Investor sentiment is excessively optimistic even for a soft-landing

I’m Javier Corominas, Head of Global Macro Strategy here at Oxford Economics. The sharp end of year rally has left investor sentiment looking rather stretched. Our risk sentiment indicator is now in extreme optimism territory. Now, all of the individual components rose in the past month and the overall indicator is back at the level it reached in June last year ahead of the Q3 equity market sell off.

The indicator is consistent with a view that the market has a very rosy outlook for 2024 and is potentially vulnerable to disappointment. Although we do expect a soft landing for the US economy this year, we think expectations of almost 150 basis points of Fed cuts this year are too optimistic given the stickiness of wages. And we see scope for a bounce back in yields as some of the earlier cuts begin to be priced out by the market.

We also expect further EPS disappointment in the near term. Consensus forecast for the Q4 reporting season have fallen sharply in recent months and do present a lower bar for companies to beat. However, we think expectations may still be too high on this front. Indeed, last week’s weak ISM release showed the US manufacturing sector remained in contraction territory at December, with new orders deteriorating. And this is inconsistent with consensus expectations of a further improvement in EPS growth for Q1.

We expect a modest decline, therefore, in US earnings over the next couple of quarters as top line growth slows and profit margins remain under pressure. Our top down model points to just about 3% EPS growth for the full year compared to the bottom up consensus, which is expecting more of a 10% rise.

In this context, we think DM equities as a whole will struggle to make further headway and are at risk of a renewed correction in the short term. We therefore see better risk-reward in safer assets and in EM equities in particular, where valuations and sentiment are not abstract.