Will October’s Pivot Shape 2024?

Not as we thought – 2023 was a different year than most investors expected. A year ago, financial markets were priced for a recession, which didn’t arrive, at least not in the US. Meanwhile, China’s widely expected post-COVID recovery stalled out. Investors began 2023 fearing inflation and the consequences of higher for longer interest rates. While the demise of SVB and the life support given to other regional banks seemed to justify their fears, the vital signs of US economic health persisted, and policy rates continued to rise until August.

Soft landing now expected – A few weeks later, following some Federal Reserve smoke signals, investors began believing rates had peaked. Bond yields tumbled, risk assets rose as short positions were closed, and the bond rush subsided. Financial conditions and liquidity eased, the dollar weakened, and investors rolled out the red carpet to greet the improbable soft landing. The “immaculate disinflation” is now investors’ base case scenario. But as we enter 2024 and financial markets are priced for multiple rate cuts, critical investor questions remain unanswered: has the recession already happened or just been delayed? And, can we return to economic growth without reigniting inflation?

Get elected – In the coming year, circa 40% of the world’s population will vote in national elections, including both its wealthiest country, the US and its most populous country, India. The results are already as good as known for some, such as Russia’s presidential election in March. Others are likely to be more geopolitically consequential, for example, Taiwan this month and South Korea in April. However, it is unlikely that many will match Argentina’s recent poll for outright radical uncertainty, but few countries compare in the severity of Argentina’s structural economic problems.

Don’t mention Brexit – By contrast, the UK’s election, likely in May or October, will be of little consequence for global investors, most of whom wrote off the UK as a home for proactive investment long ago. Having won last year’s Most Improved Player Award for Political Stability, this year, a smooth UK political transition, without its relationship with Europe featuring in the campaign, could be all that is required for both direct and portfolio investors to tie a bow on the UK as a place to increase their position sizes.

Concentration – However, in stock market terms last year, the UK remained a laggard by global standards. While the S&P 500 was pipped by Tokyo’s Nikkei 225 (+28% to +25%) in the major country indices stakes, the real story of the year was the continued power of US Big Tech, with the NASDAQ 100 up over 50%. Within it, the newly crowned Magnificent Seven AI wonder stocks (the FAANGs minus Netflix, plus Nvidia, Microsoft and Tesla) were ahead by more than 100%, ending the year, accounting for nearly 30% of the market cap of the S&P 500 and 19% of the 12,500 stocks from 23 countries comprising the MSCI Developed World All Share Index. As a result, just seven stocks now account for almost $12tn of market value (more than six times the size of the FTSE100), a degree of market concentration greater than the Dotcom Boom of 25 years ago and the Nifty Fifty of 50 years ago. When these previous periods of excessive market concentration unwound, the result was the multiyear outperformance of smaller companies and the value style. The early signs suggest that 2024 might follow such a pattern.

The unwind – While the big equity story of 2023 was the emergence of the Magnificient Seven, the equity market performance in Q4 was altogether different. As sentiment changed towards the future path of interest rates, liquidity-starved smaller companies reawakened. The NASDAQ 100 gained an impressive 14% in the final quarter, but the Russell 2000 rose by 22% from its low point in early October. Is the long-awaited divergence of return starting to take shape?

Good for us – The UK’s AIM 100 index ended the year down a disappointing 8% but also rallied from its post-COVID low in October by 8%. The more value-laden FTSE Smaller Companies Index, broadly unchanged over 2023, rose by 13% from its October low point. These moves have yet to constitute a new trend. But, they offer signs of hope that normalised rates will establish a divergence of equity returns that reward active stock picking over trend following and indexation, a trend, if established, that could significantly re-rate the UK mid-market.

Bonds – As we enter a year of elections, the issue of fiscal dominance and bond yields remain essential drivers of financial market performance. 2023 ended with US and UK 10-year yields broadly unchanged. However, this masked a roller coaster ride. Capital poured into sovereign debt during the year, offering the prospect of a real return for the first time in many years and crowding out investment for other assets. US 10-year Treasury yields hit 5% in October, while the CPI for November was just 3.1%. (The respective figures for 2022 were a 3% Treasury yield and 9% inflation).

Playing it safe – The lesson from 2023 is that bond markets influence equity valuations, but quality equities can adapt and survive. Although the stunning performance of the Magnificent Seven tech stocks is widely understood to be due to their ability to generate excess returns from implementing AI, their financial strength is undeniable. These are their average balance sheet net cash positions: Alphabet $120bn, Microsoft $140bn, Meta $60bn, Tesla $26bn, Nvidia $18bn, Amazon $64bn, Apple $61bn, which totals nearly $500bn. AI might be their prime mover, but these stocks have been significant beneficiaries of tighter monetary and looser fiscal policies over the last two years. Any continuation of the October pivot with falling rates in 2024 and investor preference for balance sheet strength might dissipate.

Fiscal overreach – Although Argentina’s recurring default cycle over recent decades reminds us that governments can fail, developed world sovereigns extend borrowing beyond normally permissible levels by imposing financial repression, creating inflation, or both. With inflation falling in most Western countries, the risk of repressive measures on capital rises, assuming projections for sovereign debt and growth remain unchanged. Unsurprisingly, since the financial pivot in October 2023, alternative stores of value, outside money or assets that are not someone else’s liability, have rallied. Gold is up 14%, and Bitcoin is up 50% since mid-October as investors discount the prospect of more repressive fiscal regimes.

Base case – Argentina’s newly elected President Javier Milei faces a more extreme version of fiscal overreach than most nations and has set about adopting radical measures to restore monetary discipline. To a lesser degree, this year’s newly elected governments will all face similar policy choices. While quality equities can sustain any bond market environment, liquidity constraints and crowding-out effects remain valuation risks. As ever, there remain too many moving parts of our complex adaptive systems we refer to as our economy, politics and financial markets to arrive at firm views, never mind definitive forecasts. But if the pivot is in, then the core narrative for 2024 is of normalised interest rates and more widely dispersed returns favouring smaller companies and the value style.

Jeremy

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