Investment Outlook October 2024

Investment Outlook
back to Perspectives
10/2024

The First Cut is the Deepest

In September, after consumer price inflation moderated further and the labor market showed signs of cooling, the US Federal Reserve cut its key interest rate for the first time in four years. The Fed now joins its European counterparts, the Swiss National Bank and the European Central Bank, which lowered their rates in March and June, respectively.

The rate cut removed one of the major uncertainties looming over financial markets: when would the Fed reverse its interest rate policy? And when it finally did move, the Fed went big, surprising with a two-step cut of 50 basis points. We expect the Fed to adopt a more measured pace with future rate cuts—unless negative surprises emerge in the US economy. And while it was a bold move, we don’t view the Fed’s jumbo rate cut as an expression of pessimism or panic. Rather, we see it as a move to play catch-up after inflation eased unexpectedly in August.

The Fed’s rate reversal creates more favorable financing conditions in the US and globally, with emerging markets, in particular, set to benefit. And a falling interest-rate differential also should support a raft of currencies including the yen, the euro, the pound and others that have remained undervalued against the US dollar. In addition, a weakening US dollar and falling real dollar rates should also support the gold price, which reached all-time highs in September.  

The move was largely anticipated by the markets, which had already priced in looser financing conditions before the rate cut was announced, bringing financing conditions roughly in line with historical averages. Nevertheless, with a range of 4.75 to 5 percent, and considering an inflation target of 2 percent, the Fed’s key interest rate is still above the neutral real interest rate, the so-called R-star rate that neither suppresses nor stimulates aggregate demand, which is estimated to be near 1.2 percent for the US. In other words, the lower fed funds rate is still at a level that is restrictive.  

A similar situation prevails in the Eurozone, bearing in mind that the true neutral interest rate is, in fact, unknowable in real time, which assures that all attempts to define it remain controversial. Among economists, this disputatious state of affairs is known as the “R-Star Wars”. In any case, while the level of the true neutral interest rate remains debatable and varies from country to country, there is no doubt that key interest rates continue to drive markets, and now the direction for the world’s most important policy rate is clearly downward. This trend is also supported by disinflationary impulses from China, the world's largest or second-largest economy, depending on the yardstick applied, as it struggles with persistently weak demand and capacity overhangs.

We think falling interest rates will continue to support fixed-income securities with long maturities and possibly also risk assets like stocks. However, how the latter will perform in the coming months will depend on broader economic developments. If US economic activity merely normalizes from its recent heated levels (the soft-landing scenario), stocks could develop positively. But if negative surprises induce a harder landing, setbacks look likely, especially given the stretched valuations and concentration risk in the US equity market.  

Against this somewhat asymmetrical backdrop, we adjusted our tactical positioning during the third quarter to a slightly more defensive stance. In July, we initially slightly underweighted stocks on a tactical basis, and in August we raised our position in fixed income to neutral, thereby closing our slight underweight. Moreover, within our fixed income allocation, the exposure to credit risk is now at its lowest level in years as, to date, credit spreads have largely ignored high policy rates (which are now set to recede) as well as rising default rates. In sum, we think our portfolios are now well positioned for falling yields that support rate-sensitive assets and for cooling economic conditions.  

1.1 North America

  • Consistent with the improved overall business sentiment, US GDP growth picked up in Q2, moving from an annualized 1.4 percent in the first quarter to 3.0 percent in the second, driven by gains in both consumer and investment spending, while rising imports eroded domestic GDP. Hence, the US economy continued to expand faster than its long-term trend would suggest thanks to buoyant domestic demand and despite high interest rates and weaknesses in global manufacturing and export demand.
  • Throughout the third quarter, overall business sentiment remained relatively robust, with the S&P Global US Composite PMI remaining solidly in the growth zone, as improved services sentiment counterbalanced the deteriorating mood in the manufacturing sector, where the PMIs began to signal contracting business activity in Q3.
  • At the same time, consumers have continued to benefit from positive, even accelerating, real wage growth, with real hourly wages picking up from 0.7 to 1.3 percent year-over-year in August.
  • Nevertheless, cooling labor market conditions caused some nervousness as the unemployment rate rose to 4.2 percent in August, half a percentage point above the 3.7-percent low recorded in January 2024. This led some observers to invoke the Sahm Rule for declaring a recession, but we find most other indicators are still in line with normalizing conditions rather than plummeting economic activity.
  • After a brief increase in Q1, US consumer price inflation continued its downward trend throughout Q2 and Q3, falling from 2.9 to 2.5 percent year-over-year in August, mainly thanks to lower energy prices. Core inflation remained stable at 3.2 percent year-over-year. While still above the Fed’s targeted 2-percent threshold, this is nonetheless a three-year low. The latest annualized monthly Personal Consumption Expenditures (PCE) inflation rate, the Fed’s preferred consumer price inflation gauge, reached a level consistent with price stability, both the overall rate and also when excluding food and energy prices. Only services price inflation has remained somewhat elevated.
  • Accordingly, a first interest-rate cut in September was widely expected, but the double cut of half a percentage point was somewhat surprising. The Fed’s Open Market Committee’s own projections now envisage further interest rate cuts totaling 0.75 percentage points by the end of the year, at the median.

