Will 2024 be a good year for investment markets?

The last two years have been tough for investment markets, especially in the UK.  As we go into 2024, is there reason to be optimistic?

Is it all about inflation and interest rates again?

The last couple of years have been dominated by two factors; rising inflation and interest rates.  After a sharp rise, there has been a lot of commentary on ‘higher for longer’ interest rates, including from the Bank of England, and stickier, higher than ‘normal’ inflation.  In last week’s Monetary Policy Committee decision, three members said ‘there was evidence of more persistent inflationary pressures’ and voted to increase interest rates.  The Bank of England also said that CPI is due to fall back to the 2% target by the end of 2025 and Governor Bailey stated it was “really too early” to talk about rate cuts and that rates would have to stay high for “an extended period”.  Most economic commentary regarding the UK over the last year has highlighted that the UK is an outlier for inflation and it will remain stickier and higher than other developed countries, which leads to a higher for longer outlook on interest rates.

Higher interest rates for longer?

You can see why Andrew Bailey is talking about higher rates for longer.  Inflation excluding volatile and external factors such as food, energy and tobacco (called core Consumer Prices Index (CPI)) is running at 5.1%.  Wage growth remains high.  There are however issues around looking at this data in relation to interest rates.  It typically takes around a year for consumers and corporates to change their behaviour to the new interest rate.  So, when the Bank of England are considering what an appropriate interest rate is today, they need to consider what the next year will look like.  That means looking at data that is backward looking and slow to change, such as wage growth isn’t hugely helpful.

Core CPI and wage growth are often a reaction to the change in price of things like food and energy, which is what we have seen over the last year.  When CPI was driven up to over 10% because of food and energy, workers wanted a similar pay rise.  Now that CPI is below 4%, it is unlikely that workers are going to get 10%+ pay rises but new pay deals at 2-5% will take several months to feed through.  We have consistently said that the UK’s inflation path isn’t that different to other countries, it has just had a bigger lag, which is what we’re now starting to see.  In Goldman Sachs’ UK outlook for 2024, it is titled ‘Not so different after all’.

CPI is a year-on-year figure, so it is important to understand what price movements drop out of the calculation as we go through the year.  We have had large price rises in energy over the last year, which will drop out.  This will create downward pressure on CPI for the next six months or so.  From February to May 2024, the amount that drops out of the CPI index calculation equals roughly 1% per month, which despite a potential uptick in Jan, could mean that inflation is below the Bank of England’s 2% target by April/May time.  If that does happen, we can see pressure being put on the BoE to cut rates.  Following this week’s CPI data, investors now expect one interest rate cut by May and for rates to finish 2024 1.35% below today’s rate, which would result in a rate of around 3.9%.

This is going to mean a sharp turnaround in communications and actions from the Bank of England in the next six months.  The Federal Reserve hinted at this last week and they are usually the most aggressive central bank and move first.  The other issue we have in 2024 is elections, which might mean that central banks have to cut rates earlier than they might otherwise do so they aren’t seen as political around the election date.  The Fed know when the US election is (November), whereas the BoE don’t.

Would a recession help low-risk assets?

If inflation does come down as expected and interest rates do fall, even marginally, it should result in a turnaround for many assets that struggled due to rising inflation and interest rates.  This is one reason why we are positive on traditionally lower risk assets, such as government and corporate bonds.  It should also benefit interest rate sensitive assets, such as infrastructure and commercial property.  Recent UK economic data has been lacklustre, which should also help these assets, however the economy should do okay in 2024 with growth picking up as we go through the year.  The combination of high inflation and rising interest rates has been a horrible combination for consumers and as these ease over the next year, disposable income should pick up as wage growth, whilst slowing, remains robust.  Rising mortgage payments will continue to hurt, however it should ease as we go through the year and behaviour adapts to the new interest rate regime.  The UK’s employment market remains tight too, partly due to the huge amount of long-term sick.  We might end up with a technical recession over the next few months, however if the employment market holds up like it has been doing, we think a deep recession is unlikely.

