Sticking the landing

The surprising resilience of US growth has been the one constant throughout this unprecedented economic cycle. This time last year we viewed recession risk as low relative to consensus, due to the underappreciated strength of the underlying fundamentals, and have confidence this trend will continue into 2024. A soft landing for the US and global economy is our base case. To us, that means that the Federal Reserve will begin lowering interest rates for a good reason (the progress made in getting inflation lower), rather than a bad reason (a deterioration in growth large enough to require monetary stimulus).

Nominal growth has considerable room to slow from its Q3 pace of 8.9% quarter-on-quarter annualized without triggering recession concerns. In aggregate, the private sector is not overextended – neither households nor businesses are spending beyond their means. Inflation has slowed by enough for markets to price in an easing cycle from central banks, so financial conditions are much more supportive of growth than they were just six weeks ago. Progress on disinflation means real income growth is still positive, while household net worth remains in a strong position, which should allow for continued growth in consumer spending.

We anticipate that stocks will meaningfully outperform bonds if the US economy achieves a soft landing. In our view, pricing in the bond market is already much more consistent with this positive economic outcome than the stock market. In a soft-landing scenario, we believe global equities will comfortably ascend to new all-time highs in 2024 while it is unclear whether longer-term bond yields have much further to fall.

Recessions are typically caused by excesses that develop in the private sector that need to be corrected (mid-2000s real estate bubble or dot-com era capital spending) or major exogenous shocks (the coronavirus pandemic). We judge that there are few obvious imbalances in the household or business sector that need to be curbed.

On the contrary, corporate executives have spent the past 18 months preparing for a recession that has not arrived. There is little scope for further retrenchment. Only recently has their perception of recession risk receded somewhat, and this decrease in pessimism happened before the recent decline in yields, which in our view should further bolster corporate confidence.

We believe the US economy will continue to receive a favorable impulse from past spending incentives for corporations (from the Inflation Reduction Act, CHIPS Act, and infrastructure package) that may help lift business investment. We see scope for upside surprises as firms engage in delayed maintenance capex or expand operations in the face of end-user demand growth which, while slowing, is still positive. Success in achieving a soft landing would provide the potential to shift from the income-driven cycle that has marked the past three-and-a-half years to one where both income and credit are contributing to higher economic activity.

Exhibit 1: Corporate sentiment is thawing

CEOs were asked: "Over the next 12-18 months, are you preparing for..."

Source: UBS Asset Management, The Conference Board, The Business Council. As of Q4 2023.

Financial conditions eased significantly in November as evidence of a cooling in US economic activity and inflation accumulated. The six-month annualized rate of core PCE inflation is running at 2.5% through October. A host of labor market metrics have also moved towards pre-pandemic norms. In the recent past the Fed has needed to push back when financial conditions have eased too much, because inflation was too far from target. There is less need to do so now because the economy has ‘earned’ the most recent easing of financial conditions. 

As such, some of the “long and variable lags” from the Federal Reserve’s tightening cycle have now been blunted, in our view. The effective interest rate paid by corporates on the looming “maturity wall” of debt will not rise as much as it otherwise would have. The drag on household disposable income and spending from higher interest rate expense should be less intense, while residential housing resales and mortgage applications are also likely to pick up steam if this interest rate environment is sustained.

Of course, maintaining this level of financial conditions, or seeing them ease further, is contingent on inflation remaining well-behaved or moving closer to central bank targets. A key risk to our view is that relatively sticky price pressures could reverse some of the improvements in financial conditions and push real income growth lower.

To be clear, the Federal Reserve is still likely to deliver some interest rate cuts in 2024 even if price pressures fail to decelerate further from their recent trend – but, in our view, not as much as markets are currently pricing. Substantial uncertainty remains as to whether inflation will allow for the 125 basis points in easing from the Federal Reserve in 2024 currently embedded in short-term interest rate markets.

Separately, there is the risk that, as economic data continue to cool, more metrics will occasionally appear to be more consistent with a recession than a soft landing. We have seen in 2023 how quickly economic narratives can change and expect the path to a soft landing to be a bumpy one. In general, we believe there will be opportunities in 2024 to address extremes in valuations by adjusting positioning whenever markets lurch too far towards pricing in either persistently sticky inflation, an imminent recession or a soft landing.

Exhibit 2:Business investment has room to catch up to trend

Source: UBS Asset Management, Bureau of Economic Analysis. As of Q3 2023.

Importantly, major economic regions outside the US – such as China and the European Union – are relatively sluggish, which is helping to reinforce the broader disinflationary regime. Soft demand in these economies, along with healing supply chains, has helped to drive the deflation in global goods prices. We believe global inflation would be higher and the Federal Reserve’s ability to consider interest rate cuts would be lower if Europe and China were firing on all cylinders.

In our view, both economies are poised to ’muddle through’ in the near term, in part due to these easier financial conditions. There are some green shoots in European survey data, both for manufacturing and investor sentiment, though few signs of a decisive turn. In China, the data are stabilizing to improving in most areas of the economy – except for the property sector. Incremental policy support has largely been successful in putting a floor under activity, and recent measures to improve conditions in real estate suggest property will be less of a drag on growth in 2024 than in 2023. In both Europe and China, the bottom-up profit revisions are underwhelming relative to other regions.

A global manufacturing recovery if easier financial conditions lift cyclical sectors could be a potential upside surprise to our global growth outlook, though this would also likely be accompanied by an increase in inflation risk, as well. 

Exhibit 3: Fund managers are betting on bonds over stocks

Which asset class do you expect to perform best in 2024?

Source: UBS Asset Management, Bank of America Global Fund Manager Survey. As of November 2023.

Stocks and bonds are in the midst of a strong run to close out the year, leading to some concerns that a soft landing is fully priced in already. We disagree, mostly in terms of the stock market.

We believe the surprise in markets for 2024 will be an equity rally without much of a decline in bond yields, only a decrease in bond market volatility. Consensus expectations are for the outperformance of bonds vs. stocks. However, we believe 12-month forward earnings revisions still point towards equity upside and stock valuations are not that stretched outside of a handful of mega-cap US technology firms.

Importantly, there is a record USD 6 trillion in money market funds. As cash rates begin to decline and recession concerns dissipate, we suspect a good portion of these assets will be redeployed in search of higher returns. Return-seeking flows into stocks and credit could catalyze much stronger performance in risk assets than consensus expects.

As growth moderates, there will be times when investors get concerned that the soft landing may turn into a hard landing. For multi-asset portfolios, this has one important consequence: A shift from inflation risk to recession risk implies the positive stock-bond correlation should weaken. This means traditional portfolio structures may see strength in their fixed income holdings offset any episodic weakness in their equity exposures.

In our view, the US dollar is poised to perform well vs. other G10 currencies due to relative growth and rate differentials. The dollar is also a broad-based hedge that offers protection against the risk that inflation and growth are too high for the Federal Reserve to ease policy as much as is priced in, or if global economic conditions deteriorate more sharply than we anticipate.

Exhibit 4: Positioning indicators suggest investors' exposure to stocks is low vs. history

Source: UBS Asset Management, Bloomberg. As of November 2023.

The chart below shows the views of our Asset Allocation team on overall asset class attractiveness as of 2 November 2023. The colored squares on the left provide our overall signal for global equities, rates, and credit. The rest of the ratings pertain to the relative attractiveness of certain regions within the asset classes of equities, rates, credit and currencies. Because the Asset Class Views table does not include all asset classes, the net overall signal may be somewhat negative or positive.