Weekly market commentary

Excitement over artificial intelligence (AI) spurred a rally in U.S. tech stocks that buoyed the market in 2023. We’ve said the rally can run for now – and broaden out. Why? Inflation will likely near the Fed’s 2% target this year, and the Fed is set to start cutting interest rates. So we upgrade broad U.S. stocks – our index level view plus AI theme preference – to overweight on a tactical horizon of six to 12 months. We stay nimble as we expect resurgent inflation to become clear later this year.

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Eyeing a broadening rally
Nasdaq 100 vs. equal-weighted S&P 500, 2010-2024

In mid-2023, we shifted how we present our tactical views to capture opportunities from mega forces, or big structural forces. Our overall U.S. equity view was neutral – consisting of an underweight at the benchmark level and an overweight to the AI theme. That selectivity has been rewarded in the past 12 months, with tech pushing U.S stocks to all-time highs. The Nasdaq 100 surged 50% in that time, while the equal-weighted S&P 500 rose 4% in what’s been a narrow rally. See the chart. We expect the rally to broaden out as inflation falls further, the Fed starts to cut rates, and the market sticks to its rosy macro outlook. Markets are pricing a soft economic landing where inflation falls to 2% without a recession. With markets tending to focus on one theme at a time, this narrative can support the rally over our tactical horizon and allow it to expand beyond tech. So we go overweight overall U.S. stocks.

Yet we stay nimble and ready to pivot as the new regime of greater macro, market and inflation volatility creates a wide range of possible outcomes. The consensus view of a soft landing could be challenged, but that may happen later in the year. We agree with markets that inflation will fall near 2% this year, helping the upward momentum extend into the year. Yet inflation is unlikely to stay there in the long run. December PCE data out last week showed declining goods prices are still pushing inflation down as consumer spending shifts back to services. Yet that drag is temporary and goods prices should rise anew when pandemic mismatches have finished unwinding. We think U.S. wage growth is still running too hot for services inflation to slow enough to keep core inflation near 2%. That means inflation will likely rollercoaster up toward 3% in 2025.

Inflation pressures

So far, corporate earnings and profit margins have held up against higher interest rates and costs. We think margins will face pressure in the medium term from high rates, wage pressures and lower but above-target inflation. Wage growth has stayed high as an aging U.S. population keeps the labor market tight. Other mega forces – or big structural shifts – like geopolitical fragmentation also add to inflation pressures, in our view. That’s part of why we think the Fed won’t be able to cut rates as much as in the past. The Fed may push back against market pricing of rate cuts, but we think any resulting equity pullback would likely be temporary – until the risk of resurgent inflation comes into view.

In the euro area, we’re not expecting resurgent inflation. It has fallen as the energy crunch has abated. We see wage growth sliding as the European Central Bank holds policy tight, as it did last week. The Bank of Japan left its loose policy the same last week as it looks for wage gains and accelerating services inflation to anchor overall inflation sustainably at 2%.

Our bottom line

Upward momentum in U.S. stocks could carry on into this year, so we are overweight in our overall view. We stay nimble given the inflation rollercoaster we see ahead. We like AI-related and Japanese stocks on strong earnings potential. In fixed income, we still favor short- and medium-term bonds as we don’t expect central banks to deliver as many rate cuts as markets expect. And we see the role of long-term bonds as a portfolio diversifier challenged – and stay neutral.

Market backdrop

The S&P 500 saw modest gains last week after hitting consecutive record highs as tech stocks rallied. The 10-year Treasury yield was steady, floating near its 2024 highs of roughly 4.16%. Data showing robust U.S. growth in the last quarter of 2023 while core inflation fell back to 2% annualized bolstered the market’s soft landing hopes. We think that should sustain the stock rally for now, but December PCE data confirmed that an inflation rollercoaster could challenge the momentum. Meanwhile, Chinese stocks rebounded as officials rolled out policy stimulus – but they remain down for the year.

We expect the Fed to hold interest rates steady at its policy meeting this week after signaling that rates have peaked at its last meeting. We don’t think the Fed will be able to cut rates as quickly or as much as markets are pricing. Growth will need to be much weaker than in the past to keep inflation down given ongoing wage pressures and structural shifts like geopolitical fragmentation. Yet the level at which rates start to dampen growth is higher than before the pandemic.

Read our past weekly market commentaries here.

Big calls

Our highest conviction views on tactical (6-12 month) and strategic (long-term) horizons, January 2024

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, January 2024

Our approach is to first determine asset allocations based on our macro outlook – and what’s in the price. The table below reflects this. It leaves aside the opportunity for alpha, or the potential to generate above-benchmark returns. The new regime is not conducive to static exposures to broad asset classes, in our view, but it is creating more space for alpha. For example, the alpha opportunity in highly efficient DM equities markets historically has been low. That’s no longer the case, we think, thanks to greater volatility, macro uncertainty and dispersion of returns. The new regime puts a premium on insights and skill, in our view.