Unloved low quality stocks will have their moment in the sun in 2024

Good day. I’m Javier Corominas, Head of Global Strategy here at Oxford Economics. The past year has seen a significant change in how equity investors respond to moves in yields. In the early stages of the Fed’s tightening cycle, rising yields weighed most heavily on long duration growth stocks such as those in the tech sector. However, over the last 12 months, the correlation has actually flipped, with those stocks outperforming even as bond yields rise.

What’s going on? Well, we think investor concerns appear to have shifted to the impact of rising borrowing costs on corporate balance sheet health. Low quality stocks like those with weak balance sheets and low profitability are now the most vulnerable to higher yields. These low quality stocks actually outperformed sharply in Q4 last year as investors moved in to prices swift easing rate cycle.

However, they have given up the relative gains over the last three months as inflation has proven sticker than expected and rate expectations have been pushed back in line with our forecasts. We think these low quality stocks may actually experience further volatility in the near term as inflation uncertainty remains elevated and the Fed is rather non-committal on the timing of the first rate cut.

However, we believe they will ultimately be the beneficiaries of our soft-landing view. We expect financial conditions indeed to continue to ease gradually as major central banks begin cutting rates in the second half of this year. Combined with the ongoing resilience of activity we still expect, this will allow the equity rally to broaden out and low quality stocks to catch up.

Within equities we actually have a preference for small or large caps and we are currently overweight financials, consumer discretionary, and REITs, which currently dominate low quality baskets.