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Investment update: positive signs emerge, but caution required

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Investment update: positive signs emerge, but caution required

While equity and bond markets had a strong finish to 2023, caution has been the watchword so far in 2024. Inflation and interest rates were the primary focus last year, and while they will continue to matter throughout this year, we’re also looking closely at the growth outlook and whether markets will experience a lag effect from the longer-term impact of successive rate rises.

All of this naturally leads to speculation over whether we’re going to see a ‘soft’ or ‘hard’ landing – or whether we’ll experience a recession. At present, it looks as though a soft landing is the base case, with continued solid growth in labour supply, but there are still a number of issues to pay attention to. A recession certainly cannot be ruled out and recent economic data continues to suggest mixed and sometimes conflicting signals for the broader economy. This makes it much harder for central banks to get the interest rate settings right – i.e., to balance out inflation and growth outcomes.

Parts of the market appear to have run ahead of themselves already – leading to talk of bubbles emerging, and in some areas prices have risen sharply (e.g., bitcoin, gold, parts of technology). The US corporate earnings season we’ve just been through has generally been positive, with profits holding up overall, unemployment staying low and the Feds talking again about disinflationary signals. However, positive or negative economic news is generally reflected in the market well ahead of time, meaning we could see periods of sideways movement as well as more volatility from here, until there’s a better understanding of what’s coming next.

To date, it is fair to say that economic data has been broadly in line with or above expectations, and this has provided the catalyst for recent market strength.

Heightened expectations of local interest rate cuts on the back of softer domestic GDP results to end 2023 also helped encourage the local market to rally this year, despite lingering concerns around China’s current growth path.

Will interest rates fall in 2024?

A big question for all market participants at present is when rates will reduce, and in this type of environment, you expect caution from the central banks. Given missteps historically, no central banker wants to drop rates too early and risk increasing inflation and having to reverse course. Markets are pricing rates to start coming down at some stage in the second half of this year, but not back down to the low levels of a couple of years ago. What’s interesting in the current debate is that it’s conceivable things could move much faster than anticipated if growth starts to fall away more quickly. In a year dominated by elections in many developed countries (including the USA in November), no incumbent wants to see this happen. Slowing growth and/or a recession is generally not good for re-election chances.

What is clear, however, is that we’re certainly not out of the current adjustment cycle, so caution needs to remain in place for portfolio structure. We need to be appropriately diversified and patient, not chasing quick wins or ‘fads’ but keeping an eye on longer-term opportunities and taking profits if and when they emerge within the cycle.

Keeping the risk factors in mind

Prior to the pandemic in 2020, economic cycles had been more driven around fluctuations in demand, while supply side issues were generally heading in a positive direction (e.g. globalisation, lower inflation and cost of funds, more stable geopolitics, etc). This made the calibration of interest rate adjustments more predictable to try and balance the economy as required (up or down).

Now, we are dealing with a more uncertain regime including tackling ageing population issues, and potentially structurally higher inflation/rates while delivering a lower carbon footprint. In this context, it’s important to be mindful of the risk factors that can disrupt the current narrative. Inflation risks still remain – as do recession risks, even if they are operating with a potential lag – and this impacts your thinking around target asset allocation.

Given the lack of definitive outcomes, we prefer to consider the issues on a scenario-weighted basis. Yes, with the base case the data’s looking positive and interest rates have now been on hold for a little while, but what else could happen? What probability do you assign the outcome? For example, growth could stall, unemployment could rise, and that could seriously impact related high-growth assets. Alternatively, governments could continue to support consumers and growth, keeping unemployment in check, inflation up and rates higher than expected. Or there may be simply a ‘bumpy landing’ where a short, shallower recession arises, pushing down inflation quicker (a positive for bond prices).

That’s why it’s essential to have an eye on longer-term valuation metrics and critically assess portfolio objectives to deal with shorter-term volatility.

This was illustrated well last year. Around the third quarter of 2023, prevailing market news became more negative and hence, it was tempting to consider cashing in some growth asset positions in favour of cash. However, the last four or five weeks of the year saw the market move very quickly and produce the bulk of the year’s results. Such cash would simply have been left by the wayside.

The presence of higher real (i.e., after inflation) interest rates does provide a more solid foundation for portfolios (i.e., income based generation), although it does apply pressure to asset price valuations around the world, particularly where corporate profits are squeezed from higher funding costs. This will challenge asset class return expectations and it all needs to be factored into the long-term portfolio mix too.

2024 looks set to be the next chapter in the post-COVID recalibration.


Speak to your Crystal Wealth adviser about your investment strategy for 2024 and beyond. 

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