12 minute read

Heading into 2024, one of the biggest questions for investors was whether the Federal Reserve would be able to steer the US economy into a so-called “soft landing” – that is, raising interest rates high enough, and for long enough, to slow the economy and rein in inflation. 

With half of the year now behind us, the macro environment appears to have been steered in another direction – towards a “no landing” scenario, where inflation stays sticky and the economy keeps on growing. Indeed, in April, our Economic Regime Asset Allocation (ERAA®) investment framework signalled a shift in the economic regime to one of inflationary growth. 

In this environment, growth assets have performed well – with AI-related stocks continuing to lead the pack. Our model also points to opportunities in cyclical equities, longer-duration bonds, and higher-risk assets in general.

With this in mind, what does the rest of the year have in store? Here’s our outlook for the second half of 2024.

Key takeaways:

• The good news: a broad-based global recovery is taking shape. Looking ahead, the data point to a broad-based recovery in the global manufacturing sector, with the US and much of Asia leading the way. The services sector, meanwhile, is continuing to enjoy sustained strength. Together, this is underpinning a recovery in company earnings.
• The not-so-good news: a global recovery, paired with looser monetary conditions, may further stall disinflation. Inflation has been cooling off, though a still-tight labour market has meant that progress has slowed in the past few months. What’s more, as the manufacturing sector recovers and global central banks start to cut interest rates, that could result in renewed inflationary pressures over the next 6-12 months. 
• US rates could stay higher for longer, but related risks should be contained. These macro conditions would suggest that the Fed is likely to keep interest rates at a higher level – even if it does start to cut rates later this year. One risk we’re monitoring is in US commercial real estate, which has over US$1 trillion in financing needs in the next 2 years. However, strong corporate balance sheets and ample liquidity should buffer negative impacts from this sector. 
• Put your cash to work. The path to reach the Fed’s 2% inflation target will be bumpy. But as long as the economy continues to expand, the current bull market in equities can be sustained and broadened out. It’s also important to remember that in bull markets, 5-10% corrections are normal. While we recommend dollar-cost averaging, these events can be opportunities to add exposure to risk assets. Since shifting to a regime of inflationary growth in April, our ERAA® framework increased allocations to cyclical sectors like industrials, and to global markets like Japan and India.
• Gold remains a better balancing asset compared to bonds in an inflationary environment. Given the uncertainty around the future interest rate path, volatility in long-duration bonds could remain high. The significant increase in US bond issuance over the coming decade adds another layer of structural concern. In the post-COVID world, gold provides a strong hedge to inflation and geopolitical risks. ERAA® has allocations to gold across all our General Investing portfolios to produce better risk-adjusted returns across economic cycles.

The good news: a broad-based global recovery is taking shape

Let’s start with the good news. Leading economic indicators like global Purchasing Managers’ Indexes (PMIs) show that the global manufacturing sector has returned to growth in recent months. Corporate earnings tend to move in tandem with such gauges – and indeed the earnings cycle is also turning positive.

That’s been driven by a manufacturing recovery in the US, some parts of Europe, and much of the Asia Pacific. Meanwhile, the services sector has remained strong, in part due to shifts in the labour market and consumer behaviour tied to the COVID-19 pandemic. 

And in general, things have been going well for the markets so far this year. US equities continue to hit all time-highs, led by the tech sector. Copper – a commodity known for tracking the global economic cycle given its broad industrial uses – is rallying.

Even Chinese equities, which had been dragged down by the country’s property market, have turned a corner. (For more on that, see last month’s CIO Insights, China’s markets have been taking off – is it still time to hop on?)

The not-so-good news: a global recovery, paired with looser monetary conditions, may further stall disinflation

While a return to growth in manufacturing and a strong services sector bode well for the economy, it complicates the picture on inflation.

The latest US consumer price inflation (CPI) data showed the core CPI reading cooling more than expected, in a positive sign for the Fed. But the larger picture is that price pressures are still somewhat sticky due to “supply-side” factors.

Examples of such factors include tightness in the labour market (which pushes up wages) or shortages in raw inputs (like what we’ve seen with recent spikes in cocoa and coffee prices). These pressures are harder to resolve and tend to be more persistent.

To be sure, the jobs market is cooling: the Fed’s favourite measure of labour market tightness shows that there are 1.2 openings for each person unemployed, which has come down significantly from a peak of 2x in March 2022. 

But a pickup in the manufacturing cycle could mean further job creation ahead. Our analysis finds that changes in the US ISM manufacturing PMI tends to lead changes in job openings by about 7 months, as shown in the chart below. 

Add looser monetary conditions to the mix – with major global central banks like the European Central Bank (ECB) and Bank of Canada (BOC) kicking off their rate cut cycles – and progress in disinflation could further stall.

And while the Fed hasn’t yet cut rates, it announced plans to taper its quantitative tightening program (our Glossary below covers this), which reduces the maximum amount of Treasuries it will allow to roll off its balance sheet from $60 billion to $25 billion – a significant decrease.

US rates could stay higher for longer, but related risks should be contained

The combination of a resilient labour market and persistent inflation mean that the Fed may need to keep interest rates higher for an extended period, even as it starts to cut rates. 

Indeed, at its June meeting the Fed signalled only 1 rate cut this year, down from expectations of 3 cuts at the start of the year. It’s a similar story for central banks like the ECB, with President Christine Lagarde suggesting it’s likely to hold steady after its June rate cut given still-high wage growth in Europe.

