Making Sense of Mixed Signals
Against long odds, 2023 marked a year of magnificent returns and the return of investor optimism.
As fears of sticky inflation faded, a combination of global liquidity injections and AI optimism helped buoy markets and push a handful of mega-cap names—the so-called Magnificent Seven—to astonishing heights. More recently, expectations of aggressive rate cuts by the Fed broadened the rally and soothed hard-landing concerns.
In our 1Q 2024 Equity Outlook, we examine the sustainability of the potentially precarious drivers that, in our view, are underpinning the market rally. We also highlight lesser-known investment characteristics of the Mag 7, as they will likely continue to shake up active-management scorecards in 2024. Against this ever-challenging backdrop, we continue to emphasize quality equity portfolios with low Beta and minimal sensitivity to the underlying business cycle.
—Raheel Siddiqui, Senior Research Analyst, Global Equity Research
It is hard to recall another year in recent memory during which the interplay between the economy and markets was more of a head-scratcher for bears, bulls, the Fed and the broader community of commentators. It was a year in which the S&P 500 and the real economy diverged quite meaningfully. We believe the nature and drivers of this divergence offer important cues for our outlook on equities in 2024.
As we anticipated, the cyclical economy began to buckle under the weight of higher interest rates over the course of the year. That cyclical slowdown in the U.S. manifested in myriad ways in 2023:
- Labor: Both the breadth and duration of unemployment rose1; cyclical employment growth stalled2; continuing claims moved higher3; and hours worked shrank.4
- Production: Both industrial production and the manufacturing PMI have declined.5
- Investment: Fed surveys find that companies are reducing their capex plans for 20246; home sales and single-family units under construction declined7; non-residential fixed investment declined8; and loan growth, leading indicators, and money supply (measured by M2) contracted.9
- Growth: More U.S. states exhibited sequential economic weakness10; small business sales contracted11; corporate bankruptcies and consumer delinquencies rose12; consumers’ share of discretionary spending contracted13; tax receipts dropped14; and net earnings revisions for the S&P 500 fell into negative territory.15
Easing Inflation
Despite gradual deterioration in the cyclical economy, the market chose to focus on inflation, which eased steadily.
As 2023 progressed, the Flexible CPI (which primarily tracks goods and energy prices) decelerated sharply towards deflation, while the Atlanta Fed’s Sticky CPI (driven mainly by labor costs) descended halfway to the Fed’s 2% target from where it ended in 2022.16 For much of the year, the market action was dominated by a stunning recovery in tech, and a handful of mega-caps pulled the S&P 500 along. The AI hype helped, as did their earnings, which proved better than expected. These events—along with substantial injections of liquidity earlier in the year—helped boost equity valuations, despite the Fed’s aggressive hiking cycle.
Oceans of Liquidity
In addition to easing inflation, we believe substantial liquidity injections have significantly buoyed global equity returns, as shown on the left side of figure 1. (For additional context, please see the “Liquidity Dynamics” sidebar.) On the right side, we show that the correlation between market liquidity and equity returns averaged an extraordinary 90% during 2023—the highest level during the six years for which we have data.
For illustrative purposes only. Source: Left chart: Neuberger Berman and FactSet; data as of November 30, 2023. Right chart: GFR Macro; data as of December 5, 2023. Past performance is not indicative of future results.
Absent these significant liquidity injections, we believe conventional wisdom would have predicted a flat-to-slightly-negative market return in light of the weakening economic backdrop. Instead, all that liquidity stoked a lopsided market in which traditional bellwethers of economic revival—small caps and value-based sectors—trailed long-duration growth stocks with ostensibly below-average economic sensitivity. (More on the mega-cap tech rally below.)
Liquidity Dynamics in 2023
- Starting in the fall of 2022 (when S&P 500 was treading in the 3500s), roughly $8 trillion in new liquidity—mostly from China, Europe and Japan—washed over the global economy in just three months.17 The stock market welcomed it, and the S&P 500 rallied 14% by the end of January.18
- Next came the U.S. banking crisis in March 2023. To prevent a run on the banks, the U.S. injected an estimated $378 billion of net liquidity into the financial system.19 We believe this potent offset to the shrinking U.S. M2 money supply eased tightening financial conditions and boosted the stock market further. Following the fall of Silicon Valley Bank, the Treasury was able to provide fiscal stimulus without siphoning liquidity from the banking system and, ultimately, the economy. The Fed’s quantitative tightening (QT) campaign, along with the build-up in the Treasury General Account, could have drained $1.44 trillion from the system; however, cash flowing out of the Fed’s Reverse Repo Purchase account (RRP)—also $1.44 trillion—financed the Treasury’s needs without pressuring bank reserves. By our estimate, U.S. liquidity effectively expanded by $381 billion over the course of 2023.20
- At the current rate of decline, the RRP may be fully drawn sometime in Q1 2024. At that point, the government will have to finance itself by issuing coupon-bearing debt, which we anticipate would simultaneously drain reserves from the banking system. If not accompanied by forceful rate cuts, we fear the reduction in systemic liquidity could become a drag on the equity market.
