We are optimistic about the investment opportunities we see ahead in bonds, alternatives and equities. At this stage, staying fully invested and well-balanced will be crucial.
After a strong end to 2023, world markets appear to have stabilised for the time being. Of the outcomes ahead, we believe that a ‘soft landing’ is the most likely – but with some important caveats.
We expect inflation in the US and Europe to slow during 2024 and end the year close to central banks’ targets of 2%. That means central banks can reduce interest rates, possibly as early as June 2024, which should in turn boost economic growth, with positive implications for a range of asset classes.
A bullish consensus
In the final quarter of 2023 financial markets were re-energised by a speech made by Christopher Waller, a Member of the US Federal Reserve (Fed) Board of Governors[1], in which he indicated how the Fed might respond to further falls in inflation.
Of particular interest to investors was his observation that, as inflation falls, real interest rates rise – causing financial conditions to tighten further, even though official interest rates remain unchanged. If inflation continues to diminish, it would therefore be appropriate for the Fed to cut interest rates in order to prevent excessive tightening that could trigger a recession.
The markets responded with sharp rallies in equities and bonds in anticipation of interest rates cuts in 2024. Market sentiment has now swung from bearishness to a bullish consensus. There is scope for disappointment if interest rates don’t fall as far as the markets expect, and this gives grounds for some caution.
What could possibly go wrong?
The two key risks to the soft-landing scenario are a resurgence in inflation and excessive tightening by central banks. Of the two, the greater risk to a soft landing is inflation, whether of the sticky-and-hard-to-remove variety or inflation caused by a supply shock, such as a sudden increase in the oil price. Both of these eventualities could delay interest rate cuts and create a re-tightening of financial conditions, with adverse implications for bond prices, equity valuations and companies’ margins.
Secondly, the effects of interest rate rises are still working their way through the economic system, and over-tightening by central banks is still a possibility, even if inflation continues to diminish. Marginal easing of interest rates would be helpful but may not be enough for companies that have put off refinancing since pandemic and, sooner or later, will need to refinance at higher rates.
Europe seems to be the most at risk in this regard given the nature of its manufacturing businesses. Some, such as auto manufacturers, are facing stiff and heavily subsidised competition from China in addition to higher financing costs.
Commercial real estate is particularly sensitive to interest rates as it undergoes a dramatic transition. This is especially true in the office sector, where post-pandemic hybrid working has reduced demand for office space. This in turn raises financial risks in the banking sector, particularly among smaller regional US banks, which are significantly exposed to the property sector.
Property is also a major fly in the ointment in China. Although China’s economic growth is likely to remain near its government target, it is unclear how the deleveraging of its property sector will play out. The central role that property plays in the Chinese economy makes it politically and economically expedient for the Chinese government to intervene. However, it is unlikely that the Chinese economy will escape the deleveraging process unscathed. Given the interconnectedness of the global economy, a recession in China could mean a significant hit to economic growth for the rest of the world.
A disputatious world
A further source of risk to the soft-landing scenario comes from geopolitical tensions and the forthcoming US elections. Current and potential flashpoints – including the conflicts in Gaza and Ukraine and tensions between China and Taiwan remain contained, but this could change rapidly. We therefore continue to hold safe-haven and diversifying assets such as gold and government bonds.
The most recent development in the Middle East – disruption to shipping in the Red Sea by Iran-backed Houthi rebels – is likely to have a minimal effect on inflation. Although disruption to the Red Sea/Suez Canal route forces more ships to take a much longer passage via the Cape of Good Hope, transportation costs usually only account for 1.5% of total trade[2]. Furthermore, shipping contracts tend to be set months in advance, so the dramatic increases in shipping costs between Europe and Asia are unlikely to be fully realised until later this year. By that point, we expect the situation to have normalised.
More concerning is the possibility of conflict in the Strait of Hormuz, a strategically important choke-point that oil tankers must pass through on their way between the Persian Gulf and the Gulf of Oman. Disruption to oil supplies in this area could cause a meaningful rise in oil prices. The recent warming in relations between Iran and Saudi Arabia is encouraging, but any signs of the conflict in Gaza spreading to other parts of the Middle East (and potentially embroiling the US) could raise significantly raise the risk premia demanded by global markets.
Finally, US presidential elections in November could result in a second Trump administration. This would not necessarily be bad for global markets (US equities thrived during Trump’s first term), but it would add to uncertainty and therefore stoke volatility. Any moves by a Trump 2.0 administration towards higher tariffs, withdrawal of support for Ukraine, a re-freeze of US-China relations or reductions in US commitments to C02 reduction could have implications for specific equity holdings and even global asset allocations.
