Why equities will rise and private credit will deflate in 2024

2023 was a year where investors fretted about downside risks that never really eventuated. First, it was sticky inflation, followed by higher-than-expected policy rates, followed by the threat of an economic recession. Yet, through all the turmoil, the global economy didn’t collapse and neither did equity markets either here or abroad.

The consensus call is to approach 2024 with a cautious tone given inflation is still too high, activity is finally slowing as excess savings run low, and central banks continue to talk tough in the hope that markets do not get too far ahead of themselves in anticipating a start to policy easing.

However, we think this consensus view will be wrong, as it was in 2023, and that the equity market will rise strongly off the back of further progress in lowering inflation, the start of a policy rate cut cycle and an economic slowdown that proves to be shallow and short rather than deep and sustained.

The equity market has had 18 months to price in the higher for longer narrative and the risk of an economic slowdown. This is clear to see in the wide distribution of valuations across the broader markets, where many stocks are trading at their cheapest levels in many years.

While equities remain vulnerable to economic disappointment – as is normally the case – we are well past peak uncertainty regarding the growth and inflation outlook. A late cycle slowdown is not a reason to be bearish equities, but rather an outlook where investors should use any weakness as an opportunity to raise risk allocations rather than get more defensive.

As we look forward, we don’t believe the Australian market needs large doses of policy relief to enter a sustainable upswing. Instead, we think it needs signs that the tightening cycle is over and that the next move is incrementally supportive for businesses and/or consumers.

The delayed impacts of rising interest rates are inevitable, but outside of signs that the slowdown is accelerating or becoming more pronounced, we think the market will take a weaker macroeconomic backdrop in its stride. We see substantial dry powder sitting on the sidelines to buy the dips (rather than sell the rallies, as the bears presume).

We do expect further downside in earnings expectations as activity softens, but corporates have had time to adjust to a post-pandemic environment (raising prices to offset input cost pressures) and do not need large amounts of additional capital.

Furthermore, because the economic slowdown has taken its time to unfold (rather than via a large shock), different stocks and sectors are at different stages of the cycle. This provides some resiliency when viewed across the market, as some stocks can perform well while others come under pressure.

In addition, we think equity valuations are reasonable. They have not reached prior cycle trough levels but this has usually corresponded with deep recession periods or coordinated downturns, rather than gradual slowdowns where investors can be more discriminant across the market.

History shows that valuations are not a strong short-term timing tool and that they tend to provide their strongest signal at extreme levels (either when they are very cheap or very expensive). If the cost of capital is set to fall, the risk premium is not rising, and the economic slowdown is modest – rolling through sectors rather than crashing them all at once – then valuations don’t need to be “cheap” as a starting point for upside.

Fixed-income investments aren't created equal

Alongside an improving equity outlook, we think government bonds will also provide reasonable returns for investors who have been hit hard by rising rates in the last two years. Extending duration in government bonds also provides a hedge against growth risks should our central case prove incorrect.

However, not all fixed-income investments are equally appealing. In the rush to lock in longer-dated returns and remove “public” market risk (reducing the need for mark-to-market), investors have been piling into private credit at an unprecedented rate.

For some, this is the result of a desire to increase private market exposure and raise portfolio diversification benefits. For others, it is just a straight hunt for yields. We are always cautious when “hot” money flows are so significant.

When equities become volatile, we have seen similar rushes to other asset classes, for example, venture capital and unlisted properties, both of which are facing challenges. There will be both good and bad outcomes for investors across private credit.

Whether they’re achieved by vintage, sector or geographic exposure, higher returns do not come without higher risk. While we don’t believe credit problems will be systemic, our fears for individual investors revolve around unrealistic expectations.

In a slowing economic environment, credit conditions will deteriorate, and prices of credit will fall. We have already witnessed this from several listed corporates that ventured into global credit in the last few years, which were on the receiving end of significant write-downs in the past six months. While we don’t see a bursting of the private credit bubble, deflation is inevitable.

For equity investors, we should focus on incremental improvement as catalysts for upside and we think the coming 12 months will see plenty of this.

Have a great holiday season and happy stock hunting – and remember “money never sleeps”.