Sometimes stock markets appear to change direction because they have simply run out of either optimism or pessimism. There are of course good underlying reasons why stock markets rise and fall, but they also present an interesting history of the patterns of collective human behavior… and we often repeat ourselves.
The pessimism mindset took over in November 2021 as it became clear that inflation was not ‘transitory’ (or not as transitory as most had hoped!) and that interest rates needed to rise and possibly stay high for a while. This pushed up the cost of capital and made it harder for most companies and asset classes to generate positive returns for investors. That changed in October/November 2023 when the Fed implied that rate increases were likely over, and cuts were on the horizon for 2024. Excluding the impact of unknown future economic events, this should have broadly the opposite effect on markets than that we experienced from November 2021.
Once optimism had taken hold, markets rallied quite strongly in the last quarter leaving most up slightly over 2023. As so often happens, the end result did not quite reflect the actual experience of investing through 2023. For large parts of the year, and for most sectors, 2023 was difficult and painful for investors, but the falls in 2022 & 2023 have, we hope, provided the necessary reset in prices to let us look forward with a positive outlook from here and with fewer pricing risks and more potential opportunities in almost all sectors.
The positive outlier in 2023 was the performance of the ‘Magnificent 7’; the collective name for the very large cap tech companies, including Microsoft, Alphabet (Google), Meta (Facebook) and Amazon. The early stage, but no less exciting, developments in Artificial Intelligence (AI) have allowed their share prices to rally on the prospect of future growth that may emerge from the potential applications of AI. These are mainly well-run companies with good cash flow and little or no debt so should be less affected than others by the rising cost of capital, but it is always difficult to justify paying a very high price for as yet unproven technological developments. Nonetheless, the sheer size of these companies means their share prices move the market, with these 7 stocks providing around two-thirds of the returns of the S&P 500 (the 500 largest stocks in the US) in 2023. We tend not to invest directly in these companies but have benefited from their rally to some extent as they feature highly in the top holdings of most of the Global and North American funds and indices; however, it is important to remain conscious of how a change in fortunes for these 7 companies might feed through into investments that have relied on them heavily to date.
Looking Ahead
We think that the main theme of 2024 will be changeable and often contradictory economic readings – in particular inflation and economic growth. For portfolios, this is likely to result in periodic rotations of winners and losers with diversification by sector and investment style being an important driver of consistent returns.
In developed markets much will hang on Central Banks’ decisions on interest rates, the timing of any cuts, and the reasons for cutting. In general, falling rates are good for most investors – putting more money into the economy and consumers’ pockets and stimulating economic growth. This should have a positive effect on both equity and bond markets but also support alternatives, property and infrastructure. Central Bankers, however, do not often cut rates just because they are high and there is unlikely to be much appetite amongst developed market Central Banks to be the first mover here at risk of reputational damage amongst the monetary policy community. Instead, rate cuts are usually initiated on the back of a slowing economy (recession) or due to an unexpected economic shock, e.g. Covid or the Financial Crisis of 2008/9. In all cases the aim is to stimulate growth, but the reason for the rate cut may have an impact on what does well, with parts of both the equity and bond market vulnerable to economic shocks.
It is also important to be alive to the fact that the data that drives these decisions involve variable time lags and rarely move up or down uniformly. It would not be too surprising if we were to see a monthly increase in inflation readings at some point, and if that happens, we would expect most markets to pull back temporarily.
Politics & Elections
With elections looming not just in the UK and US, but also across much of the democratic world, within the next 12 months we are frequently asked about the impact of political change. Over 50% of the adult population of the planet will be involved in elections this year – although not all have more than one party to choose from! In the UK our view is that a change of government is quite probable, but the constraining economic circumstances mean that substantial (market moving) policy change is less likely. In the US it is very early to call – whatever one might think of the man, the markets have historically reacted favorably to Trump who is seen as tax cutting and pro-business; however, the impact of his geopolitics might have more worrying implications. Either way, his election is by no means certain and US politics is notoriously unpredictable. Overall, we expect that politics will have less of an impact on investments than monetary policy decisions this year, but we never rule out surprises.
