Welcome to our ‘March 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. We aim to keep you updated on such matters leading to better investment decisions and by extension more acceptable returns on employed capital.

Too Much of a Good Thing?

The US economy is forecast to grow by +3.0% year/year in real terms (before accounting for inflation) in Q1 2024. When you consider that US CPI also continues to bubble along north of 3% per annum, the United States is on track to grow by 6% per annum in nominal terms for the third quarter in a row. This is extraordinary for a $28 trillion economy.

US non-farm payrolls expanded by over 350,000 in January, nearly double the consensus estimate, while the prior two months were also revised higher. The US unemployment rate, at 3.7%, continues to hold at record lows, while the labour force participation rate continues at 63%. The US is firing on all cylinders, which is why Jerome Powell has recently been more reluctant to signal to markets that he is ready to cut interest rates from their current level of 5.25%-5.5%.

Some folks question whether interest rate cuts are justified at all when the US economy is growing at over 6% per annum and inflation is showing signs of coming back to life. This poses a potential problem for the Federal Reserve (and equity investors alike). If the US economy continues on its current growth trajectory, the risk of overheating becomes a real concern. If, on the other hand, the US begins to eventually slow down, Powell could lower rates, but this would likely occur in the face of a potential recession. Powell is walking a tightrope. Ultimately, the decision is out of his hands. We explore some of the possible scenarios that could unfold in 2024 later in this month’s investor update and consider the potential impact on economies and markets around the world.

Outside the US, data remains quite mixed. We have some positive data points with the global PMI readings indicating that the global economy continued to accelerate in February. Purchasing Managers Indices (PMIs) are considered a leading indicator because they tend to provide a glimpse of economic trends before they are reflected in other economic data. Changes in the PMI can signal shifts in economic activity before those changes are seen in other indicators like GDP growth or employment numbers.

Economic growth trends are improving across services and manufacturing sectors, but inflation has also ticked higher. China remains a weak spot. Chinese GDP growth reached 5% in 2023 but the key driver for growth has come from government spending on endless real estate and infrastructure projects that have delivered poor returns on invested capital. Overbuilding has taken its toll on the country’s finances. Today, China has many similarities to Japan’s lost decade(s) with overvalued real estate, a high and rising debt burden and demographic decline being the dominant trends.

2024 is off to another positive start for equity investors. The FTSE World Equity Index has rallied +5% year-to-date in euro terms. Bonds continue to struggle in the face of stronger-than-expected economic data and the threat of rising inflation. The US dollar has gained +1% versus the Euro while commodity prices have also performed well, generally a late-cycle phenomenon. West Texas Intermediate crude oil has rallied +13% so far this year to $81/barrel. Agricultural commodities have rallied +9% while industrial metals are modestly lower. We expect volatility to pick up in the second half of the year as the US presidential election comes into focus. The bull market in equities should continue in our view, despite increased volatility.

Equities

The strong performance of many assets over the last four months, and concerns about the state of the global economy, lead us to expect lower returns as asset prices need to justify the performance. The expected move to falling interest rates has provided some impetus to markets, which await such a pivot.

Inflation is trending down from elevated levels but is still above the ECB’s 2% inflation rate across all euro countries combined. Recently, some concerns have emerged in the market that the rate of decrease is slowing, and this remains to be seen over the course of the year. Less rate cutting for 2024 is now expected by the market compared to expectations at the start of January – this is a more realistic expectation. Managers currently guide 3.5 rate cuts expected from the ECB.

Economic growth is slowing from high levels in the US as Central Bank tightening takes effect, but it remains surprisingly resilient, especially considering the consensus expectation that the US economy was about to enter a recession. Increased index concentration in the S&P500 is a commonly cited market concern. The share of the top 10 stocks in the S&P500 has increased sharply and three-quarters of S&P returns in 2023 were driven by the ‘Magnificent 7’. This increased concentration can be adjusted either by the Mag 7 stocks weaken commonly cited or by smaller cap stocks strengthening relatively.

With many assets performing better than expected in such a short space of time, we are faced with a choice: use more optimistic assumptions to suggest further strong gains or change the Model Asset Allocation away from outperforming assets and towards those that have either lagged or are less risky. Having asked several questions about the outlook for growth, the timing and extent of central bank easing (and what happens when policy is eased), what is priced into markets, whether bubbles exist and whether the outcome of US elections matters for financial markets, we opt to maintain a balanced approach to capital appreciation.

For the past year, we have been operating in a world of rising GDP growth and falling inflation on a quarter/quarter basis. Stock markets perform quite well in this regime, while bonds and the US dollar tend to underperform. There are signs now that inflation is picking up again and as long as the US economy continues to grow quarter/quarter, developed market equities, emerging market equities, commodities and commodity equities tend to perform well. The big risk, and one we are watching closely, is whether we begin to see US GDP growth decelerate in the quarters ahead. If that happens, we will see the risks associated with stagflation, disinflation/deflation. Add in a US presidential election in November and we get a recipe for stock market volatility later in 2024. Overall, positive but volatile.

