Q4 2023 reflection
Q4 2023 in summary:
- Fed’s work is done - rate cuts are coming
- A new hope: economic soft landing?
- Resurgent markets - stocks and bonds rally
- All about a few Tech stocks…?
- …but plenty of global opportunities
- Bonds are an effective part of the toolkit again
- Sterling recovery: ready for a change in government?
- A year of elections in store
Markets came into 2023 in gloomy spirits after crushing losses for both stocks and bonds in 2022. The year began with fears of imminent recession, evolving into bouts of market anxiety over stubborn inflation and higher-for-longer global interest rates. The US economy proved resilient, but stagnation in the Eurozone and UK and weak growth in China, suffering a real estate downturn, gave cause for concern. Escalating violence in the Middle East threatened both humanitarian disaster and economic uncertainty, with volatility in oil prices and fears that shipping being diverted from the Red Sea would disrupt supply chains and rekindle inflation.
Yet we closed the year with investors in a far more buoyant mood, with recession avoided (for now), new hopes for an elusive economic “soft-landing” and inflation seemingly under control. With the inflation battle won, money markets shifted from bracing for a long period of tight interest rates towards pricing in a steady procession of rate cuts beginning in early 2024. Expectations of looser monetary policy and the growing hope that a sharp downturn could be avoided fuelled an upsurge in asset prices, with bond yields retreating rapidly from post-2008 peaks and global equities back within touching distance of all-time highs.
Investors made healthy gains in 2023 across almost all assets and markets. Stocks rebounded sharply, with global equities returning 23% for the year. Other assets typically held in diversified portfolios lagged equities, but still generally provided positive returns. Global bonds returned 6% (for a broad index hedged into Sterling), with almost all segments of the bond market contributing. Most commodity prices fell, including oil and many metals and agricultural commodities, but gold - perhaps the commodity most likely to be held in investment portfolios - gained 8% in US Dollar terms. Currency was more challenging: for Sterling-based investors, overseas currency exposure was generally unhelpful, with the Pound continuing its recovery from the lows seen during the short-lived Truss premiership: Sterling was the strongest of the major currencies in 2023, gaining 5% versus the Dollar and 2% against the Euro. Of course, the reverse is true for Dollar-based investors: the Dollar’s decline in 2023 against most major currencies meant that overseas currency exposure added a small boost to returns.
Global equity market gains were driven by a handful of giant US technology firms, but it’s not quite fair to suggest that tech was the only game in town. While Value stocks made “only” 12% and small/mid-cap stocks 16%, US large-cap growth stocks returned over 40% in 2023, a stellar performance: but even they were outperformed (in USD terms) by equities in Poland, Hungary and Greece, although, few investors would have exposure to those particular markets.
When we zoom out and consider the broad US equity market, we see a standout performance again: US stocks gained 25% in the year, with the tech sector clearly responsible for the lion’s share of those gains. But many international markets did even better: equity indices in Mexico, Brazil, Taiwan, Italy, Germany and Spain all outperformed the US stock market (in US Dollar terms). Investors in Japanese equities made 28% in Yen terms - those who sidestepped the foreign exchange weakness by hedging their currency exposure also outperformed US equity. So, 2023’s gains might appear on the surface to be all about US tech, but there were widespread opportunities for strong gains elsewhere in well-diversified global portfolios.
We highlighted at the start of 2023 that investors tempted to diversify into bonds - perhaps to allow more risk-taking elsewhere in portfolios - faced a wide range of opportunities. Indeed, we saw positive returns in fixed income almost across the board, particularly towards the end of the year, as markets shifted decisively towards pricing in a steady series of rate cuts in 2024. US 10-year Treasuries endured a wild ride, nudging 5% yields in October, but ended the year where they started, with yields a little around 3.8%. Longer maturity bonds lagged a little, with yields ending the year a touch higher than they started, but returns were still positive. UK Gilts made a small gain and inflation-linked gilts a modest loss, as inflation fears ebbed and real yields rose a little. The most impressive returns came from riskier bonds, benefitting not just from falling government bond yields but also from falling credit spreads: despite ongoing concerns about the risk of recession next year, the excess yield demanded by investors for lending to riskier borrowers generally fell, boosting asset prices. Corporate bonds in the US and UK returned 8-9% in the year, with emerging market bonds (9-10%) and sub-investment grade bonds (debt issued by the riskiest borrowers) returning 13%: well ahead of UK equities or global Value stocks, with a much lower risk profile.
The bearish consensus coming into 2023 was in retrospect too pessimistic; we highlighted then that the long-term landscape for balanced or diversified portfolios was better than it had been for years, thanks both to cheaper equity valuations and especially thanks to the repricing of bonds, and that investors should stay the course: and so it proved.
The US economy in particular was far more resilient than most expected in 2023. Lead indicators and consensus forecasts point to slower growth in 2024, but not outright recession, before a modest rebound in 2025. Contingent on recession being avoided, analysts are still forecasting robust corporate earnings growth in 2024. Even so, the rally means equity valuations have become a lot more demanding, and bond markets are already factoring in significant rate cuts as inflation fades: markets have swung to a far more optimistic picture going into 2024.