Powell’s Pivot and its Potential Consequences
Fed Chair Powell, recently ignited a massive rally in nearly all financial markets, easing financial conditions very broadly and providing a stimulus for the economy in 2024. Encouraged by the progress seen in inflation and inflation expectations, the Summary of Economic Projections dialed back a 2023 hike, hinted at a 2024 cut, and forecasted an additional four cuts by 2025. In effect, the Fed telegraphed 75 bps in rate cuts en route to a potential soft landing.21 As of December, investors expected even further relief: Fed fund futures as of mid-December implied 138 bps in potential cuts.22
After Powell’s pivot, equities, bonds and precious metals soared, and the dollar’s retreat was unmistakable. Interest rate-sensitive segments of the stock market—already on the rise since October 23, when the 10-year yield peaked at 5.02%—continued to rally and significantly outpace the S&P 500’s more modest, though still substantial 12% gain.23
Investors welcomed the increase in market breadth and have begun to extrapolate it into 2024. The FOMC, on the other hand, disagreed with the market reaction, perhaps revealing at how out of tune it had been with the market’s mood. In an orchestrated expression of surprise, the Fed's leading doves broadcasted concern with the market's leap of faith, hinting that hikes were still on the table and rate cuts were a discussion premature.
It was a striking attempt at regaining narrative control, but in our view investors seemed uninterested. After the Fed’s media appearances, yields for 2, 5, 10 and 30-year U.S. treasuries tumbled between 26 and 37 bps; the Bund and JGB followed suit; and the S&P 500 advanced another 3.8% in straight gains.24 If “Don’t fight the Fed!” was the old adage for investors, December’s message from investors to the Fed felt more like “Don’t fight the markets!”
We believe it would take a series of resolute actions by the Fed to reestablish its commitment to tighter monetary policy and restore its place in the pecking order relative to the market. If Powell dampens the mood by not cutting rates soon, we fear a significant tightening of financial conditions could precipitate a sharp selloff in stocks and bonds.
Growth Challenges
While improvements in market breadth suggest that a more inclusive rally could be on the horizon, we believe a sustained rebound will require significant economic growth and liquidity—and risks to both, in our view, remain substantial.
First, fiscal stimulus is waning and broadly less supportive of growth. Consumer spending remains robust, but its drivers are fading fast: Household cash balances are being drawn down; consumer credit conditions have deteriorated; delinquencies are rising; and with the waning of inflation, the social security cost-of-living adjustments in 2024 will be a much smaller 3.2% versus 8.7% in 2023.25
And while stabilizing margins among the S&P 500 have improved the earnings outlook, topline growth is flagging, with positive sales surprises falling noticeably behind earnings surprises. Significantly, the next-12-month sales growth for the index is expected to remain below the Fed Funds rate.26 Should that trend not reverse soon, the cost of financing sales may disincentivize companies to pursue new growth initiatives.
Good News Looks Priced In
Given the onerous mix of a Fed-induced rally and a still-weakening economy, we believe a lot of good news is now priced into stocks.
First, according to Deutsche Bank, total equity exposure among discretionary investors (hedge funds and mutual funds) has reached the 86th percentile of weekly data dating to 2010.27 Similarly, elevated positioning levels have historically reverted to the mean in short order, which we think is likely next year. Additionally, positive sentiment is extremely high: Since 1987, equity investors polled in the recent AAII Investor Sentiment Surveys have been more bullish only 8% of the time,28 and we roughly estimate that U.S. large caps are now pricing in only a 5% recession probability.29
Second, we believe a favorable demand-supply balance has been providing further support for equities. J.P. Morgan estimates that, in 2023, institutional demand for stocks (primarily driven by equity long/short funds) exceeded supply by roughly $2.5 trillion, which supported the market rally.30 But the script looks likely to flip next year: The bank estimates that the supply of equities could exceed demand by $1.6 trillion in 2024, as big funds look to moderate their long positions from historically elevated levels.
In light of these developments, our analytical framework still calls for caution. Credit growth across the economy remains negative and the real Fed Funds Rate is still elevated. And while inflation continues to fall, the Fed may not be out of the woods yet: The labor market remains tight; wage growth exceeds 5%31; and above-trend savings and household net worth are fueling consumption among those with higher incomes.32
In this environment, we believe the Fed’s anticipated rate cuts, should they materialize, could run the risk of stimulating enough broad-based growth to reignite higher prices. Despite the market’s collective hopes, inflation—albeit seemingly in the rearview—may not have been fully tamed, and we fear a potential re-pivot by the Fed, amidst historically extreme investor optimism and positioning, would not bode well for equities.
