11 Dec 2023
In 2023, we saw some of the inflationary pulses of the post Covid era begin to moderate. Growth began to slow, prompting a debate as to when interest rates might peak and eventually reduce. We believe this debate will stay live for some time, with each economic data point being examined minutely.
While rates may moderate from current levels, the era of near zero rates is over and a higher cost of capital is a factor that governments, corporates and households will need to contend with. We expect there’ll be more inflation tension in the system from fiscal spend on the energy transition and commodity costs. Furthermore, complex geopolitics are putting more ‘grit’ in the system of supply-chains and shifting demographics in China will have implications for global labour costs.
From an investment perspective, company fundamentals are likely to become more important in terms of performance. Without the tailwind of ever-falling rates and ‘free money’ the ability of management teams to manage balance sheets, pricing, supply chains and deliver profits and cashflow in forecastable time periods will be vital. The previous era made asset allocation relatively simple – US, tech, growth factors. From here we expect factors to be less dominant, and stock-picking opportunities more diverse. It’s a challenging backdrop, but an exciting one for active managers.
We expect a challenging global macroeconomic backdrop ahead. Central banks and governments will continue along a path of monetary and fiscal policy, that is likely to result in the next decade looking very different to the past 10 years. This will be characterised by higher interest rates and inflation than we have experienced since the global financial crisis (GFC).
Despite macroeconomic concerns, we remain optimistic for UK equities. We believe they offer an attractive source of real income. Higher inflation and volatility are both likely to continue, but dividends should keep pace with inflation over time, affording valuable protection to investors seeking income.
Over 2024 we’ll be keeping an eye on the utility sector. We believe there are still attractive opportunities associated with energy transition, and the need for further investment to improve infrastructure in both power and water.
Among industrials, the past year has been particularly challenging for several businesses. These companies were caught out as complex supply chains re-adjusted to life post pandemic, resulting in sudden and unexpected shifts in customer orders. As we look out into 2024, we’d expect the strongest to survive, prosper, and outperform from a lowered base of expectations.
Just as it was this time last year, the outlook for European equities is complicated and, as before, our strategy is based on fundamental stock picking that is well placed to navigate the challenges.
On all metrics, European equity markets continue to be attractively valued against other regional equity markets. With the recent rapid rise in yields, European equities are one of the few equity markets to still be attractively priced relative to bonds.
For the long-term investor, Europe is turning a corner. The financial backdrop has improved, regional politics are more cohesive, there’s more fiscal support and both domestic investment and consumption are increasing.
Moving into 2024, we’re not expecting any one single factor to dominate, though valuation may set pace. We’re finding many exciting opportunities across many different themes in our approach of looking for companies that are changing for the better. These businesses have been overlooked by investors and mispriced by the market. We believe these stocks will produce the greatest returns.
Cyclical, non-consumer facing sectors such as industrials, where earnings expectations are already at recessionary lows, are interesting. Traditionally defensive areas such as large cap pharmaceuticals are attractive given the growth potential from research and development. Energy names continue to benefit from high oil and significant cash generation. Higher interest rates are relatively supportive for capital-intensive sectors and banks.
The strong trend of an increasing number of people using ETFs has been fairly constant over the past decade, and in a variety of market conditions, so there’s no reason to think this won’t continue next year. If anything, the choice and fundamental characteristics of the ETF structure could be even more attractive given the unpredictability of markets in this uncertain economic environment.
Equity investors are likely to favour high-quality, large-cap market exposures but, when conditions improve, we could see more interest in some of the markets that have been shunned over the past year. We also may see increased interest in thematic exposures such as clean energy, which have long-term structural support from the transition to a low-carbon global economy. We should also see the continued trend of investors using ETFs for low-cost, transparent ESG exposures.
Investors often use ETFs to make immediate adjustments to their portfolios as conditions change, so monitoring ETF flows can be a useful barometer of investor risk appetite. It doesn’t alter what we do in our passive funds, but it could provide some short-term insight on market trends,
There could be a shift from lower risk ETFs to quality exposures in some of the more unloved markets. It will also be worth keeping an eye on markets outside the US, as some may fare differently with an end of interest rate hikes and different local economic conditions.
Since peaking in early 2021, Asian & emerging market (EM) equity markets have struggled amidst a liquidity tightening cycle and a crescendo of negativity surrounding China.
China’s post-covid recovery has disappointed, and faltering demand in its property market reflects weak consumer confidence, despite abundant household savings and solid balance sheets.
But valuations for regional indices trade below long-term historic averages, in terms of price-to-book. This financial metric indicates how much investors are willing to pay for each dollar of a company’s net assets. Regional indices are at a significant discount to developed markets, particularly the US. We believe there is scope for this gap to narrow.
Asian and EM equities are also well placed to benefit from an improvement in liquidity conditions, as we approach the peak in interest rate expectations, with US dollar strength likely to cease being a headwind.
Furthermore, compared to previous tightening cycles, Asian & EM economies enjoy relatively solid fundamentals, suggesting greater monetary policy flexibility should growth headwinds start to build.
In China, coordinated monetary and fiscal easing is underway, with greater urgency to boost confidence and support growth.
In our view, the continued divergence in performance and valuations between different countries and sectors within the emerging world will provide interesting investment opportunities.
The view from our Hong Kong based Asian equity team is the region is poised for stable growth, supported by lower inflation levels compared to developed economies.
This favourable economic climate offers conducive conditions for businesses to thrive and supports further expansion. We believe the resurgence of tourism in Asia will add impetus to the region's economic progress.
India continues to exhibit high growth potential, driven by robust private consumption and government-led capital expenditure. We’ve particularly got our eyes on companies that will benefit from domestic demand, as well as manufacturing and construction sectors that have strong government support and are relocating their supply chains to India.
We also see opportunities in the digital space, where there’s ongoing innovation. We believe India has a comparative advantage - its young demographics are increasingly adopting digital technologies, a fast-expanding middle class is boosting consumer spending. There’s also government support for infrastructure spending.
In China, we are witnessing signs of stabilisation and improvement in macro trends, thanks to the targeted government policies. This is a positive development anticipated to have a domino effect on the economy, reversing negative sentiments among consumers and corporations.
We believe China’s economy will be normalised in 2024, and we see opportunities from consumption patterns evolution and technological advancements in innovation and production.
The value of investments and any income will fluctuate (this may partly be the result of exchange-rate fluctuations) and investors may not get back the full amount invested.
All data as of November 20, 2023, unless otherwise stated.
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