Commentary for January and February 2024

Market Overview

After a brief hiatus, markets have continued an upward path, following strong gains in the final quarter of 2023. US equities rose to a new record high for the first time since 2022, closing 6% higher as confidence grew that the Federal Reserve would achieve a soft landing for the economy. The strength was further fuelled by a positive results season for corporate earnings, with standout numbers from semiconductor stock Nvidia, the leading supplier of chips for artificial intelligence. Most other big tech names announced solid earnings, with the notable exceptions of Apple, where sales are struggling in China, and Tesla, which warned of weaker growth for electric vehicles. As a result, the so-called ‘Magnificent Seven’ has reduced to five. The US market also shrugged off concern over the health of its regional banking sector, which was reignited by weakness in the commercial real estate market. New York Community Bank, which took over parts of the failed Signature Bank last year, saw its share price plunge 45% after posting an unexpected loan provision of $550bn. This led to weakness across the sector.

Japanese equities mirrored the strength in the US, also rising 6%. The stock market has recovered strongly in recent years to finally set a record high in 2024, as profitability has enjoyed a remarkable turnaround. According to official data, more than 40% of listed companies have submitted plans to improve shareholder returns. The government also announced the launch of the new NISA (Nippon Individual Savings Account) for Japanese retail investors in a bid to increase capital inflows for listed companies.

UK equities closed marginally lower, despite a notable pick up in corporate M&A that continues to highlight the value in listed companies across the market. Currys rejected a bid from US asset manager Elliott, which, despite a 40% premium, still only valued the retailer at 7X prospective earnings. Further approaches were made to Direct Line and Wincanton, with a bidding war erupting for the latter between rival US and French suitors.

Asia and emerging markets also trod water, as China was once again a drag on the performance of these regions. Further policy loosening failed to lift sentiment against a backdrop of weaker growth as China continues to cope with the fallout of its property crisis. The Chinese market closed 2% lower, although well off its lows, as policymakers stepped in with additional support measures.

Gold was the third asset class to break convincingly to a new record high. The oil price also moved higher amid ongoing conflict in the Middle East and disruption to shipping in the Suez Canal. However, bond markets experienced a mild setback following strength in the fourth quarter, as hopes for an early cut in rates faded. Gilts closed 4% lower, while corporate bonds declined by 1%.

From a macro perspective, the theme is one of ongoing regional divergence. The US economy remains resilient, recording growth of 2.5% in 2023 led by strong fiscal stimulus and robust consumption. The latter is underpinned by a strong labour market, with a further 353,000 jobs added in January, although a strong initial number has been prone to subsequent downward revisions of late. A less welcome development is that stronger growth has caused the downtrend in inflation that began last summer to stall at the 4% level in recent months. Not surprisingly, the Fed chose to keep rates unchanged. Stronger data pushed the prospect of interest rate cuts further into the future, triggering a correction in US bonds that was mirrored worldwide. Traders scaled back expectations for the total number of cuts in 2024 from six to three across major Western economies. Yields have risen to accordingly.

The ONS confirmed that the UK economy experienced a mild recession in the second half of 2023, following two quarters of negative GDP growth. The Bank of England held interest rates at 5.25% for the fourth time in a row. However, in a more upbeat statement than usual, Governor Andrew Bailey described the downturn as mild and saw signs of growth picking up. Recent data has been more positive across the economy. Both industrial and manufacturing production exceeded forecasts. Retail sales rose 3.4% month on month in January, a strong rebound from December’s disappointing 3.2% decline. The downtrend in inflation has also faltered at the 4% level, however in the UK’s case, a further fall is expected due to the impact of a cut in the energy price cap next quarter.

Looking Forward

With US GDP growing at 2.5%, an unemployment rate below 4% and inflation stuck in the region of 4%, it’s hard to make an aggressive case for rate cuts at this juncture. Markets have dialled back expectations for 2024 as central banks have made it clear that they are in no hurry to act. However, a slow normalisation away from where policy was at when inflation was in double figures seems reasonable and this, combined with recent data, continues to point to a soft landing, which is good news for both corporate profits and equities in general. Markets should continue to attract cash from the side lines as rates fall.