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Unemployment inches up

Source: LSEG, MFO

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PCE inflation back on track

Source: LSEG, MFO

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1.2 Europe

  • The Eurozone’s GDP grew by 0.6 percent year-over-year in Q2 after expanding by 0.5 percent in Q1, but the growth looks fragile due to its uneven nature, as declining domestic demand and lower investment spending were offset by a pick-up in net exports.
  • Looking ahead, the S&P Global Composite PMI signals sluggish economic activity the Eurozone, as it cooled at the end of September. And, beneath the surface, economic activity continues to look precarious, as growth has relied solely on the services sector, with the manufacturing sector continuing to shrink.
  • Within the European Union, reliance on export demand and manufacturing varies among the member states. Traditionally this reliance has been particularly strong in Germany, which has often billed itself as the Exportweltmeister, or export world champion. But over the third quarter, Germany saw dimming economic prospects as weak export demand was compounded by persistent structural weaknesses. The latter have led to diminished competitiveness and lagging productivity growth in Germany and the EU as a whole, especially versus the US and China. Former ECB president Mario Draghi addressed these problems in a recent report for the European Commission. The report calls for a coordinated industrial policy, a fully integrated capital market, faster decision-making and massive investment.    
  • To illustrate the gravity of the situation, pillars of German industry like VW and ThyssenKrupp are currently evaluating plant closures and restructuring measures that could potentially lead to thousands of job losses in Germany. The manufacturing slump can be felt throughout the economy as a whole. The ifo Business Climate Index fell further in August as companies’ assessments of the current situation and their expectations for the future grew more pessimistic. In addition, the improved outlook for foreign trade proved temporary according to the JPMorgan Global Manufacturing PMI, which indicated a fresh decline in incoming export orders in Q3.
  • Given this complicated economic backdrop, in September the ECB delivered an expected second cut of 0.25 percentage points to its deposit facility rate, lowering it to 3.5 percent. The easing of monetary policy conditions should provide some needed support. However, with an inflation target of 2 percent, if the neutral real interest rate, the R-star, lies somewhere between -0.5 and 1 percent, as the ECB estimated in its January Economic Bulletin, the current policy rate will still have a slightly restrictive effect.

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Recovery in the Euro Area pauses

Source: LSEG, MFO

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Germany's lagging competitiveness

Source: LSEG, MFO

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1.3 Asia and Emerging Markets

  • Throughout the third quarter, business prospects in EM economies cooled according to the S&P Global Composite Purchasing Managers’ Index, which showed the outlook for emerging economies falling behind that of developed economies for the first time since early 2022 – even though most EMs enjoyed looser monetary policy conditions earlier than their developed counterparts and stand to profit further from looser USD funding conditions following the Fed’s monetary policy pivot in September.  
  • Of course, there is great heterogeneity among EM economies. India has posted stellar economic performance figures for several quarters, while China, the world’s second biggest economy – or biggest, if purchasing power is considered – faces ongoing woes from a burst property bubble, severe debt and manufacturing capacity overhangs, demographic headwinds and a deep crisis of trust among consumers, all of which combine to hobble the economy’s necessary rebalancing towards a more consumption-based growth model. And if China’s households, companies and provincial governments are over-indebted, looser financing conditions cannot help them out of the misery of a balance sheet recession.
  • In any case, China’s official GDP growth target will hardly be reached this year and any positive impulses that China might deliver to the global economy are therefore unlikely. Rather, given the persistently weak demand and the production capacity overhang, the Chinese economy will likely – despite all the talk about the potentially inflationary effect of disrupted global trade – continue to provide a global disinflationary impetus on manufactured goods. China increasingly looks like Japan in the nineties, and, as we know, it took decades for Japan to recover from its economic slump.
  • At the same time, the global trend of trading-bloc-building and the fragmentation of the global trade order are likely to continue. However, as Donald Trump’s chances of becoming the next US president dim, so too does the likelihood that the global trading system will be further disrupted by extremely damaging tariffs. We also see a small silver lining in the WTO’s recent announcement that it will work to link climate policy with trade policy and advocate a uniform global carbon pricing system. These measures could help to prevent the current uncoordinated jumble of national climate policies from leading to even further trade barriers, competitive distortions and fragmentation of the global trade order.

