

The Santa Rally which dominated the end of 2023 has been spurred on by an even bigger anticipation for rate cuts. The RBA was not tipped to cut rates at all just six months ago. Now, thanks to an inflation print that outshone almost all expectations, the Australian rates curve has two cuts priced in by the end of 2024. And as if on cue, the ASX 200 hit an all-time high. 

And until the Federal Reserve's hawkish press conference last week, there were as many as six rate cuts priced into the US curve. Even before the Fed's meeting, the S&P 500 hit its first record close in two years.

The anticipation for cuts led to the rally which loosened financial conditions around the world. Everything rallied - from bonds to equities and especially credit where one index of IG and High Yield asset values suggests that more than US$1 trillion in value has been added just since the October 2023 low. 

So is this the Goldilocks setup for a vintage year in investing? To find out, Signal or Noise is back with its trademark combination of informative debate and investable ideas. Joining me and AMP's Diana Mousina, who returns as our resident economist for a third season are:

• Sebastian Mullins, Head of Multi-Asset, Australia at Schroders
• Craig Morabito, Senior Portfolio Manager specialising in global credit investments at First Sentier Investors

Note: This episode was taped on Wednesday 31 January 2024, and before the February Federal Reserve and RBA meetings. 

EDITED SUMMARY

Is the massive shift in rate cuts a signal or noise?

Diana: SIGNAL - The move to cuts just reflects what has been a dovish shift from the Federal Reserve since November. She believes the Australian rates markets are still under-pricing the possibility of a third rate cut by the end of 2024, which happens to be AMP's house view.

Diana's Chart: New York Fed Recession Probability

Sebastian: SIGNAL - Drawing from Diana's chart, Sebastian argues that the current monetary policy is too tight. Sebastian argues that the reason we have not seen a recession this time is due to consumer and business debts - and the way they have chosen to pay off that debt (i.e. the uptake of floating rate debt is near-30 year lows.) As for the rate cuts question, Sebastian believes the RBA will still need to consider how the Stage 3 tax cut changes may affect the inflation outlook.

Craig: SIGNAL - "It's a balance," says Craig who argues the Fed has done a great job at threading the needle. He says forward rate cut expectations "feel about right". 

Is the loosening in financial conditions worth taking note of?

Sebastian: SIGNAL - Higher interest and cash rates, soaring yields, and widening spreads all worried markets last year. Now that markets are front-running central banks, the economy now has room to recover and monetary authorities don't need to do as much to cool it.

Sebastian's Chart: Inflation pressures continue to moderate

Craig: SIGNAL - Corporates are now able to fund and plan CAPEX investment at lower levels. The outlook for lower defaults and stronger fundamentals is a coincidental but very welcome signal to invest in risk assets like credit and equities.

Diana: SIGNAL - Diana agrees with Craig but argues that it's more of a short-term signal. In the medium term, it's hard to determine whether these conditions have a lasting impact.

Will we see a credit crunch this year?

Craig: NOISE - A credit crunch is a very serious event and there just aren't the fundamentals to hint at such a scenario. "Corporates are faced with more willingness than ability," as Craig puts it. When the ability to plan and make investments starts to turn, that's when you can start to be concerned. 

Craig's Chart: Credit spreads since 2001

Diana: NOISE - While specific sectors may come under pressure (with the banking crisis being a symptom of that), there is no evidence of excess build-up in any of the major economies. 

Sebastian: NOISE - High-quality consumers and corporates have been mostly insulated from credit risk. For instance, 30% of technology companies earn more on their cash than they pay out on their interest. A perfect example of this is Apple (NASDAQ: AAPL), which issued a 4.3% yielding bond in 2021. They now have $200 billion in spare cash, earning more than 5% in interest to use when it needs to.

How are these investors now positioned ahead of 2024, given what has been discussed?

Diana - The teams are invested neutrally for now. You can still have a rally in share markets up until the point that the recession becomes clear. There are a lot of risks this year, perhaps even more than last year, but we don't have the confirmation of a recession. As a result, there is still a sizeable allocation to equities.

Sebastian - There was a lot of cash (30%+*) in 2022 but that cash is now fully deployed. Between credit, equities, and government bonds, the teams are positioned neutrally. Having said this, the rally in credit spreads has Sebastian wondering when it would be safe to take profits on credit investments and shift them into equities instead. They also have an allocation to put options in case of sudden equity market downside.

*This figure is derived from when Sebastian's colleague Simon Doyle appeared on Signal or Noise last year. You can rewatch that episode here:

Macro

Why the ASX is trading like a recession is coming (and the NASDAQ isn't)

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Craig - Taking an overweight in credit risk is justified, in his view, given spreads will likely remain tight for a long time. This includes high yield where fundamentals are much healthier and defaults are comparatively lower than where they were in the last economic cycle. Craig's teams are underweight in the more volatile areas of the credit market.

Signal or Noise returns on March 4th to recap the February Reporting Season.