What’s likely in store for markets in 2024?

A good gauge of the health of the global economy is our heatmap of the Markit PMIs, which represents the makeup of the respective business sector for the private sector across the world. The heatmap uses colour to simplify the global manufacturing story. Green is good, yellow is neutral, and red is bad.

The table gives a two-year snapshot of the global economy. U.S. and global economic activity are slowing materially and are now indicating an elevated risk of a recession. As long-term investors, we think this “recession or no recession?” framing is unhelpful at best and, at worst, can stand in the way of investment returns. Instead, a more thoughtful approach is needed.

While we believe that we’re likely to experience a slowdown in the early parts of 2024, a resilient U.S. consumer, tight labour market versus history, and stable corporate balance sheets should result in a shallow slowdown.

For a deep dive into our team’s broader macroeconomic trends for 2024, click HERE to read more.

Has the fight against inflation been won?

A material and global disinflation took hold in 2023, but 2024 will likely show that the last leg of the inflation battle is more difficult because central banks will, in our view, ultimately begin easing before inflation definitively returns to target, thereby risking a reacceleration in demand and a possible reemergence of mild inflationary pressure.

Central banks are faced with an uncomfortable predicament: Do they ease in the face of deteriorating growth despite the likelihood that inflation is still materially above target? We expect that, ultimately, they'll concede that their blunt tools aren't the right ones to solve this environment and that they’ll ease into a recession providing tailwinds for bonds.

This realization will likely be driven by the very nature of present-day inflation: Central bank tools are designed to cool demand-driven inflationary pressure but are less effective against supply shocks, regardless of whether these shocks are caused by enhanced pandemic-related protocols, climate change, or geopolitical tensions. Certain central bankers have already conceded the point, outlining their constrained ability to countermand external shocks.

The consequence of this dynamic is that policymakers are likely to relent in the face of weaker growth and choose to reduce restrictive policies to counterbalance a softening economy.

What is the outlook for equities in 2024?

Over the near term, we continue to expect a similar environment for equities as we outlined in our Q3 2023 themes, where investors should prepare for near-term volatility amid uncertainty. When looking at return potential for equities, it’s important to look at both earnings and valuation; however, now is not the time to feel paralyzed as an investor. In fact, historical performance would suggest that this could be an opportunity for investors.

What will the earnings environment look like in 2024?

We expect earnings growth will likely be a source of concern for equity markets during the early parts of 2024.

Despite sluggish revenue growth in the back half of 2023, earnings proved to be resilient and surprised to the upside as executives were able to implement expense management initiatives. Moving forward, earnings growth is unlikely to benefit from further expense management, leading to S&P 500 Index profit margins likely to come under pressure from current elevated levels of nearly 12.0%. The fear is that margins will be squeezed by higher wages, elevated levels of interest rates, and slower growth.

We believe that margins are more likely to face pressures from slower growth rather than high wages and price pressures. U.S. wages have already begun trending lower measured by the Federal Reserve Bank of Atlanta’s Wage Tracker that peaked at 6.7% growth during the summer of 2022 and has fallen to 5.2%, and they’ll likely decline further in 2024. While interest costs are higher now than two years ago, high interest rates aren’t the largest or most material problem for most companies thanks to strong balance sheets: almost half of the outstanding debt of S&P 500 Index companies ex-financials mature in six-plus years. We believe margins are most vulnerable to a slowdown in revenue growth versus an increase in wages or interest-rate expenses. As a result, we believe earnings growth will be flat to slightly negative during the first half of the year.

In this environment, stock selection will remain key and may present important opportunities in 2024. Look no further than the most recent earnings cycle where the market rewards S&P 500 Index companies with positive earnings surprises (more than the average) and penalized those with negative earnings surprises (more than average).

How are valuations going into 2024?