All That Glitters…
Envy of the other 493 stocks in the S&P 500, the so-called Magnificent Seven—including Apple, Alphabet, Amazon, Meta, Microsoft, Nvidia and Tesla—wears extraordinary stripes. In the seven years prior to the Covid-19 pandemic, their collective top line grew at 15% compounded annually, versus just 2% for the rest of the index. Since 2020, the Mag 7 have increased sales by 16% a year.33
Even in a challenging growth environment, these heavyweights delivered impressively in 2023: The Mag 7’s net income grew 34% versus 1% for the other 493 stocks in the index (see the left side of figure 2), and in a show of investor confidence, their collective P/E multiple expanded 30% compared to 9% for all the rest. As a group, the Mag 7 generated a 75% return for the year, versus 25% for the S&P 500; without them, the broader index would have risen just 12% (as shown on the right).
Big tech’s influence on sector performance was palpable, too. Without these seven names, the Tech sector would have returned just 15% rather than 50%; the Communication Services sector, 7% versus 50%; and the Consumer Discretionary sector, 6% versus 33%.
We believe the collective heft of the Mag 7 has even broader implications for U.S. investors. The influence of this group—which now comprises nearly half the market-cap weight of the Russell 1000 Growth index and 28% of the S&P 500—has been boldly on display. In 2023, just one-third of U.S. core-and- growth-oriented funds outperformed their Mag 7-heavy benchmarks, whereas nearly twice as many value funds outpaced their benchmarks, which don’t include the Mag 7 (see the left chart in figure 3).
The Mag 7’s influence spans geographical borders as well. The weight of U.S. equities in the MSCI ACWI index has risen to an all-time high of 63% from just 46% in 2013. Less appreciated, perhaps, is that fully a third of this increase is due to the rise of the Mag 7! As a result, the U.S. now accounts for 1.7 times the weight of the rest of the world combined; without the Mag 7, the figure is a more modest 1.2 (as shown on the right). Such a reduction in geographical diversification within the index, we believe, could have longer-term implications for asset allocation and risk management.
In light of their sheer size and influence, we expect the Mag 7 will continue to shake up active managers’ scorecards relative to their benchmarks in 2024, and beyond.
…May Not Keep Turning To Gold
The Mag 7’s achievements in 2023 notwithstanding, we fear these marquee stocks could face headwinds in the coming year.
First, valuations appear precarious, in our view. Wall Street expects the Mag 7’s earnings and revenues to grow 33% and 17% per year, respectively, through 2025 (see the left chart in figure 4). Yet even considering the group’s relatively high returns on equity (shown on the right), the Mag 7 has the unnerving distinction of being the largest and most expensive grouping within the S&P 500. At current valuations, we believe this group—which now represents more than a quarter of the S&P 500—is roughly 60% more expensive on a P/E basis than the rest of the index, making them potentially vulnerable to even minor hiccups in the coming year.
Second, the Mag 7 may prove more cyclical than investors seem to expect. These giants are often considered defensive businesses given that their products drive the relentless modernization of society, and that they also boast strong balance sheets and relatively high, stable profit margins. Indeed, over the last three years, the Mag 7’s earnings beta to nominal GDP has been 30% lower than the rest of the S&P 500 (see the left side of figure 5); however, the price beta of these stocks—at 1.4—was 50% higher than the rest of the S&P 500 (as shown the on right).
Third, we believe the price returns of these seven stocks are highly correlated to each other—meaning that, from a portfolio perspective, owning them as a group is akin to inviting additional risk rather than diversifying away from it. Since 2017, the average pairwise correlation of the Mag 7 has been 55%—that’s 70% higher than for the rest of the 493 stocks.35 Furthermore, we find that correlation tends to rise during selloffs, which could make holding these stocks even riskier in a downturn.
Therefore—and despite some of their defensive characteristics—we fear that investors may have overlooked the inherent cyclicality and correlation of the mega-caps, potentially magnifying the investment risk should the Mag 7 begin to lose favor.
Looking at these stocks another way—through a factor lens—makes us conclude that overweighting these stocks is essentially a wager on specific factors that have contributed to their outperformance.
One of those factors is international exposure. As shown on the left side of figure 6, the Mag 7 derives roughly half of its revenues from outside the U.S., about twice the percentage for the average U.S. publicly traded company. Adding the Mag 7 to an equity portfolio could increase its sensitivity to international growth—a potential benefit when the global economy is humming, but a potential drag in a broader slowdown.
Additional factors may determine the Mag 7’s performance in 2024. Specifically, and relative to the index, the Mag 7 are rich in size, quality, momentum and growth factors, and outperform when these factors are in vogue. As noted in our previous 4Q 2023 Equity Outlook, these factors tend to be rewarded when economic growth slows—as it did in 2023—while being relatively shunned in favor of small size, lower earnings quality and high value when growth eventually rebounds.