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China's housing market in crisis

Source: LSEG, MFO

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Sluggish Chinese retail sales

Source: LSEG, MFO

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2. Financial Markets

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Medium-term market developments

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Source: LSEG, MFO

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Long-term market developments

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Source: LSEG, MFO

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2.1 Equites

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  • Equities experienced a volatile third quarter, with a severe sell-off between mid-July and the first week of August, followed by a quick recovery towards the end of the month. The turbulence was caused by a weaker-than-expected US jobs report stirring up market fears of an imminent recession, as well as the Bank of Japan’s tighter monetary policy stance that disrupted the carry trade and led to a 12 percent drop in the Nikkei 225 Index.  
  • The market’s fear gauge, the CBOE Volatility Index, or VIX, spiked in early August to the highest intraday level since March 2020. That said, a large part of the jump was due to a lack of liquidity and short covering and therefore the VIX quickly drifted lower, but the index remains above the levels seen for most of the year.
  • The perfect storm quickly passed, thanks partly to easing inflation and the Fed signaling for a rate cut of at least 25bps by the mid-September meeting. Earnings also held up relatively well in Q2 and are still slightly above the 5- and 10-year trends, which has helped to stabilize sentiment. Nevertheless, the market remained nervous, with earnings misses punished more than earnings beats were rewarded.
  • In Q2 2024, the S&P 500 reported earnings growth of 11.5 percent year-over-year, marking the highest growth rate since Q4 2021. Once again, the IT sector reported the strongest growth (+29 percent), followed by the Communication Services (+22 percent) and Consumer Discretionary (+18 percent) sectors.
  • In Q3, the MSCI World Total Return Index delivered a return of 6.1 percent, surpassing the performance of the Magnificent 7 stocks, which recorded a smaller gain of 2.7 percent. This shift underscores a broader market rotation from growth to value, as evidenced by the MSCI World Value Index's significant outperformance (+9.9 percent) compared to the MSCI World Growth Index (+2.9 percent), with a differential exceeding 7 percent.
  • In July, we initiated an underweight position in equities, prompted by deteriorating market sentiment, some weaker-than-expected earnings from market bellwethers as well as concerns over concentration risk and elevated valuations in the US stock market. Economic data points to a slowdown in economic activity, which suggests that the next earnings season will be more challenging. In addition, we are entering a period of greater market uncertainty with seasonality turning negative and the US presidential election only weeks away. In our view, this warrants a more cautious stance.

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VIX spikes in early August

Source: LSEG, MFO

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Gap narrows between value and growth

Source: LSEG, MFO

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2.2 Fixed Income

  • In the first half of the year, the global bond market, as measured by the Bloomberg Global Aggregate Bond Index USD Hedged, only achieved a return of 0.1 percent. Performance improved significantly at the beginning of the third quarter and the index ended the quarter up 4.2 percent thanks to significant yield declines in the US and Europe. In particular, yields on two- to five-year maturities fell during the quarter, as did yields on longer maturities, albeit less sharply, leading to a steepening of the yield curve.  
  • Since July 2022, the US yield curve has been inverted, meaning that yields on ten-year maturities are lower than those on two-year maturities. Historically, an inverted yield curve has almost always been followed by a recession, whereby in the last four instances, the recession only began after the yield curve had steepened again. At the beginning of September, yields on two-year maturities fell below those on ten-year maturities and the longest inversion of the US yield curve in history came to an end. It remains to be seen whether a recession indeed will unfold, or whether the US Federal Reserve will facilitate a soft landing by swiftly cutting key rates.
  • The reasons for the decline in yields were manifold, but it was mainly driven by weaker than expected US economic data in August, which led interest rate markets to price in the Fed’s anticipated interest rate turnaround. Specifically, inflation was softer than expected, and the unemployment rate rose to 4.3 percent. These developments were also addressed by Fed Chair Jerome Powell at the annual central bankers’ meeting in Jackson Hole, whereupon expectations for key interest rate cuts rose significantly. These expectations were met as the Fed cut the benchmark interest rate for the first time this cycle from 5.5 to 5.0 percent (upper bound) and is expected to cut an additional 0.75 percent during the fourth quarter.
  • However, while the economy appears to be weakening, as reflected in lower Treasury yields, the credit market has remained unaffected. Risk premiums ended at the lower end of their year-to-date range at 0.6 percent for investment grade and 3.1 percent for high yield, as measured by iTraxx.
  • The prospect of an imminent Fed pivot and the falling yields prompted us to close our remaining, minimal fixed income underweight and to raise our tactical bond positioning to neutral in August. In doing so, we further improved the already very high credit quality of the portfolio.  

