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by  E.Savoie, CFA, CMT, D.E. Chornous, CFA Mar 22, 2024

Economic data has been resilient, recession risks have diminished, and inflation has cooled sufficiently for central banks to consider cutting policy rates at some point this year. In this environment, sovereign bonds are appealing, and while stocks have surged as investors embraced the improved odds of an economic soft landing, demanding valuations in U.S. large-cap stocks may limit upside potential.

Upgrading our economic outlook

A variety of factors have motivated us to upgrade the likelihood of a soft landing for the U.S. economy to 60% from 40% last quarter, and we now look for modest growth in the first half of 2024 instead of recession. We have also boosted our 2024 forecast for real U.S. GDP growth to 2.4% from 0.3% and project further moderate growth in 2025 that could be even stronger if central-bank rate cuts unfold. Our 2024 growth forecasts are now roughly in line with the consensus for most countries, and even slightly above for the U.S. and Canada. For emerging markets, our growth forecasts have also been raised slightly to reflect the positive effect of healthier developed-world economies. Although the soft-landing scenario is now the most probable outcome, we recognize that a recession remains possible given that higher rates represent an economic headwind, mostly affecting regions outside of the U.S., and several important recession signals remain in place.

Further improvement on inflation will likely be slower

Inflation has fallen significantly from its 2022 peak as the commodity shock faded, supply-chain challenges were resolved, and extraordinary central-bank stimulus was removed. While there has been tremendous progress so far, the journey from the current range of 2.75%-3.50% down to the 2.00% level targeted by most major central banks will be more difficult. Consumer prices could be supported by elevated fiscal deficits and the economy’s general resilience. Given that our base case forecast no longer incorporates a recession, we have increased inflation forecasts from last quarter, and these forecasts are no longer below the consensus. We still believe that inflation is more likely to fall than rise over the next year, as wage pressures gradually abate, goods inflation subsides and service inflation, which is still too high, declines. Shelter costs, the largest driver of inflation today, may also be set to decline, and the range of products and services affected by high inflation is narrowing.

U.S. dollar continues to face longer-term challenges

We remain bearish on the U.S. dollar, with our outlook premised on long-term headwinds. A combination of major factors should cause the dollar to decline over the next several years: the currency’s overvaluation, a reversal of capital inflows and the erosion of U.S. fiscal credibility. We expect the early beneficiaries of such dollar weakness to be the euro and the Canadian dollar, while the yen and British pound will likely lag. Emerging-market currencies may initially be held back by central-bank rate cuts, but will eventually be buoyed by widespread weakness in the greenback.

Central banks signal likelihood of rate cuts ahead

The period of aggressive central-bank rate hikes ended last year, with a small but growing number of central banks, all of them in emerging markets, starting to ease monetary conditions. Major developed-world central banks are now in a position to do so for several reasons. Inflation has dropped significantly and most major economies have recorded uncomfortably slow growth over the past year. We forecast five 25-basis-point policy-rate cuts in the U.S. over the next year, although we recognize that the timing and pace of monetary-policy adjustments will ultimately be guided by the path of the economy and inflation.

Bonds are close to their most appealing levels in nearly two decades

Bonds are near their most attractive levels in two decades after selling off from a state of overvaluation that had not been seen in 150 years. The fixed-income bear market of 2020-2023 rapidly pulled yields above 5% for the first time since 2007 and erased all of the overvaluation that had built up since the 1980s, which was accentuated by the pandemic. While the U.S. 10-year yield has declined from its October 2023 peak, at 4.25% it remains near the upper end of the historical range excluding the 1970s and 1980s, a period that featured extreme inflation. Our models confirm that sovereign bonds are attractive, with yields well above their equilibrium levels in major markets excluding Japan, where interest rates are still subject to central-bank efforts to suppress yields. Taking everything together, our models suggest that the appropriate level for bond yields is lower, as long as inflation continues to fall as we expect. In addition to the positive fundamental backdrop, there are a variety of bullish technical measures that suggest a solid outlook for bonds. Our own forecast is for a 4.00% yield on the U.S. 10-year bond a year from now, which would result in mid-to high single-digit returns over the year ahead and, importantly, with little valuation risk.

Stocks extend gains to new records, valuations are increasingly demanding

Global equities have enjoyed a powerful rally in the past quarter, with many major markets reaching record highs. Most of the recent gains, however, have been delivered by a narrow set of mega-cap technology stocks. The “Magnificent 7” in the U.S. was up 82% last year and has risen another 10% so far this year. The equal-weighted S&P 500 Index, which neutralizes the impact of these seven stocks, was up only 11.6% in 2023 and 3% this year, which is more consistent with returns in the rest of the world. Given more moderate returns, most major equity markets outside of the U.S. are trading at attractive levels relative to our modelled fair value. With respect to the U.S., many investors are concerned that the “Magnificent 7” is in a bubble given the group’s extraordinary gains. We note that these stocks are benefiting from trends in artificial intelligence and are not necessarily overpriced, as long as their earnings can continue to grow at a fast pace. Our work suggests that the “Magnificent 7” would have to grow their aggregate earnings by 23% each year for the next 15 years to justify their current valuation premium versus the rest of the market. Elevated valuations in U.S. large-cap stocks in general means that achieving decent returns on the S&P 500 will now require that solid earnings growth and heightened investor confidence be sustained.

Asset mix – maintaining asset mix close to neutral, with a bias to fixed income

Balancing the risks and rewards, we are maintaining an asset mix close to our neutral allocation, with a bias to fixed income. Our base case expectation is for the U.S. economy to continue to expand at a moderate pace and for inflation to continue falling at a rate that will allow central banks to cut interest rates at some point this year. Falling interest rates should be supportive of fixed-income assets and, importantly, at higher yield levels, bonds provide greater ballast against equity-market volatility within a balanced portfolio. For these reasons, we have added to our fixed-income allocation over the past several quarters as yields rose, closing our prior underweight position and ultimately moving to a slight overweight as the U.S. 10-year yield approached 5% in the fall of 2023. While we remain constructive on stocks over the longer term, we recognize that in the near term, sentiment is extremely optimistic and valuations are demanding such that investors are not being sufficiently compensated for the risk of an adverse outcome. As a result, we are maintaining a neutral allocation to stocks. For a balanced global investor, we currently recommend an asset mix of 60.0 percent equities (strategic neutral position: 60.0 percent) and 38.5 percent fixed income (strategic neutral position: 38.0 percent), with the balance in cash.

Recommended asset mix

RBC GAM Investment Strategy Committee

Note: As of February 29, 2024. Source: RBC GAM

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Date of publication: Mar 22, 2024

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