Receding fears of a hard landing, mixed with hopes of significant interest rate cuts in 2024, have vaulted the STOXX Europe 16% year to date.36 However, we think bullish enthusiasm will fade as European equities reconnect with the gravity of steadily deteriorating economic fundamentals.
First, consider the contours of the recent rally: As shown in the left chart of figure 7, an equally weighted basket of 50 stocks with large-cap, high-quality, high-momentum and growth tilts—factors that we find tend to outperform when growth decelerates and investors seek to lower overall risk—has outperformed the broader equally weighted universe by 8% year-to-date; meanwhile, an opposite basket tilted toward smaller-cap, low-quality, low-momentum and value—factors that we believe tend to outperform when growth accelerates—has steadily underperformed by 16%.37 The market has spoken—and the message, in our view, isn’t entirely encouraging.
Source: Left chart, FactSet, BofA, data as of December 15, 2023.; right chart, FactSet, data as of November 30, 2023. Past performance is not indicative of future results.
Second, we believe the full impact of recent monetary tightening is yet to be fully felt. For context, since the early 1970s (when the official data began), there has never been a greater or faster reduction in the growth of M1 money supply.38 As shown in the right chart of figure 7, the current trajectory of M1 growth—which tends to lead manufacturing PMI by about nine months—could be signaling a weakening economy.
Next, higher interest rates continue to put pressure on household borrowing costs, now the highest since the European debt crisis 12 years ago.39 As a result, demand for consumer loans and mortgages has fallen for the last four quarters.40 Corporations appear no better off: Bank financing represents a full 70% of all corporate borrowing41 in the Euro bloc (versus around 21% in the U.S.). As a direct consequence of higher interest rates, we fear companies will cut back on capex, and sales growth will slow.
The European construction sector's outlook also appears to us to be worsening. Residential building permits have plunged by 20%,42 foretelling potentially weakening activity in this important sector. Furthermore, the IMF estimates that Europe’s fiscal impulse—the change in the government budget deficit as a percentage of GDP—will be negative next year, suggesting that fiscal policy could be a drag on growth in 2024. Meanwhile, in the European Industrial Production Index has contracted by a remarkable 6% over the past twelve months.43
As for whether recession is truly on the horizon, labor markets often tell the tale. We believe rising unemployment across several important European economies—Germany, Italy, and the Netherlands—has started to flash recessionary signals, even though the Eurozone’s overall jobless rate has held steady thus far.
While recent disinflation in energy-linked consumption categories has been an unqualified positive for the economy, services inflation—primarily driven by wages—remains elevated, growing at an above-target 4% year-over-year.44 At the same time, we expect real wage growth in the Eurozone is on the cusp of turning positive, which could continue to prop up services inflation.
Bulls point to the aggregate European household excess savings of about 1.1 trillion euros as a potential driver of consumer strength next year.45 Yet unlike in the U.S., where excess savings are being depleted, low consumer confidence may be curbing spending in the Eurozone. At this juncture, we believe Europe’s high and rising excess household savings is more a symptom of a worsening labor market rather than a ready source for above-trend consumer spending in 2024.
Finally, within the STOXX Europe 600 index, the signs of cyclical economic deterioration are both broadening and deepening. One key metric—the Earnings Revision Ratio—has fallen below 1.0, a level that effectively separates optimism from pessimism (see figure 8).46 Other metrics including the Sales Revision Ratio, the Capex Revision Ratio and the Price Target Revision Ratio have followed suit.
Source: BofA European Equity Quant Strategy and FactSet. Data as of December 5, 2023.
Given this potentially challenging backdrop, we think it is premature to overweight Europe in a global portfolio.
What could turn us bullish—and risk-seeking—in the new year?
We are keeping a close eye on four crucial indicators:
- Interest rates. If the Fed follows through on its projected cuts, thereby lowering the cost of capital across the economy, stocks could have more room to run.
- The Kansas City Fed’s Labor Market Conditions Index. This aggregate of 24 labor-market indicators has been falling for more than 21 months—a sustained turnaround could be a welcome sign.47
- Commercial loan growth. Thawing credit markets could imply that a sustainable economic recovery is in the works.
- The U.S. dollar. A secular decline in the greenback could be a harbinger of a broader, global economic recovery—and a tailwind for equities.
In 2024, we believe the relative weight of the Magnificent Seven—more than most other considerations—could well determine the success of active management. The challenge for portfolio managers will be to nimbly calibrate the active weights of these stocks—no mean feat if volatility continues to persist.
Against this challenging backdrop, we continue to emphasize quality equity portfolios with low Beta and minimal sensitivity to the underlying business cycle.
