The overarching story of 2023 revolves around rising stocks and falling interest rates. Among various regions, American stocks have performed notably well. The S&P 500, for instance, has surged by 26%, whereas the EuroStoxx 600 has seen a more modest increase of 17%. Conversely, it has been a challenging year for Danish stocks, which have only seen a modest uptick of 6%, and for emerging market stocks, which have experienced a 9% increase.
QQQ - Nasdaq 54.84% increase
The low returns in emerging market stocks are largely attributed to the sluggish performance of Chinese equities.
All other regions have yielded positive returns, comparable to what we observed in the USA and Europe.
China has struggled to provide sufficient stimulus to an otherwise challenged economy.
Furthermore, the increased emphasis on reshoring production to one's own or nearby countries is a significant gain for all other emerging market nations except China.
China lags significantly behind the rest of Emerging market.
In the spring, we witnessed the initial signs of challenges associated with central banks' monetary tightening when Silicon Valley Bank and Signature Bank collapsed due to significant losses on long-duration government bond investments.
Illustrated by the S&P's index of regional banks, the value of banks plummeted sharply due to heightened uncertainty about the stability of the banking sector.
Nevertheless, when factoring in dividends, the index return is close to returning to the year's starting point.
Regional banks almost back, but not my investment in Bank Of America...
One of the major and dominating themes of 2023 has been the significant outperformance of the major tech companies, which, over the course of the year, transitioned from being known as FANGMAN to the Magnificent 7.
The annual return on Bloomberg's Magnificent 7 index exceeded 100%, thus delivering an outperformance of 75% compared to the broad S&P 500.
The substantial stock gains have been partly driven by declining interest rates, but the heightened focus on artificial intelligence has particularly propelled the tech companies. With a high anticipated order influx, chip manufacturer Nvidia achieved an impressive return of 240%.
The positive sentiment has also influenced the return dynamics within intra-stocks.
Cyclical stocks have consistently outperformed throughout the year, effectively reversing the defensive outperformance observed in 2022.
Cyclical outperformance in 2023, but not 2022.
Among the classic Value/Growth factors, Growth outperformed by 9%.
Growth stocks were partly aided by declining interest rates, and given the significant presence of tech companies in the Growth segment, this factor served as one of the major driving forces.
Growth was the winning
factor in '23
The positive sentiment in the financial markets has also translated into demand for protection against declining stocks through put options.
The low demand has led to general declines in the VIX index throughout the year, except for a few peaks around events such as the banking crisis in the spring and Hamas' attack on Israel in October.
This indicates a market where many investors have gradually embraced the narrative of a soft landing in the USA.
One of the significant risks entering 2024 is if this narrative undergoes a shift due to factors such as excessively high interest rates or a deviation in private consumption.
VIX falls to a very low level.
The interest rate landscape in 2023 unfolded in two distinct phases. The first three quarters of the year were characterized by steadily rising interest rates along an upward trend with limited deviations.
However, the onset of winter marked a shift in market dynamics as interest rates suddenly began to decline significantly towards the year-end.
This abrupt change occurred, particularly following substantial progress in central banks' efforts to combat inflation. Inflation in the USA and Europe has steadily decreased since its peak in the summer of 2022, prompting the Fed to initiate discussions about possible interest rate cuts as early as spring 2024.
With the prospect of imminent and substantial interest rate reductions, this general interest rate level began to decline. As the 'soft landing' narrative gained traction, it also fueled strong increases in the prices of risk assets.
Interest rates fall at the end of the year (great for stocks in 2024).
While the Federal Reserve's communication about future lower short-term interest rates has contributed to pulling down 2-year rates, we still find ourselves with clearly inverted yield curves in both the USA and Europe.
The U.S. yield curve was inverted by over 100 basis points in the 2-10 segment during the summer. Despite a general steepening, the yield curve remains inverted by nearly 50 basis points as we approach the end of 2023.
Still inverted yield curve in the US
The credit spread on Investment Grade bonds has maintained comfortable levels throughout 2023.
It surged significantly during the U.S. banking crisis, quickly normalizing around 140 basis points.
There is currently no indication of stress in the credit market for high creditworthiness papers.
EU Investment Grade credit premium
The same pattern holds true for the High Yield market, and if possible, to an even greater extent than for Investment Grade bonds.
The yield spread for High Yield has steadily decreased throughout 2023, only interrupted by peaks around the banking crisis and the conflict in Israel.
Closing the year around 310 basis points above the government bond yield curve, this once again indicates significant confidence in the repayment capacity of the underlying companies.
US High Yield credit premium
Commodity markets, as depicted by Bloomberg's commodity index, have generally witnessed declining prices throughout 2023.
