Investment Outlook - 12 January 2024

• Stock markets consolidate recent gains

• Bond yields up a little

• The oil price risk to the Goldilocks scenario

• U.S stock valuation and concentration risk

• Bank of America survey finds investor optimism highest in 23 months

Market sentiment: Consolidating. Strong gains on risk assets in November and December have been largely retained over the past fortnight. This is despite wobbles in core government bond markets, as bond traders perhaps over-respond to stronger than expected U.S labour market data. 

Ignoring market noise, it is increasingly the case that the Goldilocks scenario for the U.S economy -defined as moderate GDP growth with inflation settling around the Fed’s 2% target- has become the consensus forecast amongst investors. It is this that supports U.S and global stock and bond markets, and other risk assets such as credit and alternatives. 

 Bond yields up. After two months of broadly supportive news for bonds, that had helped drive yields down, the rally had to end sooner or later. It ended in late December, with the 10yr Treasury yield at just 3.8% on the 27^th , having been 5% as recently as mid-October. It is currently hovering around 4%. The uptick in Treasury yields has been mirrored in bond markets across the world – such is the dominance of the Treasury market. 

The trigger was labour market data that suggests that while the U.S economy is slowing, it is not slowing fast enough to allow the Fed to ease monetary policy in March, as had been hoped. Initial jobless claims have been lower than expected in recent weeks, while December non-farm payrolls grew by 216,000 (up from 173,000 in November). Pay growth of 4.1% year-on-year is now well ahead of inflation, prompting fear that real pay growth will reverse the downward move in inflation. 

 The market now expects the Fed to begin cutting interest rates in June, as it did a month ago, from its current target rate of 5.25%-5.5% perhaps down to 4.5%-4.75%.

 The rise in real incomes last year prompted President Biden to welcome the December pay and non-farm payroll data release as evidence that ‘2023 was a great year for American workers’. It is natural for Biden to want to highlight the surprising strength of the U.S economy over the course of last year, given the widespread perception amongst voters that the economy is currently doing badly and an election is just eleven months away. However, such boasts risk being counter-productive if they result in increased confidence, and spending, at a time when the Fed is trying to anchor inflation. 

U.K gilts respond to deficit fears. The U.K also faces an autumn election, which has accentuated the recent in gilt yields over the past two weeks. The 10yr gilt yield rose from 3.4% to 3.8%, over a handful of trading sessions over the New Year. This was a significantly larger jump than that seen on similar maturity Treasuries. An explanation is that investors are afraid of pre-election giveaways, in the form of tax cuts, as Conservative prime minister Rishi Sunak tries to limit the damage to his party in the upcoming election (likely to be in October). 

 The market has not forgotten that this is the same Conservative government that gave financial markets a scare, in autumn 2022, when unfunded tax cuts were announced. A so-called ‘moron premia’ was put onto UK gilt yields and sterling, that effectively ended the short-lived premiership of Liz Truss.  

 However, continuing falls in inflation will allow the Bank of England to cut interest rates this year. Market expectations are for four 0.25% cuts, starting in the summer, which will bring the benchmark rate down from 5.25% to 4.25%.

 Oil prices and Goldilocks. Perhaps the biggest risk to the Goldilocks scenario for the U.S economy comes from a resurgence in the price of oil, which would then feed through into inflation. A recent all-time high in the gold price, to $2,088 an ounce on 28^th December, probably reflects this increase in geo-political risk. 

 However, unlike gold, the oil price has been relatively mute. WTI currently trades at $72 a barrel, well below the $85 seen in mid-October following the Hamas attack on Israel. This is despite an increased fear that the Israel/ Gaza conflict will drag in other powers, highlighted by recent attacks on western shipping by Iranian-backed Houthi rebels, and that this will disrupt Gulf oil supplies. 

 The two most popular explanations for the muted response in the oil market are that record U.S oil production, of 13 million barrels a day, off-sets OPEC+ production cuts. And that an anticipated fall in demand growth in 2024, as the global economy slows, weighs down both futures and spot prices. 

The risk remains, though, of a broader conflict in the Middle East and higher global energy prices as a result. These would delay, if not reverse, recent falls in global inflation. Central banks, wary of being accused of sitting back while inflation rises (as they were in 2021/22), will surely act to curb demand and so prevent higher energy prices from leaking into general price increases. 

 U.S stock valuations and concentration risk. The S&P500 and the tech-heavy NASDAQ index both reached new highs in late December, once again prompting questions as to their value relative to other markets. On a forward price earnings ratio of around 20 times at the end of December, the S&P500 is around twice as expensive as the FTSE100. No other major market is as expensive as the U.S. The most elevated valuations in the U.S belong to the big tech stocks, which now account for perhaps a third of U.S market by weighting (if Amazon is treated as a tech company).

 Perhaps U.S Big Tech deserves its high valuations. It reflect both optimism over the companies long term growth prospects, as well a belief that attempts by Washington regulators to crack down on some of the companies anti-competitive behaviour will not amount to much (particularly given the relatively pro-business stance of the Supreme Court). However, stock market history is unkind to industry concentrations in stock market indices. Think of tech at the turn of the century, and banking stocks just ahead of the global financial crisis.

 It is perhaps no wonder that the long-term asset class assumptions currently being produced by global fund managers favour ‘rest of the world’ over U.S stocks on a long term basis (ie, five years plus).

 Bank of America survey. With a slightly shorter time scale in mind, the monthly BoA survey of global fund managers for 2024 shows optimism at the highest level since January 2022. The commonly-held overweight in cash is being reduced, and positions in stock markets have increased. But the preferred asset class for 2024 is bonds, which are seen to benefit from good real yields and the opportunity for capital gain as interest rates are cut. A relatively soft landing for the U.S economy will help minimise defaults in credit markets.

 Sterling. The pound has spent most of the last month hovering around $1.27. Baring the risk of a return of the political ‘moron premia’ being applied to gilts and the pound, as it was in the autumn of 2022, there is no reason to believe it is either under or over-valued in the near-term. Given that the Fed looks likely to be the first major central banks to cut interest rates, the dollar may weaken against all major currencies during the first half of 2024, flattering sterling. However, the Bank of England may make more interest rate cuts than the Fed over the course of 2024 once it starts cutting, given the fundamental weakness of the U.K economy (marked by low productivity growth). Sterling may weaken longer-term.

 How should investors respond? Financial history tells us that investors should maintain exposure across a broad range of asset classes, regions and currencies, in order to achieve the best risk-adjusted returns. Balanced multi-assets funds help investors achieve this.