2023 ended so strongly that investors looking back at the year will likely recall it favorably. However, there were echoes of 2022, at times, with bond yields and interest rates rising, and high inflation remaining an issue. As the year progressed, these concerns eased, with the end of year rally driven by talks of imminent rate cuts and falling bond yields.
Inflation remained the key focus for investors over the year, although concerns reduced as the headline CPI rate in the US fell from 6.5% in January to 3.1% by the end of the year. Similarly in the UK the rate fell from 10.1% to 3.9%. The normalization of inflation rates has allowed a more serious discussion about cuts to interest rates, with the markets expecting the process to begin during 2024. However, low inflation is unlikely to be sufficient for significant cuts, a weaker economy is required. Bond markets are therefore pricing in a likely recession.
Conversely equity markets continue to paint a more optimistic picture. Valuations have risen and can now be considered expensive relative to history and particularly when considered against returns offered by fixed income. This is most clear in the US, and particularly at the large cap end of the market. The year has given rise to the “Magnificent Seven”, the largest seven listed companies by market cap, Apple, Microsoft, Alphabet (Google), Amazon, Nvidia, Tesla and Meta, making up over 18% of the global equity market. These companies have overwhelmingly contributed to overall market returns and now trade on stretched valuations.
Justification for this expansion in valuation has been Artificial Intelligence (AI). Although AI has been a noted theme in the investment world for some time, the increased focus over the year has been dramatic. However, while there are some noteworthy winners, such as Nvidia, others members of the Magnificent Seven are less obvious beneficiaries. Indeed, some of the largest technology companies will need to adapt quickly to avoid becoming disrupted themselves. Rates of investments needed to maintain their position, and capture these new markets, may need to increase.
The coming year will see a number of elections in key markets. Notably the US and UK, although elections in India, Taiwan and Russia may also draw investors attention. As usual, the most significant of these is the US Presidential Election. While this will take place towards the end of the year, there will increasing noise around the vote as the year progresses. It is widely expected that it will be a Trump vs Biden re-run, with Trump the narrow favourite. For markets, a Trump victory may be favourable as there would likely be an extension of the tax cuts implemented in his first term. However, it is prudent to expect that there could be volatility around certain sectors (eg. healthcare) as the vote approaches as the selected candidates position themselves.
Looking forward, over the course of 2024, we expect inflation to continue to fall as deflationary forces assert themselves. This should solidify the top of the interest rate hiking cycle and open the door for some loosening of policy. Economic weakness may accelerate and add to the size of any cuts. This is likely to benefit bonds and other interest rate sensitive assets, such as infrastructure. However, the outlook for equities and other risk assets in this environment is less clear. Earnings expectations have begun to weaken and an outright recession may cause a more significant hit. Falling earnings would also likely cause the market to de-rate. A notable equity market drawdown would therefore be possible in this environment. Although there is some balance between potential monetary policy support later in the year and weakness in earnings, we retain a modestly cautious equity outlook at the start of the year.