This trend has contributed to a broad moderation of inflation, effectively reversing the robust increases observed in 2022.
Generally falling commodity prices.
The headline for the global economy is the noticeable absence of a recession and the ongoing strength of the labor market in the USA. Inflation continues to trend downward, paving the way for monetary policy easing in both the USA and Europe.
On the geopolitical front, the conflict in Ukraine persists, with the parties largely entrenched in their respective positions. As a result, the impact of the war on the world economy has been limited. Western countries have managed to maintain military and economic support despite declining voter approval. This contributes, all things considered, to increased demand within the manufacturing sector and helps support economies.
Additionally, conflict erupted in the Middle East after Hamas' attack on Israel. The conflict seems confined to the region, and the feared effect on oil prices has not materialized, despite repeated attempts by OPEC to limit oil production, which has yet to show an impact.
World trade has been challenged by a combination of military unrest and global warming. Houthi attacks on merchant ships in Yemen lead shipping companies to avoid the Suez Canal, opting for the longer route around Africa. Moreover, drought has affected the Panama Canal, limiting navigability. This results in longer shipping times and higher costs, impacting corporate earnings and private consumption.
Summarizing economic indicators from the Eurozone, they generally align with analysts' expectations after significant negative surprises over the summer. However, the absence of negative surprises does not alter the fact that European economies are significantly below their potential. European GDP growth has not yet experienced two consecutive quarters of negative growth, and it is not evident that we are already in a recession, although clouds are gathering over European economies. GDP growth in the third quarter is at -0.1%, and negative growth is also expected for the fourth quarter, although these figures are yet to be released.
Negative European macro data.
The significant headwinds in the European economy have primarily stemmed from high inflation and the ECB's response with higher interest rates.
Over time, inflation has subsided significantly, with housing-related items currently exhibiting deflationary tendencies.
For the Eurozone, the annual inflation rate is now approaching the ECB's target of 2%. This opens up the possibility for them to begin lowering interest rates in 2024, which could ultimately be crucial in restoring growth.
Inflation is slowing down in the eurozone
The low activity level is widespread across European economies.
Measured by PMI, both the service and manufacturing sectors are operating at a subdued level with no immediate signs of improvement on the horizon.
The PMI is low in the euro area
Furthermore, we are witnessing a rise in the number of bankruptcies in both Germany and France.
Bankruptcies in France are approaching a high level, having been artificially suppressed during the COVID-19 crisis.
The increase in Germany is more moderate, and the level remains low in a historical context.
A rise in bankruptcies was expected in any case, as many businesses, artificially kept afloat by government support, had to succumb after the expiration of that support. Therefore, the increase in bankruptcies is not inherently alarming, but it will nonetheless contribute negatively to economic activity.
Increase in bankruptcies in Europe..
Turning our focus to the USA, we observe that macroeconomic indicators are slightly better than analyst expectations, but the economy is still operating below its long-term trend.
Nevertheless, the low activity level has not yet translated into growth. The third quarter delivered a seasonally adjusted and annualized growth rate of a robust 4.9%. However, analysts anticipate a more moderate 1.2% growth in the fourth quarter.
Negative US macro indicators
The ISM readings for both the service and manufacturing sectors are notably low.
Manufacturing in the USA is particularly struggling, with an ISM well below 50.
A solitary uptick in September failed to reverse the trend, and a clear bottom has yet to be established.
Despite ISM services being above 50, typically indicating expansion, neutral growth is often associated with a value around 54.
This suggests that the service sector is also operating below its potential, with the trend even waning since its peak at the end of 2021.
PMI continues to decline
Several American consumers are beginning to feel the impact of a high debt burden combined with rising interest rates. Consequently, there is a growing number of loans where one or more of the repayment terms are not being met.
Loans with late payments - not good...
However, any challenges for consumers do not currently stem from weakness in the job market.
This is exemplified by the unemployment rate, which remains consistently low.
It is crucial to be cautious about drawing extensive conclusions from most labor market data, as they typically come with a significant lag. Nevertheless, various indicators paint a picture of a cooling American job market that is still robust.
Low unemployment in the US
Consumers are now also benefiting from declining inflation.
The overall annual inflation in the USA, measured by the Consumer Price Index (CPI), is currently at 2.3%, very close to the Federal Reserve's target of 2%.
Although the decreasing trend in inflation has plateaued in recent months, the Fed is now in a much better position to consider lowering interest rates once again.
US inflation hits new highs
Nevertheless, interest rates remain elevated in Western countries. Major economies have swiftly increased interest rates in response to robust inflation. Currently, central banks appear to be adopting a wait-and-see approach regarding the further evolution of inflation. The next expected move in interest rates is anticipated to be downward.
