Let us start by wishing our readers a Happy New Year 2024. As it is almost “prerequisite” that all analysts offer their stock market predictions for the year ahead, we too will follow tradition. While we are drawn into assessing the market at the beginning of each year and outlook for the next 12 months, we also recognise that there is nothing magical or indeed even a reason why the performance of the stock market should be perceived, analysed or discussed within this timeframe, except that it is by convention, and it helps people’s frame of reference.
Looking back to this time last year, most analysts were predicting recession in the US. We too got the economy and market wrong. We were too cautious, too negative. We thought the economy would shrink faster with the US Federal Reserve’s aggressive interest rate hikes and, as a result, corporate earnings and asset values would fall. However, to a large extent, the expected negative impact from higher interest rates did not materialise.
While loans growth did weaken steadily through the year, and year-on-year broad money supply growth turned negative, the US economy remained resilient (see Charts 1 and 2). Gross domestic product (GDP) growth surprised on the upside, driven by strong consumer spending, which was in turn underpinned by a robust job market, wage gains and leftover pandemic excess savings. We thought the housing market would slow and demand as well as prices would drop. It did not. At the same time, inflation cooled as supply chain disruptions healed. We also did not see how significant digital/artificial intelligence was going to be, in driving the performance of the “Magnificent 7”.
The Dow Jones Industrial Average and Nasdaq 100 hit fresh all-time highs in December while the broader S&P 500 index is just a hair’s breadth away from its record high. That said, excluding this small clutch of mega-cap stocks, the rest of the market did not fare as well, at least until the last few weeks (see Chart 3). In fact, there was a market correction in 2022-2023 that drove valuations lower, until the rally in 4Q2023.
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Rally driven by valuation expansion, predicated on falling interest rates
This rally is being driven almost entirely by valuation expansion, predicated on early and big cuts in interest rates. As can be seen in Chart 4, underlying earnings forecasts for 4Q2023 were actually revised sharply lower in the past few months — even as share prices rallied higher, leading to higher valuations, such as the price-to-earnings ratio.
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Remember, the value of a stock is equal to the present value of future cash flows/ earnings. In other words, lower interest rates (discount rates) translate into higher stock values (prices) and vice versa.
The increasingly aggressive interest rate cut expectations were fanned by none other than Jerome Powell himself. The Fed chair made a (surprising) dovish pivot, following the latest Federal Open Market Committee (FOMC) meeting held on Dec 12 and 13, suggesting up to three rate cuts in 2024. (Note the big swing in projections for the fed funds rate in Table 1.) That spurred a rush of revisions.
As is often the case, analysts follow markets. As the stock market rally gained momentum, analysts, including some bearish ones, capitulated and progressively raised their target forecasts for the benchmark indices higher in the last two months of last year. Analysts are now falling over themselves attempting to “outcut” the competition.
Currently, fed fund futures pricing data shows the highest probability for the first rate cut in March 2024 (from May to June 2024 prior to the Fed pivot) and by as much as 1.5% by end-2024, double the previous 0.75% consensus forecast (and the current Fed projection). Clearly, the critical question is how realistic are these expectations — and how will they affect the stock market performance for the rest of this year?
While the positive market momentum could continue in the near term, we suspect that this rally has already front-loaded much of the disinflation for the year. Indeed, we think the market has overshot — and reality will reassert itself over the coming months. As we like to remind readers, while markets must be justified fundamentally in the longer term, in the short term, it is simply a marketplace for stocks, where prices are determined by demand and supply, and subject to volatility. Prices will continue to rise as long as there are more buyers plunging in, chasing the rally. If the market has already priced in 1.5% of rate cuts, unless the actual cuts exceed 1.5%, further upside will be difficult to sustain in the slightly longer term. Indeed, if it becomes evident that the actual cuts will be less than 1.5%, then stock prices may well fall, all else being equal.
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What would drive interest rates sharply lower?
What are the scenarios where rate cuts will end up being significantly more aggressive than what the Fed is now indicating (0.75%)? (See Table 1.) One, inflation falls well below the 2% target (the Fed’s own estimate for its preferred inflation gauge is 2.4% by end-2024). Or two, GDP growth is far weaker than the 1.4% it currently predicts and/or unemployment rises sharply (beyond 4.1%), which then necessitates sharper rate reductions to prevent a deep recession.
