How High for How Long?

How High for How Long?

The anticipated end to the rate-hiking cycle of the past two years could be an important tailwind for financial markets in 2024. But how much of a boost it gives may largely depend on the economic backdrop that unfolds – and how low central banks are willing to go if they do start cutting rates.

Investors should be feeling better about financial markets heading into 2024 than they did this time last year, when stocks and bonds were still mired in the mud of a punishing bear market. But while stocks have rallied and bonds are now rebounding, the past 12 months hasn’t exactly been a cakewalk. Markets have remained volatile, and positive returns, if any, have lacked breadth within and across asset classes. On the plus side, that leaves room for improvement and the possibility of even more opportunities to make gains in the new year.

How well markets perform most likely lies in the hands of the world’s central bankers, who continue to fight inflation while trying to navigate a soft landing for the economy and avoid a deep recession. Nowhere is this more evident than in the United States, where the U.S. Federal Reserve (Fed) has already raised interest rates from near zero to 5.5% and helped cut the country’s inflation rate by more than half, to just above 3% in October, all without seriously hindering economic growth just yet.

The questions now are whether the Fed’s tightening cycle has peaked, given its recent decision to pause on further rate hikes, and, even more importantly, when it might start loosening policy by cutting rates – and by how much.

To that end, we believe the Fed is most likely done raising rates (or near enough to it), which could be a positive for markets in and of itself. After all, most of the volatility over the past two years has been arguably caused by the speed and magnitude of the rise in rates, and not the ultimate level of them. But whether interest rates have truly peaked remains largely dependent on the still-uncertain trajectory of both the economy and inflation.

Moreover, because of that uncertainty, we believe current expectations of four or more rate cuts in 2024 should be tempered for as long as inflation remains elevated above the Fed’s 2% target and economic growth stays resilient. In fact, this could be true even in the case of a recession next year. Despite the central bank’s past propensity to immediately cut rates at the first sign of an economic downturn, that’s hardly a given this time around. We believe the Fed is likely to be much more deliberate in its actions.     

Granted, this potentially delayed response may only be a matter of degree and timing. In our opinion, it’s still probable that interest rates will be lower by this time next year – not just in the U.S., but in many countries, notably Canada, where growth already turned negative in Q3 – and is expected to start dropping in an eventual response to slumping economic growth that raises unemployment rates, but keeps inflation in check.

In this scenario, markets are likely to remain volatile in the short term yet could find better footing in the second half of the year. Equity markets, for instance, often fall heading into recession and may tumble again if earnings expectations adjust downward to reflect economic conditions. But that weakness should give way to a more constructive period, guided by looser monetary policy and the anticipation of an economic recovery. That, in turn, could give a lift to a much broader swath of stocks and sectors than the handful that have largely driven the rebound in equities this year.   

Meanwhile, bond markets could benefit in 2024 from their traditional role as a haven during times of increased economic uncertainty, but also because central bank interest rate cuts would make existing bonds issued at higher rates generally more attractive. This would be a welcome development for many fixed income investors, particularly those who have suffered through negative returns in the past three years.

Still, investors shouldn’t rule out a soft-landing scenario entirely, especially in the U.S., where growth is expected to moderate this quarter, but still remain positive. And should the Fed reach its 2% inflation target and not cause a recession, it could lead to a much different – albeit still promising – backdrop for markets. Namely, interest rates may not fall as much as they would otherwise, but neither would investors likely demand that they do if they are convinced economic growth can be sustained longer term.

Either way, while the path might be different under these two scenarios, both equity and fixed income markets could eventually end up in a better place than they are now. Yet, that’s hardly a guarantee, especially if other factors come into play and change the trajectory of the current backdrop. In particular, close attention still needs to be paid to the geopolitical climate, which due to the wars in Ukraine and the Middle East continues to be rife with risks. At the same time, next year’s U.S. presidential election could set the stage for increased volatility, especially in the case of another contentious result.  

Practically speaking, then, there is still grounds for caution heading into 2024, even as market dynamics seem pointed in the right direction. As such, we believe a neutral stance on equities and underweight to bonds should at least for now be offset by a slightly larger-than-normal allocation to cash within a 60/40 portfolio. But as next year progresses, we fully expect to become more aggressive in our asset allocation and put more money to work in what should end up being another year of improvement for financial markets in our opinion.