While 2023 has presented significant challenges for investors, there has nonetheless been much that should help buoy sentiment as we move into the new year.
To touch on the negative first, geopolitical tensions have heightened as the year progressed — in Ukraine, in the Middle East and in Asia — as China’s long shadow falls across Taiwan and the South China Sea. Central banks have fought to stem inflation with higher interest rates, and the potential for recession has loomed over markets.
Despite these clouds, there are reasons to be cautiously optimistic as we enter 2024. Equities have largely surprised on the upside in 2023, while fixed income assets turned a corner after an extremely challenging 2022.
Despite the spectre of a recession spooking markets, most economies, with the exceptions of Germany and Italy, have so far demonstrated healthy growth, the US particularly so, although the expectation is that growth will be more subdued this year.
As central banks pivot from fighting inflation to encouraging growth, the balance between growth, inflation and interest rates is likely to define market performance for 2024.
Central banks continue to view inflation as problematic and remain committed to bring it in check. While inflation has undoubtedly eased, it remains stubbornly above the targets set by most central banks.
Positive inflation data
Recent data sets look more encouraging, with year-on-year inflation in the US and the UK coming in at 3.2 per cent and 4.6 per cent, respectively, in October, healthier than markets had anticipated. Meanwhile, eurozone inflation fell to 2.4 per cent in November. These decreases support the view that the current round of interest rate hikes may be ending, with the central banks in all three of these regions choosing to leave rates steady in November.
The balance between inflation and interest rates weighed on fixed income markets in 2023. Yields rose sharply (and prices dropped) across the board since their lows in 2020; in October, yields on UK and US government 10-year bonds reached levels not seen since 2007-08.
The large losses witnessed in 2022 were not repeated in 2023, implying that much of the valuation readjustment has already happenedHowever, the more positive inflation data in November saw bond yields fall from their peaks. Furthermore, the large losses witnessed in 2022 were not repeated in 2023, implying that much of the valuation readjustment has already happened.
In fact, although October was generally a weaker month, the recent rally in bond prices since has meant that most bond markets, bar UK government bonds, are in positive territory year to date.
Stock markets have also been at the mercy of the inflationary and interest rate backdrop, as well heightened geopolitical tensions, yet most delivered reasonable gains in 2023. Despite this, the journey has not been a smooth one and global markets traded choppily through the year.
Nor has this journey been entirely one way, with investors favouring the largest companies over their medium and smaller peers.
Looking at the US market, there is a considerable divergence of 23 per cent between the top 50 largest stocks compared with the bottom 2,000 year to date. This is largely due to the structure of the US market, where technology stocks dominate.
The dominance of the “Magnificent Seven” — Tesla, Nvidia, Amazon, Alphabet, Apple, Microsoft and Meta — as these tech mega caps have been dubbed, is striking and their strong performance has made the US market as a whole appear expensive. However, if the top 10 largest stocks are stripped out, the US is trading at around its long-term average valuation.
The underperformance of medium and smaller-sized companies relative to their larger peers has also been a prevalent narrative in the UK stock market. Again, its structure has played its part in this divergence, with higher oil prices driving up the share prices of multinational energy companies such as Shell, which make up nearly 9 per cent of the FTSE 100.
UK lagging behind world peers
Despite the support of these larger companies, the UK has still returned less than its major world peers year to date. It continues to be shunned by international investors and its medium and smaller-sized constituents are actively unloved.
There may be myriad reasons for this, with politics likely playing its part, but as such the UK market is currently cheaper using conventional valuation measures than the US, Europe and the emerging markets.
Elsewhere, China has been a notably weak outlier. The expectation was that once the world’s second-largest economy reopened following its Covid-related restrictions, it would experience a boom period.
This has not materialised, while at the same time concerns over the country’s debt-laden property market have weighed on investor sentiment. This disappointment over the performance of Chinese equities acted as a drag on Asian and wider emerging markets, although Japan was a strong performer during the year.
On the whole, strategists believe that the rally in equity markets is likely to continue in 2024, although they will remain sensitive to news flow. Value has come back into bond markets and with current yields it should mean decent returns to come, even if central banks do not make significant cuts in interest rates this year.
Certainly, this provides some reason to be cheerful as we bid farewell to 2023.
Mark Harries is chief investment officer at Square Mile Investment Consulting and Research
