Welcome to our ‘January 2024 Insights’ report where we provide you with the means to keep informed of the latest economic and investment market conditions. In this report, we set out our views on the current environment and the challenges and opportunities that lie ahead for investors over the next twelve months. Our aim is to keep you updated on such matters leading to better investment decisions and by extension more acceptable returns on employed capital.

The Year of the Fed Pivot?

Equity markets closed off 2023 delivering strong gains in the final months of the year.

The S&P 500 rallied for 9 consecutive weeks, posting a return of +16% in the November to end-of-December period with a 20.59% 12-month return. The ISEQ performed well with a 12-month return of 13.93% of which circa 12% was achieved from the 15th of October to the 31st of December. European equities rallied +17%, just ahead of the US.

What drove this incredible end-of-year market surge? There were a number of factors at play. We had a -12% correction in crude oil prices from $80/barrel to $70/barrel. The USD also weakened versus the Euro (-5.5%) and the Japanese yen (-6.5%). The catalyst behind the reversal of fortune was the shift in Fed policy from interest rate increases to cuts for 2024. While markets wrongly priced in such a pivot several times over the past year and a half, by year-end, inflation pressures had turned strongly enough toward disinflation to make it a reality.

For 2024, the biggest influence on financial market returns will be the shift from tightening policy to easing by major central banks in the US and around the world. Can Jerome Powell deliver a soft landing while navigating the biggest inflation surge in decades? So far, he has done a commendable job. 2024 will be a bumpy ride for equity investors. However, a positive market in equities should continue throughout the year, in our view, despite increased volatility.

Analysts believe inflation should continue to moderate. This may cause central banks to believe real rates are too restrictive, allowing them to reduce short-term rates before inflation targets are reached. In the US, the Bond markets have already priced in six 25 basis points interest rate cuts this year and in Europe 4.

As Jerome Powell pivots from hawk to dove, the US yield curve should steepen (lower short-term rates and flat to rising long-term rates) and the US dollar should decline versus other major currencies. Analysts expect real GDP growth to moderate, but a severe global recession is a low probability.

Equities

As we approach 2024, we expect both inflation data and economic demand to soften, as the tailwinds for growth and risk markets are fading.

Overall, we are cautious about the performance of risky assets and the broader macro outlook over the next 12 months, due to building monetary headwinds, geopolitical risks and expensive asset valuations. Looking ahead, assuming the US economy grows by 1%-2% in real terms and inflation bottoms out at 2.5%-3.0%, US companies should be able to grow top-line revenues by 3.5%-5.0% in aggregate.

As inflation falls, corporate margins should feel less pressure from rising input costs, wages, etc. If margins are flat year/year, corporate earnings can deliver 3.5%-5.0% growth after tax. If we include an additional potential benefit of 1%-2% growth from share buybacks, then we get to 4.5%-7.0% net earnings growth in 2024. The key question becomes: what multiple of earnings will investors pay for companies that deliver mid-single-digit earnings growth in 2024? Price/earnings multiples swing widely over time. When investors are optimistic, they often pay over twenty times earnings for individual companies. Pessimistic investors are reluctant at times to buy stocks trading at ten times earnings.

An alternative way to look at stock market valuations is to measure equities relative to the size of the local economy. For example, the S&P 500 currently trades at 0.16 times US GDP. This places US equities in rarefied air, above the prior bull market peaks of 2000 and 2007. Equities were only more expensive versus US GDP heading into the (possible) bull market top in 2021.

Perhaps, all is not what it appears at first glance. Thanks to the powers of passive investing and the very strong performance of the technology sector over the years, the top seven stocks in the S&P 500 now account for 28% of the index, with the remaining 493 stocks accounting for 72% of the index. These companies are incredibly profitable businesses and hugely successful. Their valuations reflect this performance. In aggregate, they trade at close to fifty times earnings. Together, Apple, Microsoft, Amazon, Alphabet, Nvidia, Meta and Tesla have a higher weighting in the MSCI World Index than all of the stocks in Japan, France, China, and the UK combined.

If we look at a broader index, valuations are less stretched. The NYSE Composite Index for example, includes over 3,700 stocks and is a much better reflection of the US economy. The NYSE Composite has traded in a range of 0.3 times US GDP to 0.7 times US GDP over the last thirty years. Today, the NYSE Composite trades at 0.58 times US GDP; above average, but not excessively so.

We can conclude that parts of the stock market are certainly overvalued, but not all sectors. Value stocks have underperformed growth for years. Perhaps we will see some rotation into the cheaper and more defensive sectors of the market in 2024. If we get a weaker US dollar, which is expected as part of the Powell pivot process, stock markets outside the US should also do well. Brazil, Japan, and emerging markets (ex-China) look promising. It will certainly be a year of increased market volatility, particularly if inflation does not behave and long bond yields start rising again. We also have a contentious US presidential election in November.

Bonds

The Federal Funds Rate (in red on the chart below) tends to follow the US 2-year yield (in black) with a lag. The 2-year yield peaked in October 2023 at 5.2% and then declined sharply to 4.3% by year-end. This 90-basis point decline in yield drove a ferocious rally in stocks and bonds of all types and durations in November and December.

Where to next for Fed policy and short-term interest rates? A further decline in yields may add fuel to the stock and bond rally in the short term. However, as readers examine the chart below, you will recognise that prior peaks in rates (1994, 2000, 2007) have also coincided with weak subsequent periods for stock markets, economic growth and sometimes, outright recessions during past cycles.