When we look at valuation, we tend to look at it through the lens of the current levels of the 12-month trailing price/earnings ratio relative to the 20-year history for various indexes. That gives a good gauge of whether they seem overly expensive, fairly valued, or cheap. Given that we expect a weak earnings environment over the near term, it appears that valuation has shrugged that off in North America as it’s relatively in line with long-term averages. While in Europe and the emerging markets, even though valuation looks attractive on an index-level basis, there remains some concern over the economic and geopolitical environment; sometimes, an index is cheap for a reason.

It's important not to take this relative valuation picture simply at face value. For example, the S&P 500 Index looks moderately expensive; however, much of that is driven by the top 10 companies. If you stripped those out, you would be closer to 19 times trailing, which is much more in line with fair value.

When looking at the relative valuation and the underlying risks and opportunities, we believe that this environment is much more conducive to individual security selection rather than investing purely on an index-level basis. It also points out the need to be diversified geographically but doesn’t suggest that one area of the world is poised to materially outperform another.

What is the outlook for fixed income in 2024?

Coming into 2023, many (us included) thought that the environment was ripe for bonds to reverse course from the negative returns of 2022. For much of the year, that wasn’t the case as the U.S. Federal Reserve (Fed) raised rates to 5.5% and the 10-year U.S. Treasury yield hit 5.0%, its highest level since the financial crisis. We believed the opportunity for bond investors was delayed, not destroyed, and has been a test of patience. The performance in the fourth quarter of 2023 has followed the historical path that shows it’s a good opportunity for bond investors when central banks have stopped raising rates and government bond yields begin to come off their peaks. We don’t believe that is time to abandon bonds in a portfolio.

Have yields in the United States and Canada peaked?

During the summer of 2020, yields set lows of 0.5% and have marched higher in line with central banks raising interest rates. We believe that yields have likely peaked in this tightening cycle in the United States and Canada as central banks are unlikely to be raising rates into a slowdown in 2024.

Historically, yields typically peak in and around when central banks pause raising interest rates. In the last six U.S. interest-rate tightening cycles since the early 1980s, typically, four out of the six, the 10-year peaks roughly 3 months before the last Fed hike. In one instance, they peaked almost simultaneously, while in another, the 10-year peaked roughly 1 month after the last Fed hike. Overall, we believe it’s safe to assume that the 10-year typically peaks a few months around the last Fed hike.

In addition to central bank policy, the 10-year U.S. Treasury yield has been inversely correlated with the direction of U.S. manufacturing. Despite a sluggish manufacturing backdrop, yields haven’t reflected the weak backdrop. Typical leading indicators of manufacturing, including new orders placed by manufacturing, suggest that manufacturing is unlikely to pick up materially in the near term. We believe that the current gap will close, as a result of yields falling versus manufacturing picking up.

For the first 10 months of last year, hawkish central banks, uncomfortable increases in inflation, and resilient economies (and some technical factors related to the supply of U.S. Treasuries) led to an increase in yields. These factors are now reversing and the end of central bank rate hikes will likely push yields lower in 2024.

Is this the year that patience pays off for bond investors?

Last year, we outlined how we believed the bond opportunity would unfold over the course of the next few years, in our article, "The three phases of fixed income investing.” The first phase, “clipping the coupon,” continues to serve investors well, as yields are materially higher than where they were at the beginning of 2022.

Now that we believe peak yields are behind us and that the market is now looking ahead to cuts by the Fed and Bank of Canada, among others, it may be time to transition into phase 2, where “duration is your friend.” Tactically adding duration to bond portfolios can improve the return potential as yields fall.

Calculating future bond returns is very complex as there are many factors at play: yield, duration, convexity, roll, and so on. First, we need to understand that price and yield have an inverse relationship, so when yields fall, bond prices generally rise, and vice versa. The same way that rising yields are a headwind to performance (as in 2022), falling yields can be a tailwind. Second, we need to know that duration is the sensitivity of bond prices to a change in yield. The longer the duration, the more sensitive the bond is to a change in yield. For example, a bond with a duration of five years will increase in price by approximately 5% if the yield drops by 1%.