The United States tends to dominate the headlines whenever conversations about equity investing take place, and rightly so. US equities have handsomely outperformed all other regions for over a decade. As a result, the US now accounts for 71% of the MSCI World Equity Index. In this investor update, we focus namely on Europe. Despite the pessimism that European equities tend to attract, we share a more constructive view held by some managers.

European stocks, as measured by the SPDR Euro Stoxx 50 Index, are discounting zero earnings growth for the next decade. European companies face several significant challenges including volatile energy prices, China becoming a more competitive threat and carbon policies that impact certain sectors that are heavy users of carbon emissions. However, companies most directly affected by these headwinds – automakers, industrials, and utilities – account for less than 30% of the Euro Stoxx 50 Index today, down from almost 60% a decade ago. Examples include Siemens, Schneider Electric, BASF, Mercedes-Benz, BMW, and Volkswagen. The remaining 70% of the index includes companies in the technology, consumer products and services, financial, healthcare, food, and beverage industries, where analysts are forecasting a much more positive earnings outlook, which is not being reflected in market pricing today. Examples include ASML, SAP, LVMH, Sanofi, Nokia, Airbus, and Safran.

When you compare analyst earnings forecasts for US versus EU equities, the difference is stark. The S&P 500 is discounting double-digit earnings growth for the next decade, compared to zero for the Euro Stoxx 50. European equities also trade at all-time low valuations today relative to US equities. This is interesting particularly as the slow growers in the European market have almost halved as an overall weighting in the Euro Stoxx 50 compared to a decade ago. The Euro Stoxx 50 has delivered a positive start to 2024, rallying +8.5% in euro terms. We think the challenges facing European companies today have been adequately discounted in today’s prices.

Bonds

With the US economy growing strongly and inflation picking up again, investors are starting to reprice their expectations for interest rate cuts later this year. In previous cycles, the Fed only began lowering interest rates once economic growth slowed sharply and recession approached. The ECB would then follow the lead of its US counterpart. We are not there yet today. For example, during the technology bust in 2001, the Fed started cutting rates in January 2001. The ECB followed four months later. In the run-up to the financial crisis in 2008, the Fed started cutting rates in September 2007. The ECB raised rates in July 2008 and then started cutting in October 2008. Historically, the Fed has always acted earlier and faster than the ECB in their interest rate-cutting cycles.

Now in Europe, growth and inflation expectations are contained, raising the prospect of the ECB taking the lead in cutting interest rates in 2024 for the first time, ahead of the Fed. The ECB hasn’t led the Fed in any easing cycle since 2000. Should the ECB lead with interest rate reductions in the coming months while the Federal Reserve holds firm, or even increases rates, the euro will likely decline in value versus the US dollar. A weaker euro would give a welcome boost to the region’s exporters but also increase inflationary pressures across the region as imported goods become more expensive. Most likely, the ECB will wait for the Fed to lead once again. We do not believe that central banks are ready yet to begin lowering interest rates.

Alternatives

Commodities are off to a solid start in 2024 with the Goldman Sachs Commodities Index returning +6% year-to-date after delivering quite a poor showing in 2023. Commodities tend to perform well late in the business cycle when strong demand and inflation pressures have their greatest impact. Energy prices have been mixed with crude oil (+12%) and natural gas (-26%). The abundant supply of the latter has led to a collapse in natural gas prices over the last 12 months. Agriculture commodities are also reacting to stronger demand and increased inflationary pressures this year. Perhaps most interesting of all is that the perceived best monetary inflation hedges, gold and bitcoin, are breaking out to new all-time highs in USD terms at the time of writing. Investors are starting to get increasingly concerned about ‘sticky’ inflation impacting markets. Should we be worried?

The answer to this question can determined by the future path of energy prices relative to the stock market. When crude oil prices outperform equities on a trending basis, stocks tend to struggle. Conversely, when equities outperform crude oil, stocks have delivered strong rewards for patient investors. Looking at the next chart, from 1990 to 1999, crude oil underperformed the S&P 500, which coincided with a strong decade-long bull market for equities. From 1999 to 2012, crude oil outperformed the S&P 500. During this time, US equities failed to make new highs, instead trading in a wide range with deep corrections and two painful bear markets. The trend resolved once again in favour of equities relative to oil from 2012 to 2020. This was another strong period for stock markets. However, since 2020, energy prices have once again started outperforming on a relative basis. Stocks have held up relatively well to date but this may well be a result of loose monetary policy (until recently) and record loose fiscal policy in the US.