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Yield-curve’s perma-inversion ends

Source: LSEG MFO

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US rate cut expectations

Source: LSEG, MFO

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2.3 Alternatives

Hedge funds, private markets and commodities

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  • Hedge funds had a good third quarter, according to the HFRX Global Hedge Fund Index, as they managed to navigate volatile markets profitably. Equity long-short managers started to reduce net exposure and holdings in Magnificent 7 tech stocks in July, which helped in late July and early August when markets sold off. However, it also meant that the upside capture was not as high when markets rallied after the sell-off. Overall, the alpha environment for equity strategies was more muted than in H1 as correlation increased with macro-driven markets. Repricing of interest rates curves, particularly in the US, helped discretionary global macro strategies as yield curves sharply steepened. Trend-following strategies grappled with trend reversals in a volatile environment for most asset classes and detracted from overall performance during the quarter.
  • Another quarter, another record for gold. Increasing volatility, a lower path for interest rates and a weaker US dollar made gold more desirable. However, gold was mostly range-bound for CHF investors, but still managed to set a new record at the end of the quarter.
  • The data for private markets, which lags behind data for public markets, points to a rebound in private equity dealmaking in Q2, albeit from a low base. Investors saw a rebound in exit values finally in Q2, but it remains to be seen if this marks a turning point. Fundraising for PE funds remains challenging but H1 fundraising numbers in Europe indicate that another record year could be in the making, while prices in the secondary market have recovered to long-term averages, according to PEFOX.  

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Currencies

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  • The Swiss franc continued its appreciation trend in Q3 largely driven by market expectations of further interest rate adjustments and inflation concerns in the Eurozone. Over the quarter, the franc gained 2.9 percent against the euro and 6.3 percent against the US dollar. Nevertheless, in purchasing-power-parity terms, the franc avoided significant overvaluation.
  • In July, the Bank of Japan raised short-term interest rates for the second time this year. This led to the unwinding of carry trades that had used the yen for funding. Accordingly, in September the massively undervalued yen had appreciated by more than 11.0 percent from its four-decade low against the US dollar in July. We think the yen has further significant appreciation potential against the USD.

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Gold climbs to another record high

Source: LSEG, MFO

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The yen’s comeback

Source: LSEG, MFO

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3. Investment Views

  • At the end of July, weaker market sentiment, high concentration risk and stretched valuations in the US stock market, along with our observation that negative earnings surprises were punished more heavily than positive surprises were rewarded, plus some signs of deterioration in the US economic outlook, persuaded us to adopt a more cautious stance on equities. We moved to a slight tactical underweight of the asset class as we think that risks are tilted slightly more to the down- than to the upside.  
  • At the same time, we closed our remaining small fixed income underweight in August, upgrading the asset class to neutral as the anticipated Fed pivot seemed to come closer. This step was rewarded, as Treasuries subsequently rallied and the Fed indeed pivoted to a looser monetary policy stance in September, cutting rates for the first time in the current policy cycle.
  • The Fed’s current loosening stance and the expected associated yield compression should continue to support rate-sensitive fixed income securities going forward. We also have kept the duration of our bond allocation in line with the benchmark, which currently stands at about 6.7. At the same time, as we pointed out in the previous Investment Outlook, we think that credit spreads, which have remained near historical lows, do not adequately reward investors for the risks that they entail. In fact, we think the risk/reward ratio looks extremely asymmetrical, and we therefore currently maintain our fixed income portfolio at the highest credit quality that we’ve had in years. However, we are ready to re-build credit exposure if a sudden spread-widening would make credit attractive.
  • In parallel with the increase in the bond allocation, we had reduced our overweight in hedge funds. However, we still retain a slight overweight, funded by the equity underweight. As Q3 showed once again, hedge funds manage to do well in volatile environments. Given the prevailing uncertainties about the extent of an economic slowdown and the depth and pace of future rate cuts, we think this agility is exactly what is needed going forward. Thus, for now, we prefer these flexible strategies over long-only equity exposure.
  • We also keep our small gold overweight as the yellow metal should see a boost from a weakening US dollar, falling real yields and elevated geopolitical uncertainty. However, given the fact that the real gold price is near historical highs, we think that downside risks are likely to accumulate once the Fed’s loosening stance nears its end and the associated macro tailwinds begin to fade.

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Nadja Bleuler

Chief Economist, Partner
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