Recent analysis by AJ Bell for Moneyweek shows that, despite savings rates hitting a 15-year high, the stock market still beat cash ISAs last year. When inflation is considered, savers made a loss, with a real return of -1.2%. Over longer periods, the gap between cash and stock market returns becomes much larger. For the five years to the end of 2023, the average cash ISA grew 5.5%, while the average UK equity fund returned 31.6%. Over twenty years, the gap widens to an average cash ISA return of 53.4%, compared to an average UK equity return of 257%. The fact that equities have outperformed cash over longer timeframes is generally expected, however it’s more surprising that cash ISAs underperformed last year given the environment of rising rates. The data also shows that the average cash ISA lost money in real terms over both longer time periods due to the corrosive effect of inflation. While the stock market does follow a more volatile path, it has demonstrated a clear track record of beating both cash and inflation over the long run. Data from Barclays going back to 1899 found that over a ten-year period, UK shares have beaten cash more than 90% of the time.

Market Outlook

The key question going forward is one of divergence. Will recent gains in the US led by the mega cap tech names spread out to other areas of the market, including undervalued regions such as the UK? Investors have recently been caught up in the exciting potential of AI in a move that has drawn parallels with the internet boom in early 2000. Many of the early winners in the internet era such as Cisco did subsequently see their earnings soar. However, in share price terms, the company still trades below its heady 2000 level today, as valuations have gradually fallen back to earth. Hence our mantra that while valuations may not matter in the short term, they are key to generating stronger returns over a longer time horizon. In the current environment, expensive valuations among mega cap tech stocks do not preclude further gains. However, opportunities elsewhere are looking much more attractive on a relative risk reward basis.

Another reason for the strength of the US market has been the relative strength of its economy. The US has been an outlier in growth terms but should see some headwinds going forward as the extra boost from record fiscal stimulus should start to wane. In contrast, growth elsewhere is forecast to pick up, helped by falling inflation and rates. This should translate to a more positive environment, allowing the relative valuation discount between the US and the rest of the world to narrow. The recent pick up in M&A among listed companies in the UK is an extremely encouraging sign. On average two companies are now getting snapped up a week, either by private equity or other corporates and average premiums have also risen to above 50%, highlighting the degree of undervaluation that exists at current levels.

34 years on, the Japanese stock market has finally set a record high, surpassing the level last reached in December 1989! It might surprise readers to learn that Japanese equities have had higher earnings growth than the US since the financial crisis back in 2007, with an average rate of 9.9% in Japan versus 6.6% in the US. However, a key difference is that Japanese equities have become cheaper over this period, as share price gains have not kept pace with growth in earnings, whereas the opposite is true for the US. As a result, despite strong performance in recent years Japan still trades at a 25% discount to global markets. The corporate sector has undergone a material restructuring, with share buy backs and an increase in dividends driving a step fold increase in shareholder returns. Earnings should receive a further boost as the economy finally exits inflation, helping to restore pricing power and increase profitability.

Our Strategy

Our standard portfolios have remained overweight Japan for a considerable period. Historic returns have received an additional boost from the decision to own a share class hedged back to sterling, as while the stock market rose, the yen declined. This has allowed our clients to benefit from both trends. However, positions have more recently been switched back to local currency shares, as the yen is now looking undervalued and should benefit as the Bank of Japan finally raises rates. Exposure to the US remains indexed to the S&P500 for now, as given the dominance of mega cap tech stocks we feel that it’s easier to capture these returns through a passive approach. However, portfolios are underweight in aggregate, in line with our preference for other regions. Exposure to the UK has been gradually increased, with a focus on small and mid-cap stocks that are especially attractive at current levels. Valuations are trading at 9X earnings, a material discount to the long-term average of 14X, and share prices have lagged large caps, despite superior earnings growth. Portfolios are also overweight Asia and emerging markets. Earnings are growing across these regions and valuations are trading at a discount that is close to 20-year lows. Falling US rates combined with a weaker dollar will remove what has been a major headwind going forward.