Will a soft landing be achieved?

By Andrea DiCenso, Portfolio Manager, Alpha Strategies, Loomis, Sayles & Co

Heading into 2024, a key question continues to be: Will a soft landing be achieved? History suggests the likelihood is low, however, I think 2023’s market action and global Central Bank rhetoric suggest we are setting up for such an accomplishment. As investors debate portfolio allocations in the new year, I believe there are a few macro factors that will likely influence flows and total returns.

First, treasury risk premium is at 20-year highs relative to equities, marking a potentially attractive entry point for fixed income. Second, investors have generally been underweight global bonds for the last few years and there could be room to cover underweights. Third, interest rate volatility is falling. Much of 2023’s price action was driven by rate volatility as investors faced an environment of rising inflation and rising rates, beyond the realm of historical standards. In my view, global inflation has peaked, and I believe we will continue to trend lower over the next 12 months as supply chain bottle necks have normalized and demand price pressures are fading. Services prices remain sticky, however; as we’ve seen in most historical expansion late cycles, Central Banks tend to hike until something breaks. I believe the labor market is at risk for destabilizing expectations for a softer landing.

As of the end of December 2023, markets were pricing an 80% probability of a soft landing. What can
disrupt market expectations? Fed Fund futures are currently pricing 150bps of cuts through the end of 2024; in other words, the bar seems low for an upside surprise. With cross asset volatility trending near the lows, if inflation were to re-emerge, I would expect markets to price a hard landing shortly thereafter. I would view that as a possible buying opportunity, focusing my attention to global high yield securities as we would likely be transitioning to the credit repair phase of the credit cycle. Historically, 12 months beyond the Fed’s last hike has produced strong total returns for the high yield market. While defaults are at risk of rising, I believe the current yield is large enough to absorb much of those losses, potentially offering high single digit return prospects in the year ahead.

In my view, a key macro factor that stands to set the tone for risk-taking across global markets will be the path for the US Dollar. In inflation-adjusted terms, the Dollar currently seems 10 – 15% rich relative to its long-term average. This Dollar bull market began in Q2 2011, exceeding the historical 6 -9 year average cycle, largely attributed to a decade of US exceptionalism, in my opinion. What we can observe is that Dollar cycles often persist. In the year ahead, we could be seeing the Dollar break lower driven by falling interest rate differentials and non-US growth recoveries. I believe we are in the process of transitioning to a multi-year Dollar bear market cycle if US rates converge towards the long-term neutral average, potentially providing a window of opportunity for EM carry trades to perform well, despite elevated economic risks in China and Europe.