From a tactical viewpoint, the 10-year yield isn’t quite as high versus the fed funds rate as it typically is at a turn in the cycle, so yields could still rise. It’s a commonly held view that the odds are better that a larger-yield move will be down, increasing the potential benefit of adding duration relatively soon. However, the yield curve is still flat, so the “risk” of continued strong economic growth would make equities and short duration more attractive. And the dispersion of potential macro outcomes is unusually wide right now.
We think the tactical view could come down to the odds that growth slows. If this is the case, our tactical earnings indicator is consistent with a remarkably soft landing and US earnings growth of 9% one year forward. In other words, the bottom-up consensus could be right—but it depends on strong consumer data.
The strategic duration case is mixed. It presents a more attractive entry point than at any time in the past two years, but what about a longer horizon? The violent yield surge has spurred questions about whether “bond vigilantes” have returned, which really refers to the net supply/demand outlook for sovereign bonds. From an asset-allocation perspective—where the decision is about one asset class versus another rather than an asset class in absolute terms—it’s interesting how this balance stacks up versus equities.
We think buybacks exceeding issuance will be the main determinant of net equity supply/demand, so the net supply of public equity in the US should fall by about 3.4% in the next five years. Bonds face the opposite situation: demand from foreign investors could fall, as might strategic allocations from inflation-sensitive investors. A high and growing primary deficit will boost the supply of treasuries at a time when the Fed continues to shrink its balance sheet. As a result, we expect a net increase of about 17% in US bond supply over the next five years.
It's debatable how much the supply situation has driven the latest bond-market moves, and net supply/demand doesn’t directly affect bond or stock valuations, but we think it’s an important aspect for asset allocation over the next five years. Investors face structurally higher inflation and the potential that sovereign bonds will be less effective diversifiers. So, in absolute terms, the case for government bonds is stronger than it was a year ago, but their relative attractiveness in a portfolio that must beat inflation over a long horizon is moot.
2023 Has Been Bad for Active Equity So Far—What’s the Prognosis for 2024?
The past 12 months have been tough for actively managed stock funds, in part because of strong returns from US mega-cap tech firms. A right-hand skew to cross-sectional returns is not unusual and typically benefits skilled managers, but it becomes a problem if the very largest companies lead.
We won’t call a tactical turning point in the leadership of tech mega-caps, but the valuation of the 10 largest stocks versus the rest of the market is far beyond the bounds of previous experience and unlikely to last over strategic time frames. The average pairwise correlations of both global stocks and factors are low (Display), which is somewhat surprising given that correlations tend to be elevated when macro uncertainty is high.