We are watching closely to see whether energy prices and inflation are about to accelerate higher once again or whether this trend resolves lower in the months ahead. It will have important consequences for investors and risk managers alike.

That concludes our March investment update. We look forward to providing you with further insights and our updated views on markets again in our next report in May.

Topic in Focus

What is a Balanced Investment Portfolio?

It’s a phrase so many investment professionals use, but for a pension or non-pension investor, what does it mean? How do I achieve it and is it applicable to me?

The answer is most definitely ‘yes’. Regardless of the purpose of accumulating Capital, achieving balance of holdings is crucial to achieving the investment returns you strive for. A balanced portfolio invests in a range of assets that match your risk tolerance and time horizon.

But how do we determine the right mix?

Most of us know why we shouldn’t keep our eggs in one basket. When trying to build a portfolio, much will depend on your stage in life. If you are new to investing, the balance of your portfolio may be quite different to that of a more senior individual or company thinking of wealth usage.

Step 1. Seek Independent Advice and understand your risk tolerance.

One of your first considerations is to seek advice from those who have travelled this road before you. The Advisor Market is the first step in getting informed as to what is available from a variety of options, as opposed to a particular institution’s suite.

Understanding why you are investing is an important step. What do you want to achieve, and in how many years do you wish to use the accumulated capital? Patience will be rewarded over the long term, and we advocate allowing sufficient time to set realistic and meaningful investment goals. The most effective goals are genuinely aligned with your ambitions and preferences. For a retired investor, that could mean sufficient income, legacy benefits, or world travel. For someone younger, it could mean home ownership or children’s education. Whatever the requirements, your tailored portfolio should meet your needs today without compromising what you wish for tomorrow.

Knowing your risk tolerance is a fundamental building block of long-term investment success. In tandem with your advisor, setting goals and understanding the difference between desiring and delivering will go a long way towards determining the level of risk that you are willing and able to take. In turn, your risk tolerance will affect the type of assets you own and, ultimately, the shape of your portfolio.

Step 2. Diversify your assets.

In contrast, a younger investor may have a longer-term outlook, demand higher returns and be more tolerant of investment volatility. By accepting more risk, this investor is potentially willing to take more substantial short-term losses in return for higher long-term growth. Once we understand our risk appetite, it’s time to protect our assets for the longer term. The key task is diversification. Diversification is a risk management strategy that creates a mix of various investments within a portfolio.

Once we have a better sense of our values and interests, we’ll be more likely to find assets that suit our personality and meet our financial criteria. That’s the theory. Real-world investing is not always black and white. Most portfolios are likely to contain a balance of stable, low-risk investments and a smaller proportion of higher-growth assets that carry more risk. This is something called a core-satellite strategy. In this scenario, many investors delegate the day-to-day management of the core portfolio to experienced investment professionals using investment funds. This approach offers peace of mind about our portfolio yet still allows you to explore your investment ideas. Now that you’ve established your goals and risk appetite, and recognise the benefits of diversification, it’s time to design your portfolio.

 

A balanced portfolio consists of different percentages of bonds, commodities, equities, and other so-called asset classes. At Insight Private Clients, there are several strategies to consider: fixed income, income, balanced, growth and yield. Each approach is designed to offer a different profile of risk and return. If your risk tolerance is low, you might want to add more bonds to your portfolio and choose the ‘fixed income’ strategy. On the contrary, if your risk profile is very high, you might want to add a higher percentage of equities to the mix (‘growth’ or ‘yield’).

Textbooks have been written about asset allocation, which is an area where many investors seek advice from experienced professionals. In the meantime, here are three tips for budding asset allocators:

  1. Don’t rely on past performance as a guide to future returns. Historical correlations are often unstable and unreliable. It can be tempting to look back at how asset classes have behaved over time, but it’s like driving while staring in the rear-view mirror.
  2. Diversify across and within different asset types. This can help you manage risks and maximise returns. For example, if you invest in stocks, consider diversifying across different sectors and company sizes. If you invest in bonds, think about spreading your exposure across various maturities and qualities.
  3. Get involved! Checking stock prices too often is counterproductive, but having an emotional connection with your investments helps you to stay engaged. Once you have a better sense of your values and interests, you’ll be more likely to find assets that suit your personality and meet your financial criteria.

Step 3. Rebalance regularly

Over time, the balance of your portfolio will shift and certain assets may outperform others. When this happens, you should rebalance them so that your investments continue to support your long-term goals without running unintended risks. For example, if your portfolio has a 60% allocation to stocks and 40% to bonds, you may become over-allocated to stocks if they outperform. Generally, stocks are considered riskier than bonds, so your portfolio may need to be rebalanced by selling stocks.

Remember, portfolios are more likely to become unbalanced when markets are unpredictable. This is when the time spent setting your investment goals will pay.

Remember your goals, stick with your strategy, invest for the long term and make informed decisions.