This is not the forecast this time around, however. The United States remains the global growth driver and the US economy continues to experience very healthy economic growth, record low unemployment rates and inflation that is trending back towards its long-term mean. CPI inflation in the US is on track to finish 2023 below 3.5% and it is expected that US inflation will continue to moderate in 2024, albeit slowly and end the year in the 2.5%-3.0% range. Jerome Powell’s 2% inflation target will likely become a floor rather than a ceiling in future years.

With healthy GDP growth and inflation near 3%, US interest rates will remain elevated relative to history. It’s likely that the bond bull market that began in 1981 with 15% interest rates, ended in 2022. If US CPI rates settle in the 2.5%-3.0% range, and US real interest rates average 2.0% (slightly above the current real rate on 10-year TIPS), this suggests 4.5%-5.0% as a reasonable expectation for US 10-year yields over the next cycle. Today, US 10-year yields are 3.9%.

Looking ahead

Global equities face headwinds as we enter 2024.

The most prominent headwinds stem from the interest rate changes we have seen in recent years. They have impacted corporate financing costs, economic growth expectations, and the relative appeal of equities versus fixed income. Taken together, the expectation is that global equity performance will be below its long-term median of 15% in 2024. Still, Investment Managers do not believe they should ‘underweight’ equities and ‘overweight’ fixed income relative to policy allocations, they see better tactical opportunities within equities and fixed income.

The Q4 rally of 2023 was largely based on easing financial conditions and expectations of a soft or no landing in 2024. There is a disconnect between valuations in some segments and earnings potential, which raises risks of de-ratings.

However, select markets such as Europe may benefit from peaking rates and bottoming out of economic activity. Managers remain selective and explore value, and quality names in DM (US, Europe, Japan) and EM. Managers also see opportunities within fixed income to add protection.  Equity Markets can continue to benefit from a policy “sweet spot” in which a mixed growth picture and disinflation have allowed the liquidity backdrop to dominate.

Alternatives

Bitcoin was the standout performer in 2023 gaining an eye-watering +150%. The next halving event is scheduled to take place in April 2024 when the Bitcoin block reward decreases from 6.25 BTC to 3.125 BTC. If history is a guide, the price performance of Bitcoin post-halving tends to be the strongest part of the 4-year cycle. The crypto community is getting giddy again, perhaps rightly so.

Commodities struggled overall in 2023. Crude oil and natural gas prices fell double digits, while industrial metals and agricultural commodities also ended the year in the red. Precious metals were the exception with gold up +10% for the year. Rising interest rates proved a formidable headwind. Given the expectation for a weaker USD in 2024, we expect commodities to deliver much better returns this year.

While there is a positive outlook for cryptocurrencies, commodities, energy and precious metals in particular in 2024, there are a couple of sub-asset classes within the ‘alternatives’ sector where caution exists. Commercial real estate and private equity will continue to face strong headwinds this year. A cut in short-term interest rates may help a little but each market is facing its own set of longer-term structural problems.

Sector in Focus

As it’s January, we tend to be flooded with predictions for the year ahead. In keeping with our tradition, we wanted to take a look back at our own set of predictions that we made in January 2023.

It’s hard to imagine that 12 months have elapsed since we penned our top predictions for 2023. To remind ourselves, in our January ’23 Newsletter we outlined the following Business & Sporting ‘predictions’ for the year ahead. So how did we do?

  1. Global Equity Markets to post a strong recovery in 2023. The first few months to reflect economic uncertainty with volatile returns. The MSCI World Index (a widely followed global stock market index that tracks the performance of large and mid-cap companies across 23 developed countries) returned 20.20% on the Calendar year. – Correct. It should be noted the Index returned 11.47% from the 27th October alone.
  2. Ireland beat the All Blacks in the Rugby World Cup Quarter Final. Wrong. But sooo close.
  3. China reopening drives a bullish cycle in commodities, particularly energy. Wrong, but coming.
  4. Arsenal will not win the English Premiership Title in 2023 (Sadly, I don’t see Utd winning it either). Correct. Looking better this year, but still out of reach?
  5. Fixed Interest benefits from the disinflationary trend and an end to Central Bank monetary tightening. Correct, but a lot more to come.
  6. Gold to exceed $2,000 per ounce in 2023. Correct – Ended the year at $2,071.98.
  7. Rory McIlroy to win at least 1 Golf Major in 2023. Wrong. Will he ever get the Grand Slam of Golf?
  8. For those Techies amongst us, they will wonder how they existed without Chat GPT. Correct. Has become a main staple of many within the industry.

The above reflects a 5 out of 8 accuracy rate. Not bad. So let’s see how we do in 2024 with our top 8 predictions for the next 12 months.

It’s going to be an interesting year, in many respects. More than half the people on the planet live in countries that will hold nationwide elections in 2024, the first time this milestone has been reached. Based on recent patterns of voter turnout, close to 2 billion people in more than 70 countries will head to the polls. Ballots will be cast from Britain to Bangladesh, from India to Indonesia.

As a Manchester United Fan, I am tempted to say United will win the league too but that would test the most optimistic forecast for 2024. So, for better or worse, our top predictions are:

  1. Donald Trump does not become the next President of the United States.
  2. Viktor Hovland goes off as the favourite at the Masters.
  3. Thanks to fracking technology, the US oil output overtakes OPEC in 2024.
  4. Cillian Murphy wins the Best Actor Oscar in 2024.
  5. Netanyahu will be unseated as Israeli prime minister.
  6. Russia-Ukraine conflict is not resolved in 2024.
  7. England win Euro 2024.
  8. Ursula von der Leyen secures a second term as European Commission president.