Hugh Gimber (pictured), global market strategist at JP Morgan Asset Management.
Economies have so far coped remarkably well with higher rates.
Coupled with signs that pandemic-related inflation is easing, the market narrative has shifted towards the prospect of a soft landing.
Bond markets are excited about rate cuts, spreads are at or below historical averages in most areas of credit, and equity analysts are forecasting double-digit earnings growth for 2024.
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Were this to play out, it would represent an extraordinary success for central banks.
But in my mind, such a benign outcome still feels a little too good to be true.
Interest rates still bite
There are reasons Western economies are less interest rate sensitive than in the past.
Overall private sector debt is a little lower than the last time interest rates reached these levels.
The big accumulation of debt in recent years has been by governments.
Many US households took advantage of the low interest rates on offer in the pandemic and the typical mortgage is locked for 30 years.
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In Europe, a higher proportion of households are mortgage-free relative to the US, and rates started rising from a much lower base.
Things look worse when we look at non-mortgage debt though, where rates are still largely variable.
In the US, total spending on interest payments has accelerated in recent months and delinquencies on auto and credit card loans are the highest level in over ten years.
Corporates also took advantage of lower rates a couple of years ago.
However, the amount of corporate debt that will have to be refinanced at higher rates starts to pick up more substantially over the next two years.
Overall, we are cautious about the idea that economies can easily cope with interest rates of 5% or more in the US and UK, and 4% in the eurozone.
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We expect the damage of higher interest rates will become increasingly evident in the consumer and business spending data in the coming months.
It is possible that the central banks will cut rates quickly next year in an attempt to avoid a downturn.
This concept has certainly gained traction post the Fed's dovish messaging at its December meeting.
Yet in cutting rates pre-emptively, policymakers would be risking a reacceleration in the inflation they have fought so hard against over the past two years.
Time to act in core fixed income
With uncertainty elevated and short-term interest rates at high levels versus history, cash looks tempting.
With no additional yield on offer from longer-term bonds, why take on more interest rate risk?
The answer is because we think that today's cash rates are a mirage.
In our base case scenario, the attractive cash rates available today will no longer be available in a year's time, as central banks, convinced that their work is done, finally start to ease off the brakes.
Sitting with large cash allocations therefore entails significant reinvestment risk.
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We would expect core bonds to outperform cash, as they have done in the two years at the end of each US rate hiking cycle since the mid-1980s.
Therefore, investors should focus on locking in yields currently on offer in core bond markets.
Although these yields are below current cash rates, investors should view this difference as an insurance premium that will pay out handsomely if a deeper recession than many anticipate does happen.
If the economy holds up more strongly, core fixed income will still have provided a healthy coupon.
Focus on margins
Across equity markets, we think investors should focus on higher quality stocks - those with robust balance sheets, proven management teams and a stronger ability to defend margins.
Firms are unlikely to have the same pricing power in 2024 that they did in times of bumper consumer demand, making the resilience of corporate margins a key differentiator.
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We also think investors should look at income strategies.
Despite potential downgrades to earnings expectations ahead, payout ratios are still well below pre-pandemic levels, which should still leave management plenty of room to return cash to shareholders.
Diversify via real assets
Negative correlation between stock and bond prices has been a key pillar of portfolio construction for much of the past two decades.
While falling inflation should help stock/bond correlations to decline over the coming year, we also anticipate more volatile inflation, and therefore more volatile stock/bond correlations over the medium term.
We therefore see an increased role for real assets, such as private infrastructure and timber.
These asset classes are often able to pass through higher inflation into higher returns, and therefore can be good diversifiers against the inflation shocks that lead to periods of positive stock/bond correlation.
For investors that do not have access to private market vehicles, commodity strategies and macro hedge funds could also help protect portfolios when both stocks and bonds are falling.
Hugh Gimber is global market strategist at JP Morgan Asset Management