Investment Thinking
When thinking about structuring portfolios for the medium to long term, we are keen to make sure they are well diversified and that the ability of the investments that we select to deliver long-term returns is clear. That said, we are also mindful of ‘duration’ (the sensitivity of an investment to a change in interest rates) and particularly how portfolios might perform in one of several possible outcomes for the year(s) to come, such as a recession, the economy moving into a stagflationary environment (stubbornly high inflation and weak economic growth) or, the ideal outcome, a soft economic landing. We would not be surprised if 2024 had elements of all three of these potential outcomes; however, with many sectors that looked expensive in 2022 becoming much cheaper throughout 2023, there are several traditional diversifiers (notably Fixed Interest but also a number of ‘real assets’) that should help deliver consistent portfolio returns as we move through this potentially changeable year.
Cash – It is now possible to obtain a rate of interest above the rate of inflation, however variable rates are likely to fall with interest rate expectations. We always recommend holding cash to meet short-term needs or for emergencies, and it is currently possible to lock in quite attractive rates on fixed term deposit. As a long-term investment/hedge against inflation, however, cash is less useful and poses a reasonable timing risk if one attempts reinvest before interest rates fall, cash returns reduce and investments increase in value. As uncertainty remains, we see some advantages in holding slightly higher cash balances in the short term to reduce volatility and provide liquidity to be invested as the interest rate picture develops; however, for long term objectives, staying in the market is usually the best policy.
Bonds (Fixed interest) – Better returns are now available from these traditionally ‘medium to lower risk’ investments. As we covered in last quarter’s commentary, we have been gradually adding bond exposure to portfolios as income/yields are now quite attractive and bond values should rise if interest rates fall – both of which add diversification to portfolios. We favour Government Bonds for safety and high quality ‘strategic’ corporate bond funds to help manage credit risk as defaults in the private sector may increase if the reason for a rate cut proves to be a significant recession in developed markets. With this in mind, we remain cautiously optimistic about starting to build bond exposure in portfolios, albeit selectively.
UK Equities – Since Brexit and its ensuing political fallout, exacerbated by the November 2022 ‘Mini-Budget’, the rest of the world has taken a dim view of the UK as a sensible place to invest. As a result, perfectly good UK listed companies, some of which are global businesses, are valued substantially more cheaply than their European or US counterparts. Whilst the UK is not without its problems, we think this pricing anomaly is overdone and should resolve over time; indeed, there is already evidence of US corporates snapping up UK assets at bargain prices. Consequently, we are quite keen on UK Equity funds in general – there are a number of quality dividend income funds that we regard as core holdings, but we have been adding exposure to UK smaller companies for those prepared to take more risk.
Overseas Equities – Aside from the more speculative excitements of AI stocks, the good news for investors is that following the purge of pessimism, most global equities are now looking more sensibly priced and it is quite possible to buy developed and developing market shares on relatively attractive valuations. On the assumption of either the ‘soft landing’ scenario, or a mild recession followed by recovery, US Mid and Small Caps should do well. Europe has its own problems but includes good companies at reasonable valuations and Asia is in a similar position. We remain wary about direct investment into China, mainly because we cannot gauge the political and economic risk, but other parts of India and Asia are attractive and generally supported by better long-term demographics than the west.
Alternatives – This heading includes funds invested in real assets such as specialist property, infrastructure, and renewable energy amongst other things. A common feature of these funds is that they have good, long term and often index-linked income streams. Many, particularly those structured as investment trusts, have been hit by rising interest rates, but should rebound as interest rates fall. Should we experience stagflation, resulting in interest rates falling to support the economy but inflation remaining high, many of these assets could hold up well. In the meantime, investors are being paid high levels of income as they wait for recovery.
Overall, we are positive about the prospect of good investment returns in the coming years, but we do not think that these will be delivered smoothly through one investment style or sector as volatility in economic readings persist. We would rather avoid direct exposure to China, and we approach investment in the Magnificent 7 with some caution on valuation grounds, but we think most other stock and bond markets offer the potential for good risk adjusted real returns without looking too highly correlated with one another. History and the long run data illustrates the importance of valuation on future returns so we will be looking to take advantage of good opportunities as they arise, but the uncertainty over the path and timing of interest rates means we will continue to take a long view and diversify appropriately.
This note is intended as a general market update and should not be regarded as specific advice or treated as a recommendation to invest in any particular fund or asset class. Stock market investments can fall as well as rise. If you would like to discuss the implications for your own portfolio, please do get in touch.