Investing is probability based. There are no guarantees of future returns, so investors need to weigh the upside and downside risk and understand the probabilities of each. Since we expect yields to fall over the next year, investing in longer duration bonds is starting to look very attractive, especially from a risk/return perspective.

Maybe, it’s time to start moving the phase 2 of our three-phased approach to bond investing, where duration is your friend. It appears that patience is finally paying off for bond investors.

Source: Bloomberg, Manulife Investment Management, as of 11/2/23.

Will the U.S. election have an impact on equity markets?

2024 is set to be one of, if not, the busiest years for elections around the world. According to Bloomberg Economics, voters in countries representing approximately 41% of the world’s population and 42% of its gross domestic product have a chance to elect new leaders this year. Of course, the one that Canadians are mostly focused on is the one in November south of the border.

While it’s far too early to start predicting outcomes (it’s currently a dead heat by the way), we can still look at history to see how the S&P 500 Index fared on average in the 12 months following an election under different combinations of government.

We examined the calendar year returns (including dividends) for the S&P 500 Index going back to World War II.  Since 1945, there has been a clear stock market favourite at the party level. The S&P 500 Total Return Index averaged gains of 14.37% in years where the sitting president was a Democrat, and 10.76% when a Republican was in office. The average for all years 1945 to 2022 was 12.52%. Not surprisingly (or maybe surprisingly for some), the average returns aren’t widely different under different party leadership.

While the next 12 months will be littered with election headlines, from a broad market perspective, it‘s mostly much ado about nothing. If anything, it’ll likely be disruptive rather than destructive. Recent history should also have taught us not to try and predict the market’s reaction to one outcome or the other.

Source: Bloomberg, Manulife Investment Management, as of 12/31/22

Will markets be influenced by potential geopolitical risk?

Skittish investors who have been nervous about potential policy mistakes by the Fed have also been losing sleep over the Middle East conflict that erupted in October, in addition to the ongoing situation in Ukraine. These two events will likely contribute to volatility in the short term.

From a market perspective, if we were to restrict our observations to the performance of key stock indexes during periods of conflict, it’s fair to say that geopolitical events tend to create short-term volatility but seldom leave deep scars over the longer term.

This observation stacks up mathematically: Looking back at the past 24 material geopolitical events, using the S&P 500 Index as a proxy for the broader market, we can see that, on average, the index sold off approximately 5% around the time these events took place, but was able to recover after 40 days. This seems to suggest that the stock markets are typically able to take these events in their stride and that negative sentiment arising from these conflicts aren’t likely to linger. Things, however, might be changing.

In our view, geopolitics now play a much more prominent role in the financial markets. As the world retreats from globalization and embedded within that, with the idea of intertwined economic fortunes, we might need to rethink the lens through which we’ve understood the correlation between geopolitical conflicts and the reaction function of the markets. The growing incidences of these events in recent years might suggest something has shifted. From a purely economic perspective, we’d be remiss not to recognize that these events could depress global growth and price pressures in ways that may not be observable yet.

Source: Deutsche Bank , As of December 31, 2023

What’s your outlook for the Canadian Dollar? Will the loonie soar again?

From our point of view, although we don’t expect material upside, we don’t see material downside either. We’re likely to see the Canadian dollar remain in a tight trading range over the near term.

Historically, there have been two main drivers over time of the CAD/USD exchange rate: oil prices and the spread between the two-year Canadian government bond yield and the 2-year U.S. Treasury yield. However, we’ve seen these correlations break down over the past few years as more factors have been influencing short-term movements.

Given that we expect the Bank of Canada to cut yields earlier and slightly faster than the Fed, coupled with a potential risk-off rally, there could be near-term weakness for the Canadian dollar. That being said, we expect a migration closer to a fair value in the mid-70s over the course of the year.