A key investment theme throughout 2023 was: Get off the sidelines, lighten your cash holdings, and stop waiting for the one perfect moment that might never arrive. This tenet still applies, but for wary investors needing additional clarity, a new observation may help: Both global inflation and central bank tightening have most likely peaked for this cycle.
Over the last year and a half, major global central banks focused entirely on fighting inflation. The US Federal Reserve, European Central Bank and Bank of England each raised policy rates between 450 and 525 bps, from near-zero to multi-decade highs. And while we believe that US inflation has crested, it is still higher than the Fed’s 2% target. Pinpointing how rapidly it falls from here is no simple task, but our analysis suggests further moderation over the course of 2024.
A few outliers may emerge, such as high odds of a rate hike from the Bank of Japan and Australia following suit. However, policy rates are not poised to plunge from their precipice either. Instead, they have more than likely plateaued — extending the “higher for longer” rate environment and making the trajectory of monetary policy for the next few quarters look like a cross-country trek rather than a downhill run.
Meanwhile, we have already seen markets get ahead of their skis at various points in this cycle, prematurely anticipating rate cuts. Rates probably will not be lowered until the cumulative — and lagging — impact of the Fed’s historic hawkishness comes home to roost in the form of a mild recession, which we expect will occur in the second half of 2024. This leads us to identify several investment themes we believe are particularly well-suited for a past-the-peak, but pre-rate cut, prerecession environment.
Follow the trails to fixed income
Though bond yields have retreated from their cycle highs in October, investors can still take advantage of today’s yields by overweighting fixed income in their portfolios. As we move closer to potential rate cuts in the back half of 2024, we anticipate intermediate- to longer-maturity yields will decline modestly, creating attractive return opportunities across higher-quality fixed income segments, particularly in municipal bonds and securitised assets.
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At the same time, investors may want to consider bar-belling their traditional fixed income with sectors with floating-rate coupons. Our investment teams continue to find compelling opportunities in the higher-quality segments of floating-rate senior loans. For those with a tolerance for less liquid assets, private credit continues to benefit from high starting yields and improved deal flow as we head into 2024.
Deploy cash into areas of relative value
In the US, we are focused on dividend growers and high-quality growth areas, and we generally see more risks in non-US developed markets. We also think that areas of the equity market where valuations were punished in 2023, such as emerging markets equities — which also enjoy strong earnings growth projections — and US REITs, are set up well for 2024.
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US REITs offer a combination of appealing traits for investors to consider. First, REITs have significantly lagged the broader equity market since the start of 2022. Importantly, however, REIT earnings have held up relatively well during the period, creating value for the market as a whole.
REITs also appear well-positioned for the current and prevailing market environment. They are generally a long-duration asset class given the structure of rents and cash flows, and as such have performed relatively well when interest rates peaked and were on the verge of moving lower — REITs were the best-performing US equity sector in 2014 amid the taper tantrum. It is also worth noting that although financial headlines focus on structural issues within the office sector, traditional offices represent only about 3% of the overall REIT market.
Our highest-conviction views
Municipals are enjoying solid fundamentals — strong credit quality and reliable tax streams — and attractive supply/demand technicals. Given the shifting interest rate environment, we also think it makes sense to extend duration in municipal bond holdings.
Private credit remains a favoured area for us, and investor demand has remained high. We continue to focus on more resilient areas of the market such as healthcare, software and insurance brokers — all of which are relatively well-positioned to withstand economic downturns.
Infrastructure should benefit from still-high inflation and looks well-positioned for resiliency in the face of slowing economic growth. Both public and private infrastructure appears compelling, especially the attractive valuations within public infrastructure. Farmland investments may also represent an intriguing source of diversified returns and are among the categories we favour.
Additionally, we think investors should move past the “60/40” approach to portfolio construction to take advantage of prospects offered by alternative investments. Private real estate remains under some pressure, but real estate debt should benefit from the rates backdrop.
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Equities positioning
Our primary equity investment theme is reducing broad cyclical exposures and focusing on high-quality companies with strong fundamentals and free cash flows that may be better-positioned to withstand an economic deceleration. Market gains have primarily come through improved corporate earnings in the second half of 2023, resulting in more compressed valuations. As such, despite select opportunities across global equity markets, we are retaining an overall neutral rating.
Due to valuation compression, we are slightly less positive towards US large caps than we were last quarter. Within this area, we are focused on dividend growers, which tend to be high-quality companies that offer strong free cash flow levels, solid profit margins and consistent income; and high-quality growth areas, chiefly in technology sectors such as software and semiconductors. We favor public real estate and public infrastructure equities, which can potentially withstand slower economic growth.
Geographically, we continue to favour the US over other developed markets. US corporate earnings appear to be further along the road to recovery, and the US offers better defensive characteristics in the face of a potential global economic slowdown. Within emerging markets, we are wary towards China given the country’s shaky growth prospects. More broadly, we expect dollar strength to be less of a headwind for emerging markets, but also believe geopolitical risks could act as a headwind. Regarding private equity, we see more value and opportunities, and anticipate rising deal volume over the coming quarters.
Get real with portfolio positioning
Our macro-outlook hinges on three key variables. Inflation has peaked, economic growth will peak soon, and central bank policy rates are peaking now. Historically, these dynamics have tended to coincide with a peak in rates broadly, as well as with a re-steepening of the yield curve. We expect Treasury yields to gradually move lower from their current levels over the coming quarters, as high inflation risks ebb, downside growth risks escalate, and central banks start to signal eventual rate cuts.
However, a few variables could certainly push against our base case. If growth remains healthy, the Fed may not need to cut rates at all, and Treasuries accordingly would not rally. Persistent and outsized fiscal deficits should offset upward pressure on rates. Non-US demand for US fixed income remains pressured by high currency hedging costs. We are cognisant of these risks, but increasingly believe that the case for overweighting fixed income is becoming progressively more persuasive.
The bottom line is that for those who may still be waiting, it is time to start making tracks. And while we are confident the most challenging peaks will continue to recede from view, we will be on the lookout — as always — for twists and turns ahead.
Saira Malik is chief investment officer at Nuveen
