Knut Hellandsvik*, Head of Equities at DNB Asset Management
Prior to providing any predictions for the coming year, it is worth taking a brief look at how the current situation at the stock markets developed. The last three years have been anything but ordinary. We have seen a global pandemic, a mini banking crisis and an AI-driven tech bonanza. In addition, two wars have started and the geopolitical situation looks more worrying than it has for decades. In terms of equity markets, the pandemic and the forceful fiscal and monetary measures taken by authorities around the world have had the biggest impact on financial markets. With hindsight, we can see that the Covid stimuli were too strong, as they led to an overheating of the global economy and thus to a massive rise in inflation. As a countermeasure, the central banks had to introduce the most aggressive interest rate hike program in decades, which is now taking effect. In recent months, a significant decline in inflation has been observed, which has been accompanied by a massive fall in long-term interest rates and caused the MSCI World to rise by over
9% in November alone.
Against this backdrop, global equity markets have performed relatively well. Since the beginning of 2020 (before the Covid-related lockdown) until today, the MSCI World has risen by 26 %, led by the US stock market. The S&P 500 has gained 36% and the Nasdaq 45% over the same period. Beneath the surface, however, we are seeing a very concentrated market - typically a worrying sign. The US hasn't seen a market this tight since the 1970s, and the so-called Magnificent Seven (Apple, Microsoft, Meta, Alphabet, Tesla, Nvidia and Amazon) now constitute a whopping 28% of the S&P 500. The combined market capitalization of these stocks has risen by more than 100 % this year, while the equally weighted S&P 500 index has only gained 6 %. The Russell 2000 Index, which comprises the smallest 2000 companies in the Russell 3000 Index, has also risen by a meagre 6 %. More than 40 % of the shares in the S&P 1500 Index fell over the course of the year.
Many therefore believe that the next rally in the global equity market should be led by underperformers such as small caps, emerging markets and China, banks and value. We are cautious to support this thesis as we also see headwinds for the equity market in 2024:
Economic deceleration: In the post-pandemic world, economic growth has performed better than expected for 2023 - led by record low unemployment, real wage growth, a solvent consumer and strong post-pandemic order books. For the coming year, we expect weaker economic growth, as indicated by the global purchasing managers' indices, as well as extremely restrictive monetary and fiscal policy.
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Excess savings disappear: The excess liquidity that households gained during the Covid period is shrinking fast. JP Morgan estimates that the excess cash is now mainly held by the relatively wealthy Americans (top 20%), while the real liquidity of the middle class (top 20% to 60%) is falling back to pre-Covid levels and the bottom 40% are even worse off.
Dwindling liquidity and weakening credit markets: The money supply is shrinking in both the US and Europe. Banks are tightening their lending standards for both consumers and companies, and financing costs continue to rise. Credit card delinquencies are increasing and the commercial real estate market is weakening, while significant maturities are due in 2024. Default rates are also rising for syndicated loans.
Higher for longer? Fed Chairman Powell has always emphasized that interest rates will rise for a longer period of time. Yes, the inflation rate has come down significantly, but with the market now expecting 130 basis points of Fed cuts next year, one can wonder if the market is ahead of itself? Such a massive cut will only happen if the US economy is in trouble, which would not be good news for the stock market, or if inflation continues to plummet, which we think is unlikely.
Pressure on profit margin: profit margin is likely to weaken from now on due to disinflation, lower pricing power, cooling global demand, tighter credit and lending standards and persistent labor costs. Nevertheless, consensus expects EPS growth of +9% for MSCI World in 2024.
Iverted yield slope: Historically, we have never avoided a recession after a sustained period of an inverted yield slope. Let's hope history does not repeat itself.
Valuation: The market expects a near perfect touchdown with falling inflation and no impact on demand or pricing power. The US equity market, which accounts for more than 70% of the MSCI World, has a preliminary price-to-earnings (P/E) ratio of 19, compared to a median of 16. Valuations in Japan and Europe look more austere and broadly in line with the historical median. Nevertheless, there is not much leeway for misalignments - especially as we consider the EPS estimates worldwide to be somewhat optimistic.
Geopolitical risk: With two ongoing wars, both of which carry the risk of escalation, we would argue that the geopolitical risk has reached a multi-decade high. 2024 is also a major election year, with national elections being held in more than 40 countries (including the US) that could trigger significant political change.
What are the reasons for a bull market in equities? A controlled decline in inflation towards the 2% target, allowing central banks to cut interest rates significantly. The slowdown in economic growth is cushioned, the labour market stabilizes and corporate earnings surprise positively. Based on the lower cost of capital, we could see a multiple expansion in such a scenario. Of course, lower geopolitical tensions would also have a positive impact on general sentiment.
The bear market, on the other hand, could be triggered by a geopolitical shock, e.g. an escalation of the war in the Middle East, leading to a rise in energy prices and inflation, which in turn could lead to a drop in profits and ultimately to a recession. The situation in southern China is also very tense and a military conflict could have a devastating impact on the global economy. There is also a scenario where the margin compression mentioned above is so severe that companies will begin to drastically reduce their workforce. This is something that typically happens at the end of an economic cycle. A jump in unemployment could drastically reduce economic activity, as consumer spending typically accounts for 2/3 of GDP, and could lead to a full-blown recession. In recessions, the stock market usually declines between 20% and 30%.
Conclusion
For the reasons mentioned above, we are cautious for 2024 as we believe that the market is currently pricing in an unrealistic Goldilocks scenario. We are maintaining a barbell strategy that combines quality growth with value stocks from the energy and technology sectors but also parts of the financial sector. Within the quality growth category, we have an overweight in healthcare, home and personal care and luxury goods - where we own companies that benefit from strong structural growth drivers. We believe this is not fully reflected in the current price. In terms of regions, we prefer Europe and Japan to the US due to valuation.
* These are the personal views of the author and should not be considered as reflecting the official views of DNB Asset Management or its affiliates.
2024: Will the Goldilocks Scenario Kick in? |… | DNB Asset Management