Interest rate increases in a number of countries.
Central banks are actively reducing their balance sheets through Quantitative Tightening (QT). While Quantitative Easing (QE) previously injected liquidity into economies, QT is now working to reverse the movements from the crisis period. Excluding a slight increase during the banking crisis in the spring, the Fed's balance sheet has significantly decreased from its peak. The same holds true for the ECB.
Fed initiates QT (Quantitative Tightening)
ECB initiates QT (Quantitative Tightening)
In general, I anticipate that inflation will continue to decline, albeit at a slower pace than before.
This will provide central banks with room to lower interest rates. I do not expect the ECB to be able to lower rates quickly enough to avoid a recession. If the Eurozone is not already in a recession, I consider it inevitable. However, by recession, I don't necessarily mean a deep crisis like the one in 2009, but I still anticipate negative growth.
The outlook is more uncertain when it comes to the United States. In principle, I see it as possible for the Fed to lower rates quickly enough to avoid a recession.
However, this might require interest rate cuts of a magnitude and speed typically associated with a recession, leaving the U.S. economy delicately balanced on a knife's edge, in my view.
Global growth is expected to land around 3% in 2023, then dip to 2.6% in 2024, and rise again to 3% in 2025.
Global GDP Growth Expectations
In the USA, growth is expected to slow down over the coming years. Analysts currently anticipate a growth rate of 2.4% in 2023, which is projected to decline to 1.3% in 2024 and then rebound slightly to 1.7% in 2025.
GDP growth expectations for the United States
FED will lower interest rates even more aggressively than the current market pricing
I anticipate that the Fed will significantly lower interest rates in both 2024 and 2025. Currently, markets are pricing in rate cuts totaling 150 basis points in 2024 and an additional 50 basis points in 2025. This would bring the short-term interest rate down to 3.25% by the end of 2025. Assuming that inflation is under control and hovers around 2%, it still must be considered a restrictive level. Therefore, I believe the Fed needs to cut rates even more aggressively than the current market pricing to prevent a recession, and they will do so.
Fed rate cuts in ’24 and ’25
The diminishing expectations for future interest rates have further depressed the overall interest rate landscape. This has allowed for higher P/E ratios for American stocks. Measured by companies' expected future earnings, the S&P 500 is trading at a P/E ratio of 20x, which we consider to be high. If U.S. stocks are to move higher from their current levels in 2024, it will also need to be accompanied by increased earnings.
S&P 500 12m forward P/E
On the earnings front, analysts are currently anticipating a growth of 12.5% in 2024 and an additional 11% in 2025. These are high growth rates in earnings, even if the U.S. economy manages to avoid a recession. With declining inflation and further softening of the labor market, we do not expect earnings expectations to be revised significantly upward from their current levels.
S&P 500 EPS Expectations
Europe paints a more somber picture with very low growth expected in both 2023 and 2024. It is only in 2025 that growth is anticipated to turn genuinely positive, reaching a modest 1.4%.
GDP growth expectations Eurozone
The market is also anticipating significant interest rate cuts from the ECB. Market pricing indicates a reduction of 160 basis points in rates in 2024 and an additional 40 basis points during 2025. This would bring the interest rate down to 2.25% as early as 2024. Assuming inflation is controlled around 2%, the rate would be close to neutral. However, we expect that a recession in Europe would also be deflationary, making the priced real interest level in 2024 and 2025 more restrictive.
ECB interest rate cuts in ’24 and ’25
In Europe, the Stoxx 600 is currently trading at a more moderate P/E ratio of 13x, despite an increase from the very low 11x observed just a few months ago. This level aligns with historical values, and we do not immediately perceive European stocks as expensive relative to expected future earnings. If interest rates decline further from this point, it is certainly plausible for the P/E ratio to increase, providing support to European stocks.
Stoxx600 12m forward P/E
The outlook, however, is not as optimistic when it comes to expected earnings, which have been declining in recent months. Nevertheless, analysts anticipate a more moderate growth in earnings per share of 5% in 2024 and an additional 7% in 2025. Depending on the severity of the recession in Europe, these expectations may still prove to be overly optimistic, and we see limited potential for upward revisions entering into 2024.
Stoxx600 EPS Expectations
Despite significant challenges in the Chinese economy and the absence of substantial government stimulus, analysts still anticipate slightly over 5% GDP growth. However, estimates for 2024 and 2025 have been consistently declining, with values of 4.5% and 4.3%, respectively, which would not be satisfactory for the Chinese government.
GDP growth expectations for China.
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