Commentary on December 2023
Financial markets continued to record strong gains in December as the US Federal Reserve gave its clearest signal yet that rate cuts are coming. Everything from global stocks to bonds and commodities surged higher, ending one of the strongest quarters for markets in the last two decades. The US index rallied 5% over the month, closing just shy of its record high set in early 2022. Japan and emerging markets gained 3%, while Asia and the UK rose by a more muted 2%, although UK smaller companies leapt 8%. Sectors that benefit from lower interest rates such as banks, utilities and real estate led the surge along with cyclicals, while tech lagged. Google lost the first of multiple anti-trust cases that the company is facing across different parts of its business. A court determined that Google has harmed rival Epic Games, maker of the popular video game franchise Fortnite, through the anti-competitive practices of its app store. This landmark ruling threatens to upend the industry, where Google and Apple charge commissions of as much as 30% to software developers to distribute their apps, potentially costing them billions of dollars in future revenue.
The escalation of conflict in the Middle East pushed up the price of both oil and gold. Gold hit a record high, touching $2135, helped also by a weaker dollar. Freight rates also jumped, as the shipping industry braced for weeks without its most important trade route following attacks by Houthi rebels targeting commercial ships heading to Israel.
The month began with a decisive shift in US interest rate policy that took markets by surprise. Following a steep fall in bond yields during November, Federal Reserve Chair Powell had been expected to push back on growing expectations of lower rates, having stated only two weeks prior that it was “premature to speculate on rate cuts”. The Fed held rates steady for a third consecutive meeting but went on to forecast a series of cuts in 2024. Not to be outdone, markets proceeded to price in six quarter-point cuts in 2024, double the amount implied by the central bank’s own forecasts.
Bonds rallied sharply, as yields on the 10-year US Treasury bond fell to 3.9% (from a peak of 5% in October). UK 10-year gilt yields fell by a similar amount and the dollar sold off. However, central banks elsewhere were in no hurry to join the US pivot towards rate cuts. The Bank of England and European Central Bank both struck a more cautious tone later in the week, reiterating their ‘higher for longer’ message, despite growth being much weaker in these regions. The Bank of England stressed that a further slowdown in inflation cannot be taken for granted. But these fighting words did little to sway traders from moving to price in an equally dramatic cut in rates for 2024 as in the US. Elsewhere, Norway’s Norges Bank continued to hike rates, while the Bank of Japan maintained what is now the world’s last remaining negative interest rate.
Despite the fireworks surrounding the US policy pivot, economic data remained relatively robust overall. US job openings eased in November, adding to evidence of a gradually cooling labour market. The ISM manufacturing gauge remained stuck in contraction for a 14th consecutive month, restrained by weak orders. However, retail sales unexpectedly picked up, confirming other consumer indicators that signalled a solid start to the holiday shopping season. CPI for November saw the core rate unchanged on the month at 4%, adding a note of uncertainty to the cooling inflation narrative that contrasted with investor’s exuberance over lower rates.
The UK’s inflation rate fell sharply to 3.9% in November, marking the lowest level since September 2021. The annual rise was significantly lower than the 4.4% predicted by economists and a welcome drop from October’s 4.6%. However, growth in the UK remains much weaker. The economy shrank in October, with GDP registering a decline of 0.3% versus expectations for flat growth. However, the ONS cited the likelihood that poor weather patterns may have negatively affected the construction, retail and hospitality sectors. The central bank expects zero growth in the fourth quarter. Wage growth remained above the rate of inflation, rising 6.5%. Consumer confidence edged higher, as households look forward to lower inflation and a fall in mortgage rates in coming months. Retail sales data for November was better than expected. Recent earnings have also been generally upbeat, with strong numbers from M&S, Wimpey and Whitbread, among others. Property prices recorded a third consecutive monthly rise and managed to record a gain of 1.7% in 2023, according to the Halifax.
Investor sentiment has reached extreme levels following the strong rebound during the final months of 2023. It would therefore not be surprising to see a period of consolidation as markets digest these gains. However, with cash rates starting to fall, we would continue to advocate being invested in financial markets, with an overweight stance in equities.
The good news is that inflationary pressures are easing, and interest rates are set to fall. How soon and by how much is likely to remain a matter of great debate. A key issue for bonds is that the rate cut scenario they’re now pricing in is consistent with a hard landing environment for the economy that isn’t being borne out by the current data, suggesting that expectations may need to be reined in. Current economic trends are more consistent with an economic soft-landing, which would be most positive for equities.
Recent small cap leadership is a welcome sign that market breadth is expanding and moving past the leadership of just a handful of mega-cap stocks. The top 10 stocks in the US now make up almost one-third of the index’s total market capitalisation, with the Magnificent Seven over one-quarter. This level of concentration is historically unprecedented, exceeding that reached in 2000 at the height of the internet boom. It highlights the potential for a change of leadership, which would create fresh opportunities in other parts of the market that have lagged and trade at a discount.
The best opportunities in 2024 are therefore likely to come from the UK, Japan, Asia and emerging markets, as investors move away from the US in search of greater value. The UK is no longer an outlier among its peers and there is plenty of scope for a recovery with valuations approaching a 20-year low. Japan has waited over thirty years for its moment in the sun. The market has been outperforming steadily for the past couple of years, a trend that has plenty of scope to continue as the economy exits deflation and reforms in the corporate sector continue to drive a recovery in earnings. Exposure to both markets has been increased across our standard portfolios over the past year. We also favour Asia and emerging markets. These regions offer a relatively strong economic growth outlook that should translate into a favourable environment for earnings. A more pro-growth, stimulus orientated policy stance in China could also remove a major headwind.
Another theme for 2024 is the potential for a catch-up by smaller companies, which have underperformed their larger peers by an extremely wide margin in recent years and are priced at valuations that imply a deep recession. Small companies tend to outperform as the economy recovers, at which point the combination of lower rates, growing earnings and attractive valuations should favour a strong recovery.
The key risks for 2024 remain the potential for either a recession or an increase in geopolitical risk that feeds through to a resurgence in inflation. Our standard portfolios are diversified to help withstand these different potential outcomes through positions in fixed income, infrastructure, absolute return strategies, gold, oil and other commodities. Among our core equity holdings, we strongly believe that the best defence is owning markets and sectors with cheap valuations. Despite current uncertainties this has historically been a good time to invest, as the returns you get are generally linked to the valuations you pay, and currently these are low in many areas around the globe.