We think the market is too complacent about the speed of disinflation. The data shows disinflation to have stalled somewhat — and the recent drop in headline inflation was driven, primarily, by falling fuel prices. The decline in the so-called core inflation (excluding volatile fuel and food) has been more muted (see Charts 2 and 5).
Yes, there are arguments that the 12-month rolling average methodology in deriving both the indicators are lagging, because of the rent component, which makes up about one-third of the consumer price index (CPI) and 40% of core inflation. Case in point: The y-o-y change in the Zillow Observed Rent Index (which measures current asking rents) is below the official measures for the CPI, thus paving the way for lower future inflation rates (see Chart 6).
The disinflation thus far has been due mainly to the normalisation of pandemic supply disruptions and that should apply to the rental component as well. That said, we suspect that most of the supply chain adjustments are in the rear-view mirror. We have explained in previous articles why we think inflation will not return to pre-pandemic lows anytime soon. For one, the US labour market remains exceptionally tight — unemployment is hovering near historic lows — and wage growth is strong on the back of greater bargaining power. With rising wealth disparity, unionisation is regaining favour among workers. The spillover impact on prices from geopolitics too is hard to predict. Hence, we would caution against being overly sanguine on the inflation front — and accordingly, on interest rate cut expectations.
Conclusion
We think current expectations for six interest rate cuts — compared to the Fed’s three — are overly optimistic, if the economy does achieve a soft landing. We still believe that interest rates, especially longer-dated Treasury yields, will stay higher for longer than the market currently expects — and higher than levels that had persisted since the global financial crisis. The end of the era of ultra-low interest rates will likely bring about more uncertainties and risks, perhaps some we do not yet know, to the global financial market and economies.
The US economy may or may not fall into recession, but a slowdown is almost certain. But if there are to be six rounds of rate cuts, then that must mean the economy is in a lot more trouble. And if that is the case, then the market must surely be underpricing the risks to demand, corporate margins and profits.
As such, we maintain our cautious view on stocks. We believe the current risk-reward proposition is unattractive. Bonds will fare comparatively better in the early stages of recession (if there is to be one), and against the backdrop of falling interest rates, as will banking and high-growth tech stocks (in general). That said, the US economy will likely still be one of the stronger-performing developed economies in the world.
China’s GDP growth will not return to levels we are used to seeing in the past. Growth was already slowing well before the pandemic as the country transitions from an export-investment-dependent economy to one that is driven by domestic consumption. Consumer sentiment is comparatively weak, dampened by troubles in its real estate sector — which accounts for a disproportionately high percentage of GDP (up to one-quarter) and household wealth — job market uncertainties and weak social safety net. Unemployment among youth is high. Global trade will slow, made worse by geopolitical tensions and rising protectionism, and that will affect the rest of the world, especially export-oriented economies, including many in Europe.
Growth in the eurozone has pretty much stagnated — its biggest economy, Germany, US economy and companies have outperformed in the long run, underpinned by a free market tong’s portfolio from previous pag e is in recession — as countries struggle with high energy costs (that will remain higher than they had been before the Russia-Ukraine war), broad-based inflation as well as higher interest rates. The recovery will likely also be tepid this year — and slower than growth in the US — considering the lag effects of rate hikes. Plus, there remain uncertainties with the ongoing war in its backyard.
This slower global economic growth scenario is perhaps best underscored by persistent weakness in oil prices, despite ongoing production cuts by Opec+ (see Chart 7). And rising gold prices suggest, at least in part, investor flight to safety amid heightened uncertainties. Credit risks, particularly in highly leveraged governments and companies, by and large, have yet to surface.
Increasing demand, including by central banks, and prices for gold are likely also due to the weaponisation of the US dollar. For example, some oil trades are now priced in currencies other than the greenback. (The petrodollar has been a cornerstone in the US dollar hegemony for the past 50 years.) It is why we think that longer-dated Treasury yields will not fall by as much as the market expects, even if the Fed cuts the shortterm policy rates. In other words, the yield curve will steepen, instead of a broad decline in the cost of borrowing as the market expects. Large foreign buyers such as China are paring their holdings. Although there is still robust demand for “risk-free” treasuries, the private market will be more price-sensitive.
But the real lesson is this (and the main reason we wrote this article): Over time, Corporate America and the US capital markets have outperformed the rest of the world, in terms of resilience and dynamism, driven by innovation and adaptability. Why? It has well-established legal and regulatory framework and robust institutions, including world-renowned educational and research institutions. And despite all attempts to de-dollarise global trade and end the US dollar hegemony, its usage continues to rise (see Chart 8).