Valuations are supportive, apart from US equities

The other reason why we are optimistic for 2024 is the starting values for assets.  For the first time in years there are very few assets that look expensive.  Most assets either have a high level of income or are pricing in recessionary conditions, with some having both characteristics.  The only area of slight concern is the large-cap end of the US equity market.  There was a good paper from US investment firm AQR this week which highlighted the conditions needed for the US equity market to repeat the performance of the last decade (give us a shout if you want a copy of the report).  It’s not impossible but would need very favourable conditions to achieve.  Investors are currently expecting 17% earnings growth for US equities in 2024, which is punchy and there is plenty of scope for disappointment, especially if the economy is weaker than expected.  This year’s US equity market performance has been dominated by the so called ‘magnificent seven’; Apple, Microsoft, Amazon, Nvidia, Alphabet, Tesla and Meta.  Up to mid-November, the average performance of these seven stocks is +71% year-to-date.  The average performance of the remaining 493 stocks in the S&P 500 were up 6%.

These seven companies are the largest seven for a reason.  They are well managed and have delivered superior margins and earnings over the last decade compared to the other 493 stocks.  However, the share price and expectations associated with the magnificent seven mean that we prefer exposure to the 493.  We have added to exposure to the magnificent seven earlier this year as the trade could continue to perform but the risks are rising.  The US equity market might still lead the way, due to the concentration in the technology sector, which has a positive outlook, especially with the growing adaptation of artificial intelligence.

2024 should be a good year for infrastructure and property

Two sectors that we are excited about for 2024 is infrastructure and commercial property.  For commercial property, we own three REITs and I’ll highlight Schroder Real Estate.  It is currently on a dividend yield of 7.3% that is fully covered by net income.  Its net asset value has fallen by 23.5% since last summer and the share price remains a 30% discount to that depressed net asset value.  This is an example of an asset with a high level of income and priced for recession.  The second sector we like is infrastructure.  In ways it is similar to commercial property, however the assets tend to be longer term and have less economic sensitivity.  An example would be Greencoat UK Wind.  It is on a prospective yield of 5.9% after increasing the dividend by 14.2% for 2024.  The share price is around 12% below the net asset value.  Commercial property and infrastructure have had a torrid time in the last 18 months, however the characteristics of both sectors should thrive in the next year and both have started to pick up nicely over the last month or so.

What could go wrong?

Whilst we’re optimistic that we’re past the worst of the impact of rising inflation and interest rates, the economies in UK, US, Europe and China could still struggle more than expected, which could hurt riskier assets but provide a boost for lower risk assets.  There are low expectations for economic growth next year but a severe contraction is also not priced in most assets.

Stress will remain in refinancing for consumers and companies as whilst interest rates might come down slightly, they are not heading back to the levels we have become accustomed to over the last decade.  Inflation could pick up again and remain sticky, which would be unhelpful.  Other things, such as the wars in Russia/Ukraine and Israel/Gaza could clearly still get worse.  A known unknown is if Japan raise interest rates.  We know it is a risk but don’t know the scale of the market reaction.  It is one of the world’s largest international investors (Japanese investors are the largest lender to the US Treasury at $1.1 trillion) and what would happen to these holdings if Japan had a positive interest rate?  Japan hasn’t had an interest rate more than 0.5% this century.  There are also unknown unknowns.  Despite these challenges, markets are in a better position to cope with stress as valuations and expectations are low.

Stay invested for 2024!

It’s likely that the first few months of the year is again dominated by macroeconomic issues around inflation and interest rates.  If things go to plan in this respect, these issues should provide a tailwind to markets and it’s likely that headline returns on cash will fall.  If inflation does settle down as expected, focus should turn to company and asset fundamentals.  If economic growth is weak, those companies that can grow should be well rewarded.  The breadth of opportunity remains huge and cash returns at 4-5% should set the bar for returns.