Investment markets had quite a volatile 2023 but ended on a strong note with most markets posting significant gains over the year.
Global equities returned as much as 22.1% in local currency terms, reversing their losses the previous year and returning close to their all-time high at the start of 2022. It was a bit less of a rollercoaster ride in sterling terms, with global equities up 15.7% in 2023 and now back slightly above their end-2021 peak.
Fixed income also recovered some of the large losses sustained in 2022. US Treasuries returned 4.4% last year, while UK gilts and corporate bonds gained 3.7% and 9.7% respectively.
The strong market performance since October has been down to growing hopes that an economic soft landing is on the cards and interest rates will be cut considerably over the coming year. The key call now is whether these hopes are justified, or the market has got rather ahead of itself as it has done on occasion in the past.
Global economic activity has held up much better than expected and the outlook now seems to be for moderate growth, rather than a recession. The big squeeze on consumer real incomes is now behind us with wages once again increasing faster than prices.
Much of the hit from the rise in rates should also be over and the gains in markets have eased financial conditions significantly. Crucially, the recent good news on inflation means central banks will be willing to cut rates to support growth if necessary.
Inflation has slowed substantially, even on the core measures favoured by the central banks and even in the UK. Core inflation is down to 3.2%, 3.4% and 5.1% in the US, Eurozone and UK respectively. These declines have occurred despite labour markets remaining very tight.
Still, it remains far from clear how easy it will be to reduce inflation all the way down to the 2% targeted by central banks. Longer term sources of inflation pressure include deglobalisation, decarbonisation and ageing populations. If growth were to remain firm, inflation could quite conceivably rear its ugly head again down the road. When push comes to shove, the authorities may well tolerate inflation remaining closer to 3%, if a return to 2% required a recession.
The Fed has abandoned its previous mantra of rates needing to remain higher for longer and is now very much talking of lowering rates, with three 0.25% cuts pencilled in by year-end. The ECB and BOE, by contrast, remain much more cautious about the prospect for policy easing.
However, as far as the market is concerned, substantial rate cuts are looming. It is now pricing in rates in all three regions starting to be reduced in the spring and being lowered by as much as 1.25-1.5% over the coming year.
Where does this all leave us? We believe the macro backdrop is much improved although a lot of the good news is now priced in. Global equity valuations are back a bit above their long-term average, while bonds are now pricing in rates falling considerably faster than the central banks are suggesting.
Valuations, however, are really only a good guide to returns in the medium to long-term. In the meantime, the apparent goldilocks-type outlook could well continue to drive markets higher. They should be supported, when rates start falling, by a reversal of some of the large inflows into money market funds seen over the last couple of years.
There also lies a wide dispersion in valuations behind the cautionary global picture. Whereas the US continues to look excessively expensive, other markets such as the UK and to a lesser extent emerging markets appear abnormally cheap. Small and mid-cap stocks also look good value, both here in the UK and the US. We continue to favour areas such as these where cheap valuations boost the potential upside.
As for bonds, yields may now be down significantly from their highs but remain the highest on offer for over a decade. And with yields likely to fall further as rate cuts materialise, returns should be boosted by capital gains.
History certainly suggests that the rein of cash as king tends to be quite short-lived. In the past, bonds and equities have both outperformed cash significantly in the years following the first interest rate cut. The recent strong performance has only highlighted the danger of being holed up in cash for too long and trying to fine tune one’s re-entry back into the markets.
This all sounds fairly positive. Even so, there is still reason for some caution. As we have noted before, the momentous forecasting misses by almost all and sundry in recent years mean one should keep a fairly open mind about what lies ahead. The structural changes underway in the global economy mean economic forecasting is even more difficult than ever.
The political backdrop can also not be wholly ignored even if, nine times out of ten, this is in fact the correct approach. Geopolitical tensions remain heightened and an escalation of the conflict in the Middle East is a clear risk.
Over half of the world’s population also goes to the polls this year, although arguably only one election really matters. And even here, it is far from clear what the implications are. The election of Donald Trump in 2016 was greeted with trepidation, only for markets then to rally.
All said and done, despite the market gains already seen, the better economic outlook means there are still opportunities to exploit. This is true for both bonds and equities, particularly in the cheaper parts of these markets.
That said, while our investment portfolios are tilted to these areas, they remain well diversified. We continue to believe diversification remains crucial in these unusually uncertain times.
Rupert Thompson – Chief Economist