Much though markets may be hoping for - and pricing in - a gentle economic slowdown and a recovery without a recession, this is a hard trick for central banks to pull off, and is still not guaranteed. There are clear downside risks as we head into 2024. Borrowing costs are higher than companies and households have been used to for the last decade or more, and the effects of this are feeding through, as companies roll over maturing debt and consumers face higher mortgage costs, perhaps at the end of fixed rate terms. Corporate bankruptcies have already risen, and there are more signs of consumers struggling to service debt, and unemployment rates have been trending higher. Inflation may have moderated, but households are still adjusting to higher prices, with the excess cash savings built up by many in the lockdown years now greatly reduced. Surveys of sentiment and spending intentions among both consumers and companies look very weak, at levels associated with recession in the past. China remains a drag, with expectations of a Covid-reopening surge failing to materialise, and activity undermined by a fragile property market. Markets may be pricing in a soft landing, but the risk of a bumpier landing has not been eliminated.
So much depends on the path of inflation: was the inflation shock transient after all? Headline and core inflation readings have fallen worldwide and continue to fall sharply. Annualised inflation over the last six months in the US is now at the Federal Reserve’s target. Services inflation has been stickier than inflation in Goods, especially in the UK, but is clearly falling now, and lead indicators suggest this should continue, easing pressure on households and creating more space for central banks to reduce rates and limit downside risks. External factors could still change these trends - a conflict-related oil price spike, perhaps - but otherwise the trend in inflation looks to be lower.
The interplay between growth, inflation and interest rates from here is critical for equity markets in particular. Investors are cheering the prospect of rate cuts, but the precedents are mixed. In past cycles, Fed rate cuts in the face of recession have seen meaningful stockmarket corrections; in the rarer circumstances when the Fed cuts rates and recession is avoided, stocks have rallied. If inflation is truly fading and markets no longer expect the Fed to return to a tightening bias, we should expect a strong focus on lead indicators that the economy is rebounding - flickers of demand, new orders rising relative to inventories, capital goods orders picking up and signs of life in consumer and corporate confidence surveys.
The coming year will be one of the most significant ever for elections around the world, with polls taking place in at least 40 countries. Some will be foregone conclusions: the ongoing war in Ukraine hardly seems likely to stop President Putin “winning” again. Others will see far more market focus. In the UK, the continued recovery of Sterling - up 5% over the last year - suggests that investors are relaxed at the likelihood of a change of government in the UK. In the US, presidential primaries begin imminently: the courts, and the potential emergence of new candidates on both sides, could yet play a role, but we should have a close eye on the economy: in the last hundred years, incumbent presidents running again have tended to win - as long as they haven’t experienced a recession on their watch. Scope for an economic soft landing will have political implications too.
So much is written about geo-political risk in the investment world, but it is arguably rare for geo-political events to have a lasting impact on markets. Nonetheless, it would be remiss not to mention several risks, but we need to go further than observing that the world is a risky place, and examine why any given risk should matter for investors. Investors are right to have a close eye on risks to shipping through the Red Sea: with more freighters diverted over longer routes, global supply chains are extended, increasing the risks of shortages or bottlenecks, with scope to reignite some inflation concerns. Perhaps investors are right to worry about relations between China and Taiwan, especially in an election year for the latter: Taiwan is the source of over 90% of advanced semiconductors, and clearly disruption in the supply of these would have devastating global economic impacts. Both of these issues highlight the risks of extended global supply chains and encourage governments and companies to invest capital in more resilient supply closer to home.
We have endured a period where good news for the economy was not always good news for markets, with stocks and bonds highly correlated, driven heavily by interest rate expectations. The recent rebound in both asset classes has been a bonus for investors, but it presents a challenge for portfolio construction. A shift in market focus away from inflation and interest rates towards growth suggests we might expect a shift in correlations: good news for the economy could become unequivocally good news for stocks again (and vice versa). With demanding valuations and sky-high expectations already priced in for large-cap tech stocks in the US, confirmation of a soft-landing could see investor demand spread more widely, to cyclicals, small-caps, value stocks and emerging markets.
On the other hand, while so much investor focus has until recently been on the risks of resurgent inflation - a natural tendency to fight the last war all over again - less is said about the risk of inflation falling faster and further than expected. Current yields for long-dated bonds in the US and UK are at levels scarcely seen since the 2008 financial crisis and could still play a role for investors looking to lock in yields, as well as protecting portfolios against recession and deflation in the future. Credit spreads are quite narrow and don’t offer much compensation for the risk of downgrade or default, but yields of 5-6% can still be had for lending to high quality corporate borrowers, far higher than the yields available for the last decade and a half; this will also be attractive to some.
N.b. All content is based on data at the time of writing on 5th January 2024.