To read more about the five key global risks we are currently monitoring, and their implications for portfolio holdings, see our most recent Geopolitical Pulse.
A benign environment for equities
If our base-case outlook of a soft landing holds good, the prospects for equities are encouraging. Positive economic growth is naturally supportive for company earnings, while slowing inflation and wage growth, and lower energy and raw material prices suggests lower input costs. This should be positive for companies’ margins, provided that supply chains are not overly disrupted. Meanwhile, falling interest rates can reduce the servicing and refinancing costs of corporate debt.
US equity valuations are towards the expensive side but they should be supported by falling interest rates. The US market also benefits from being home to the Magnificent 7, the seven largest US technology companies. These are expected to provide the majority of US earnings growth for the first three quarters of 2024 and underpin higher valuations in the US market as a whole.
Outside of the US, valuations elsewhere are more in line with their historical averages and provide a good base for investment if global economic growth remains positive. Two outlying areas deserve mentions. These are Japanese equities, where corporate reforms and changes in monetary policy could release significant value, and global smaller companies, which have so far lagged the wider improvement in equity markets.
In terms of areas of strong ongoing growth, we particularly favour semiconductors, which are indispensable for the long-term themes of digitalisation, automation and integration of artificial intelligence (AI) into business models.
But bond yields are just as attractive
Both equities and bonds can perform well from today’s starting point, but investment grade corporate bonds offer a compelling margin of safety in comparison with equities.
For much of the ultra-low interest rate era since the Great Financial Crisis (GFC) of 2008, bonds have provided relatively low-income yields. Today, income yields have recovered to levels not seen in over a decade, while falling interest rates will support total returns as bonds are likely to rise in price. Furthermore, after the highest interest rate rises for 40 years, and with inflation appearing to be under control, bonds once again offer positive real (i.e. above inflation) returns.
For the first time in years, multi-asset investors are able to use bonds as diversifying assets and be paid a real return for doing so. Even low-risk government bonds show yields of roughly double the 2% inflation rate that major central banks are targeting. However, we particularly favour the risk-return profile of investment grade corporate bonds, where some yields are higher than the earnings yield on equities[3], and corporate bond spreads have scope to tighten further if recession is avoided.
Daylight ahead for alternatives
The third key area that could be an attractive source of returns as interest rates fall is alternative investments – specifically those that share characteristics with equities and bonds.
Alternatives such as infrastructure often have bond-like cash flows that extend years into the future, and they therefore respond to changes in interest rates in a bond-like way. Many such infrastructure investments are currently trading at steep discounts to their net asset values (NAVs) and offer attractive yields.
Private equity (PE) activity is also likely to recover in the year ahead. Higher interest rates have been challenging for PE, with tighter financial conditions reducing deal flow and leaving all but the largest PE firms struggling to raise capital. As a result, many PE firms have been unable to sell companies they have nurtured into the public markets as initial public offerings (IPOs).
However, as interest rates fall we can expect to see a potentially sharp recovery in IPO activity as a backlog of privately-owned companies come to market. Having the ability to realise the value of companies in their portfolios could be highly beneficial for the share prices of PE trusts that we hold in our portfolios.
Stay fully invested and well balanced
We are optimistic about the range of investment opportunities available, both in the short term as inflation continues to fall and interest rates follow suit, and over the long term in our most-favoured global investment themes.
Many assets are trading on attractive valuations, especially when compared to the post-GFC-to-Covid era and are supported by resilient economic growth. This is particularly true for bonds and alternatives. Meanwhile, equities offer fair valuations and expectations for strong growth in a number of sectors, including semiconductors and AI.
As always, risks are present – both known and unknown. Our best protections against them are balanced asset allocations, a commitment to holding good-quality core investments and the support of safe-haven diversifiers. At this stage, erring too far on the side of caution is itself a risk: remaining fully invested is crucial if investors are to reap the positive returns that we believe lie ahead.
[1] Something’s got to give, Governor Christopher J. Waller, 18 October 2023, speech at the Distinguished Speaker Seminar, European Economics and Financial Center, London, United Kingdom
[2] Goldman Sachs, quoted in Business Insider, Two reasons why Red Sea disruptions won't send inflation soaring again, 29/01/2024
[3] Bloomberg, 13/02/2024
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