Importantly, the US is a free market, in terms of doing business as well as labour and capital flows. As a result, the US economy and stock market have both depth and diversity, which helps buffer the impact of downturns in any single sector or stock. Case in point: While the economy as a whole avoided recession, there was rolling recession in certain sectors such as housing in 2022 and semiconductors and manufacturing (as consumption shifted from goods to services) in 2023. Its companies are performance-driven, and competitive, where only the best thrive. And this is what Malaysia must emulate — if we want to prosper. We will return to this in greater depth in 2024 as we focus more on the economic future of Malaysia.
Because the market is liquid and transparent, stock prices very quickly reflect underlying fundamentals and idiosyncrasies. For instance, while the share price for Pfizer was down by more than 45% for 2023, Eli Lilly and Company was up by more than 57% — both are in the pharmaceutical industry. In other words, the market is efficient, and there will always be winners and losers, even within industries. It also means that if you do not have the inside track or information, or better-than-market-average analyses, then your best bet may simply be to invest in exchange-traded funds (ETFs) for the broad market indices. As the economy grows over time, the benchmark indices (and ETFs) will rise. To quote Warren Buffett, “Never bet against America”. At least, not yet.
Box Article: What pushed the Fed to make its dovish December pivot?
There is no question that the US Federal Reserve’s unexpectedly dovish pivot in December added fuel to the stock market rally. Emboldened by Fed chair Jerome Powell’s comments, the market began pricing in at least three more rate cuts than it had before the meeting. That, in turn, justified another surge in stock prices. Surely, the Fed must have some inkling of the effects of its words on the market.
Stock market gains will create a positive wealth effect and boost consumption, while expectations for short-term rate cuts also drove down longer-dated Treasury yields, which are the benchmark for the pricing of almost all commercial borrowings, including mortgage rates. The resulting looser financial conditions could lead to resurgent inflation and complicate the Fed’s objective to bring inflation down below 2%.
So, why did Powell say what he did, a complete reversal from his previous higherfor-longer narrative? As recent as early December, the Fed chair was insisting that it would be premature to speculate on when policy might ease. By mid-December, rate cuts were something that “begins to come into view” and “clearly is a topic of discussion”. What changed in those two weeks is less clear.
There was no evidence of imminent recession. In fact, recession fears have all but evaporated. A soft landing became the overwhelming consensus. The latest Atlanta Fed’s GDPNow estimates a significantly more robust 4Q2023 real GDP growth of 2.7%, up from 1.2% over the two-week period. US retail sales for November came in stronger than expected. The latest unemployment reading dropped to nearhistoric lows, of 3.7% and lower than the forecast 3.9%. The economy added 199,000 jobs in November, again slightly better than the market expected. Average hourly earnings, a key inflation indicator, increased 4% y-o-y. Indeed, there were few changes in the Fed’s own economic projections from the last one made in September (Table 1 in main article).
This begs the question: Why the hurry to cut rates if the economy is holding up so well? Does the Fed know something it is not telling? Or was it due to political pressure, as some are suggesting, with the November 2024 presidential election looming? Stock market performance is a highly visible metric, and often viewed as a proxy for economic strength. Prosperity (perceived or real) tends to favour the incumbent while recession will favour the challenger. Case in point: President Joe Biden flaunted the stock market’s record highs in his recent campaign video. (Scan the QR codes for selected articles on the subject.)
The Fed is an independent institution and does not answer to the White House. Nonetheless, the Fed chair may not be entirely immune to some heat either, even if the central bank ultimately does what is necessary.
— Box Article Ends —
The Malaysian Portfolio chalked up another week of gains, rising 1.1% and outperforming the broader market. The top gainers were REDtone Digital Holdings (+4.3%), DBS Group Holdings (+1.6%) and Frasers Logistics & Commercial Trust BUOU (+0.6%), while the sole loser was Malayan Banking (-0.1%). Our acquisition of the Singapore Exchange S68 -listed stocks has been very timely — they have outperformed in recent weeks. And we do apologise for adding SGX stocks into this Malaysian Portfolio, owing to the lack of equivalent opportunities on the Bursa Malaysia.
Total portfolio returns now stand at 168.8% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 20.1%, by a long, long way.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
