Investors face tough choices in an imperfect world, but can look for opportunities in fixed income while remaining cautious on emerging markets and commodities.
Investors will need to make deliberate choices in 2024, paying close attention to monetary policy if they want to avoid a variety of potential pitfalls and find opportunities in an imperfect world of cooling but still-too-high inflation and slowing global growth.
Markets have already baked into asset prices the idea that central banks will manage a smooth transition to reduced levels of inflation—meaning there’s limited runway for increased valuations. But 2024 should be a good year for income investing, with Morgan Stanley Research strategists calling bright spots in high-quality fixed income and government bonds in developed markets, among other areas.
“Central banks will have to get the balance correct between tightening just enough and easing quickly enough,” says Serena Tang, Chief Global Cross-Asset Strategist at Morgan Stanley Research. “For investors, 2024 should be all about threading the needle and looking for small openings in markets that can generate positive returns.”
Getting through the last stretch of inflation is likely to lead to slower growth, particularly in the U.S., Europe and the UK. Meanwhile, China's tepid growth will weigh on emerging markets, and there's a risk that the country's economy could get sucked into a wider debt-deflation spiral, with ripple effects for the rest of Asia and beyond. Morgan Stanley predicts that China will avoid the worst-case scenario, and that U.S. and European policymakers will begin cutting rates in June 2024, improving the macroeconomic outlook for the second half of the year.
In 2023, equity markets showed strong performance as they recovered from the recession fears that fed into the October 2022 trough, proving more resilient than analysts expected. However, 2024 is likely to be a “tale of two halves,” with a cautious first half giving way to stronger performance in the second half of the year.
For the first half of 2024, strategists recommend that investors stay patient and be selective. Risks to global growth—driven by monetary policy—remain high, and earnings headwinds may persist into early 2024 before a recovery takes hold. Global stocks typically begin to sell off in the three months leading into a new round of monetary easing, as risk assets start pricing in slower growth. If central banks stay on track to begin cutting rates in June, global equities may see a decrease in valuation early in the year.
In the second half of the year, however, falling inflation should lead to monetary easing, bolstering growth. “We think near-term uncertainty will give way to a comeback in U.S. equities,” says Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. And Wilson expects earnings growth to remain robust into 2025: “Positive operating leverage and productivity growth from artificial intelligence should lead to margin expansion.”
Throughout the year, however, there should be a few constants. Overall, U.S. equities are likely to have fair returns and better outcomes than European or emerging-market stocks. “This becomes especially true if these economies don’t manage a soft landing,” says Tang. “In that case, we are likely to see a flight to quality in which the U.S. outperforms.”
Emerging-markets equities face obstacles, including a strengthening dollar and lackluster growth in China, where policymakers face the triple challenges of debt, demographics and deflation. These risks are compounded by the corporate focus on diversifying supply chains amid geopolitical tensions and the fallout from pandemic-era disruptions. However, emerging markets could see stronger recovery in the second half as lower rates and a weakening U.S. dollar could prompt inflows.
One global bright spot is high-quality fixed income. Yields on a broad cross-section of U.S. corporate and government bonds reached 6%, the highest since 2009. U.S. Treasury and German Bund yields are the highest they have been in a decade, and Morgan Stanley forecasts 10-year yields on U.S. Treasurys at 3.95%, and DBR at 1.8% by the end of 2024.
Overweight: A higher-than-average portfolio allocation Equal weight: An average portfolio allocation Underweight: A lower-than-average portfolio allocation
What might work for investors in this imperfect world? Morgan Stanley’s recommended portfolio construction has a lower risk profile than our cross-asset benchmark, largely due to strategists’ recommendations for lower-than-average allocations in commodities and emerging-market stocks.
Overall, Morgan Stanley strategists suggest an overweight across a broad range of bonds, an equal weight in both stocks and cash, and a significant underweight for commodities.
Here are some of the key views:
Overweight core fixed income, including government debt, agency mortgage-backed debt and investment-grade debt. It is likely to be a good year for income investing as high-quality debt continues to provide attractive yields, especially when compared against the risk/reward tradeoffs of other assets.
Overweight Japanese stocks. Japanese policymakers have been an outlier among central banks, keeping interest rates low to boost growth.
Equal weight U.S. equities. For the past two years, the outlook was gloomier for stocks in the U.S. than anywhere else in the world. However, 2024 is shaping up to be different as U.S. equities should notch better outcomes than European or emerging market equities, particularly as central bankers globally aim for target rates. Within the U.S., healthcare is forecast to outperform, and Morgan Stanley prefers industrials relative to other cyclical sectors.
Underweight emerging-market equities, except Mexico and India. China’s lackluster growth will weigh on emerging markets broadly, and there is an added risk that its economy will get caught in a debt-deflation tailspin. By contrast, Mexico is likely to benefit from the post-pandemic near-shoring trend, while India is forecast to see superior growth in earnings per share compared with broader emerging markets.
Underweight commodities. Oil is forecast to trade at relatively flat prices in 2024 and geopolitics remain a concern, while gold appears overvalued. Copper, which could outperform because of stronger-than-expected demand from China, may be an exception.
Investors should keep in mind that the markets have priced in the expectation that economic growth will go smoothly, and that central bankers will succeed in engineering a soft landing.
“Markets seem to already assume that central banks can stick the landing,” Tang said says. “There is little room for error as far as valuations are concerned.”