Higher-for-longer rates pose challenges for parts of the market that are heavily indebted and are looking to refinance in the months ahead. 

One of the risks we’ve been monitoring is the US commercial real estate (CRE) sector, which tends to rely on debt financing to raise capital. The sector is facing over US$1 trillion in maturing debt in the next 2 years. It’s also facing structural challenges, particularly the office segment, given rising vacancy rates post-COVID. 

That said, given that corporate balance sheets are still strong and liquidity is still abundant, we think systemic risks should be manageable. In addition, the office segment comprises a smaller portion of the upcoming debt, of about 20%. All things considered, ERAA® is underweight the financial sector. Regional banks have sizable exposure to CRE, and as refinancing continues to get worked out in the sector, its risk-return profile remains less appealing versus other cyclical sectors. 

How you can think about putting your cash to work in this environment

Taken together, the factors above suggest that the path to the Fed’s 2% inflation target will likely be a bumpy one, as we’ve seen over the past few months.

But as long as the economy continues to expand, it’s likely that the current bull market in equities can be sustained. And while AI and tech-related stocks have led the market for much of the past year and half, we see scope for market breadth to increase as other sectors benefit from growth.

In addition, despite concerns over US equities being expensive, most sectors – aside from tech  – are still reasonably priced relative to their longer-term average. Even valuations for the Magnificent 7, with a forward P/E ratio of about 31x, are not far from its average 28x over the past 10 years. 

It’s also important to remember that even in bull markets, it’s normal to see corrections of 5-10%. In general, we recommend dollar-cost averaging through the market’s ups and downs – corrections can be opportunities to add exposure to risk assets.

The chart below highlights just how much equities have outperformed cash during periods of inflationary growth – about 7.7% per annum for the S&P 500 and 10% for the US industrials sector.

Given this current regime, our ERAA® framework has placed an overweight exposure to cyclical sectors like US industrials, which tend to perform well during periods of economic expansion and higher inflation. And given the potential for increased market breadth, it’s added exposure to equal-weight US equities – which has also tended to outperform the market-weighted index when PMIs have trended higher.

Looking beyond the US, ERAA® continues to be overweight in markets like Japan and India. As we covered in our H1 2024 macro outlook, we still see opportunities in the Japanese market – especially relative to other developed markets like Europe. For one, Japanese equities are experiencing a more advanced recovery in earnings growth than their European counterparts.

We also see more room for margin expansion in key Japanese sectors such as financials (where margins are currently around 11-12%) as the Bank of Japan raises interest rates. In contrast, European financials (at around 16-17%) are likely to face margin compression as the ECB cuts rates.

And in India, despite volatility in equities following its national election results, the country’s structural drivers suggest its longer-term growth picture remains intact. In fact, the MSCI India is now back to an all-time high.

Gold remains a better hedge compared to bonds in an inflationary environment

Even though the markets have been doing well so far this year, a diversified portfolio of both risky and balancing assets still helps to mitigate the impact of market fluctuations.

Given the current post-COVID environment of higher inflation and elevated geopolitical risk, gold’s characteristics as an inflation hedge and a safe-haven asset make it a solid defensive and diversifying asset versus stocks and bonds.

As we shared in our April CIO Insights, How we put your money to work – the nuts and bolts of ERAA®, our investment framework, we’ve added gold to our portfolio benchmarks with the goal of improving risk-adjusted returns across economic cycles.

That’s especially important given a structural increase in volatility in the bond market in recent years, as well as concerns over higher US government bond issuance in the decades ahead. 

What’s more, we see both cyclical and structural opportunities in gold. In the near-term, it could benefit from falling real interest rates as the Fed starts to cut rates. Over the longer-term, we also see efforts from global central banks to diversify their international reserves away from USD holdings supporting the asset class.

In particular, over the past 18 months the People’s Bank of China has bolstered its holdings of gold reserves by 16%, bringing them to more than 2,200 tonnes. In doing so, it’s increased the share of gold in its total reserves from 3.2% to about 5% currently. 

Even so, that’s still well below its global peers. Assuming China moves towards a double-digit share for gold in its reserves over the longer term, similar to other emerging market central banks, that would be a strong, structural source of demand.

Putting your cash to work in H2 and beyond

As we head into the second half of 2024, we see both opportunity and risk. While the recovery in global manufacturing and corporate earnings are encouraging, the path ahead could still be bumpy as the Fed – and other global central banks – work to get inflation back to target.

A diversified, resilient portfolio helps when navigating a complex macroeconomic environment like this. Our General Investing portfolios provide exposure to a range of asset classes, and use our ERAA® investment framework to keep your selected level of risk constant across various economic cycles over the longer term.

Investing consistently, via dollar-cost averaging, can also help to mitigate the risk of timing the market. When you put the broader picture in focus, short-term market corrections can start to look more like long-term opportunities.

Ultimately, what really matters is staying invested at a level of risk that’s comfortable to you – ensuring that your cash is always being put to work.

Glossary of Terms

Disinflation

A slowdown in the rate of inflation – prices are still rising but at a slower pace. This is different from deflation, which refers to prices falling.

Quantitative tightening

A central bank policy aimed at reducing the amount of money floating around in the economy, by letting the bonds it owns mature without buying new ones.

International reserves

The savings that a country's central bank keeps in foreign currencies and other assets like gold; used for international settlements and to manage the value of its own currency.

Cyclical sector

Economic sectors that are sensitive to business cycles, typically seeing stronger performance during expansions and weaker performance during downturns.