A Major Change in the Markets

March 24, 2024

4 minute read

by Erik L. Knutzen, CFA, CAIA, Chief Investment Officer—Multi-Asset Class, Multi Asset Strategies – EMEA, Neuberger Berman

Investors are now focused on growth more than inflation—what might that mean for portfolios?

When our Asset Allocation Committee (AAC) met last Friday, they did so in a very different market environment than three months ago.

In December, investors were still focused on the inflation and rates outlook, as they had been for two years.

The sell-off in both equities and bonds through August, September and October was followed by a mighty rally in November and December, driven by changing expectations around inflation and central bank policies. Month-over-month U.S. inflation dropped from its recent highs and, despite the cautious note in central bank commentary, investors priced for as many as six Federal Reserve rate cuts during 2024.

As the calendar turned to January, however, market participants appeared to start taking their cues not so much from changing inflation and central bank policy expectations, but from updated and improving data on economic growth. What has been happening, and what might it mean for portfolios?

Reversing Correlation

Inflation data has come in somewhat hotter than expected so far this year, and investors have accordingly repriced for three Fed rate cuts, not six. But a strange thing happened: Equities rallied even as bonds struggled, reversing the strong positive correlation we have seen between these two major asset classes for the last two years.

The change has been tentative but recognizable.

We noted it in these Perspectives at the start of February, for example. At the time, we acknowledged hawkish Fed messaging behind the sell-off on the last day of January, but as the quarter has unfolded, those equity-market stumbles have gotten shallower even as inflation and rate expectations have continued to rise. And in a busy week for central banks that included a surprise rate cut from the Swiss National Bank and a historic rate hike from the Bank of Japan, the Fed gave us upward revisions to inflation and rate expectations that were viewed as very positive for equities, but had only a modest impact on bonds.

Today, equities are up between 5% and 19% for the year, depending on which market you look at, while the Bloomberg Global Aggregate Government Bond Index is down some 3%. The 10-year U.S. Treasury yield has risen by almost 30 basis points.

In a way, the entire developed world appears to have reached the sweet spot that Japan has made its own over the past year or so. Last week saw a jump in Japan’s already above-target year-over-year inflation rate as well as an end to the longest period of sub-zero rates in history, but the TOPIX Index climbed to a new record high.

Think of inflation as normalizing worldwide: In Japan, inflation has normalized upward; elsewhere, while sticky, it has begun to normalize downward. Normalizing inflation allows investors to refocus on growth—and they have decided they like the resilience they see.

Bonds as Diversifiers

When it comes to portfolio implications, it is worth recalling that we anticipated these conditions in our Solving for 2024 outlook.

“Stickier inflation and slower growth may not be so bad for investors,” we suggested. “These conditions mean relatively high nominal growth compared with much of the past decade. This could be tricky for long-dated bonds and interest rate-sensitive equities, but more neutral for quality companies—those with strong balance sheets to shelter against the rising cost of capital, and the ability to sustain margins.”

First of all, then, recognize that these are improving conditions for equities, and perhaps especially for some of the high-quality but out-of-favor segments that are not already priced to perfection. Like the transition to the second wave of the artificial intelligence investment theme, a change of focus from inflation to growth could help broaden equity market performance beyond the “Magnificent Seven” and “Granolas” that have been hogging the limelight.

Second, recognize the reemerging role of bonds as diversifiers, now that stock-bond correlation has broken down. If growth persists, it may indeed be “tricky” for long-dated bonds. But if growth stumbles, perhaps because of the lagged effect of higher rates, we think equities now seem more likely to stumble, too—and bonds are more likely to benefit. Currently, more than $9 trillion of investor assets is sitting in cash and money market funds worldwide; we believe now is the time to add some duration in those assets and “make your money move.”

And third, do not dismiss the potential for inflation to become uncomfortably hot again, whether due to wage rises or geopolitical and trade shocks. Consider asset classes that might hedge that risk. Commodities are beginning to demonstrate that quality with recent rallies by oil, copper and precious metals.

Significant Change

Stay tuned for our second quarter Asset Allocation Committee Outlook in the first half of April, where you will be able to read more about how this significant change in the market backdrop is feeding into our broader investment thinking.

*****

What to Watch For

- Monday, March 25:
  - U.S. New Home Sales
- Tuesday, March 26:
  - U.S. Durable Goods Orders
  - S&P Case-Shiller Home Price Index
  - U.S. Consumer Confidence
- Thursday, March 28:
  - U.S. Q4 GDP (Final)
- Friday, March 29:
  - U.S. Personal Income and Outlays