Our view on the investment markets

Market Review

January 2024

After some mixed progress for investment assets over the first nine months of 2023, the final quarter saw some excellent returns across most fixed income and equity markets. The main driver was better than expected reductions in inflation across key countries which encouraged investors to believe that central banks would be cutting interest rates sooner and by more than previously expected during 2024.

The fourth quarter started with losses due to concerns that global interest rates would need to stay higher for longer to fully subdue inflation and from new geopolitical risks following the Israel-Hamas conflict. However, a run of better than expected economic and inflation data and a measured response to the economic impacts of events in the Middle East subsequently enabled markets to end the quarter strongly. 

Inflation data saw substantial declines across the UK, Europe and the US during the quarter. In the UK, the headline consumer price inflation level fell from 6.7% down to 3.9%, with further declines expected in coming months. After a period of significant interest rate increases, the Bank of England maintained the bank rate at 5.25% throughout the quarter. Despite markets beginning to price in a number of interest rate cuts in 2024, the UK and European central banks continued to suggest that rates would need to remain high for longer, but crucially the US Federal Reserve softened its language and didn’t discourage rate cut speculation and this propelled both equity and bond markets higher into year end.

Higher interest rates were expected to cause challenges to global economic growth, but although growth remained relatively subdued in many countries, the earlier recession fears have proved largely unfounded and the important US economy remained surprisingly healthy thanks to resilient consumer spending and increased fiscal support.

Equity markets saw widespread healthy gains across the quarter thanks to the improved outlook for inflation and interest rates. After outperforming other markets in a difficult 2022, the weakness of commodity prices held the UK market back due to its above average exposure to the energy and mining sectors, but the fourth quarter still achieved gains of 3.2%, taking the 2023 FTSE All-Share index return to 7.9%.

The relative strength of sterling continued to soften returns for UK investors in international equities, but the quarter still achieved sterling terms gains of 6.5%. This took returns for 2023 to 16.0% (an impressive 22.6% in local currency terms). All regions saw healthy gains in the quarter, but over the year the US had consistently led the way and ended with a gain of 19.9% thanks to a strong year for its large technology stocks amid excitement over the prospects for artificial intelligence. Europe and Japan also achieved double digit returns, but concerns over China restricted Emerging Markets and Asia Pacific ex-Japan to more modest gains.

Following a difficult period for most bond markets, the benefits from greatly improved yields and growing expectations for a series of interest rate cuts saw strong returns for fixed income assets over the quarter, which took all categories into positive territory for 2023. UK gilts saw gains of 8.1% for the quarter and 3.7% for the year. Whilst 2023 returns for index-linked gilts were only 0.9%, corporate bonds, high yield bonds and emerging market debt achieved gains of 9.7%, 12.7% and 9.9% respectively.

UK commercial property had another challenging year with the combination of stubbornly high inflation and interest rates pushing property yields higher, leading to falls in capital values. The occupational market proved surprisingly resilient with rental growth continuing to be seen, with overall 2023 market returns expected to be slightly negative.

Although UK interest rates seem to have peaked at 5.25%, the significant increases over the last two years have greatly improved the returns on cash deposits. 

Market Outlook

We have seen a roller-coaster of investor sentiment in recent years as markets have had to deal with a number of unexpected events such as the Covid pandemic and an invasion of Ukraine which has seen significantly higher inflation and interest rates. With economic growth being more resilient than initially feared and with encouraging recent declines in inflation creating hopes that central banks will soon be cutting interest rates, this proved supportive for both equities and fixed income assets as we approached 2024.

Having previously been in a long period of relatively subdued inflation, very supportive central bank policies and ongoing benefits from globalisation, this recent period created a very different investment environment with a number of challenges, but also one which has seen a notable improvement in yields on offer from fixed income assets such as government and corporate bonds.

Whilst ongoing geopolitical issues and a year coming up with a significant number of elections produces a lot of background noise, barring a significant escalation the main debate for investment markets is likely to revolve around the success of efforts to reduce inflation back to target levels and whether key economies can continue to avoid the previously feared recessions. Both headline and core (excluding the more volatile food and energy elements) inflation have now seen significant declines from their peaks in key developed economies and central banks are now viewed as having reached the peak of the interest rate hiking cycle, but with varying views as to how soon and by how much rates will be cut.

Having been seen as slow to raise interest rates in the face of escalating inflation, central banks are being cautious and not forecasting rate cuts to the extent that markets are already pricing in, and this will remain a key battleground in determining the direction of markets in the coming year. Whilst inflation has made good progress and further declines are widely expected, core inflation does remain well above target and there are still dangers from areas like high wage settlements and geopolitical threats to energy prices.  

Most economies have coped well in the face of much higher interest rates, especially in the US, with the impact of higher borrowing costs being somewhat offset by the resilience of consumer spending and fiscal policy support. The UK will see a headwind from higher mortgage costs as loan deals locked in at lower rates expire, but mortgage rates are well off their peaks and above inflation wage rises will also provide some support to consumers. Whilst there remain risks of a mild recession in some countries, most forecasters see a further period of modest economic growth for the global economy in the short term before picking up from 2025.

We previously identified that many investment assets had discounted a lot of bad news and markets would be looking for signs of turning points in the interest rate cycle and benefits from moving towards a lower inflation higher growth environment. Evidence of some of this emerging in the last quarter enabled a strong move in equities and bonds and this has taken the edge off some of the valuation attractions that previously existed, but our medium to longer-term views remain broadly positive.

Whilst the previous substantial fall in bond prices was painful for investors, the resulting improvement in yields has meant that fixed income assets are offering better value than we have seen for a long time, and are once more offering their traditional attractions of both reasonable income and return potential and also useful diversification benefits within mixed asset portfolios. However, high levels of government debt in many countries and heavy bond issuance to fund deficits will act as a constraint on prices.

Yields have come down from recent peaks, but 10-year UK government bonds (gilts) are still offering yields of around 4%. Other fixed income options such as investment grade corporate bonds, high yield and emerging market debt offer even more income to compensate for their greater risk. These additional yields over gilts (known as spreads) take overall yields up to some attractive levels of income by recent standards and whilst defaults are edging higher they remain relatively low.

Equity markets have also been caught up in the ebbs and flows of inflation and interest rate expectations, with occasional short-term reactions to geopolitical events, and this is likely to continue. Gains in 2023 were initially driven by a relatively small group of predominantly US-based technology companies, and especially those seen as potential beneficiaries of the rapid growth of artificial intelligence, but this turned into a broader based rally as the inflation and interest rate outlook improved.  There remain a number of risks that could see short-term sentiment turn again, but falling inflation and rate cuts could continue to drive markets and there are other potential positive drivers from developments in areas like AI, decarbonisation and healthcare. Most equities continue to be priced at or below their long term average valuations, they have a long track record of delivering above inflation growth, and still offer reasonable potential for patient investors who are able to cope with any shorter term volatility.

The UK market has an above average exposure to commodity based sectors like energy and a below average exposure to technology companies, and this has seen it behave quite differently to markets like the US in recent years. Whilst the domestic economy still struggles with subdued growth and above average inflation, it has moved closer to peers. 2024 is a record year for elections around the world, and whilst some pose risks, the two main UK parties have moved towards the centre ground and likely outcomes look relatively benign for investors. The UK market still hosts a number of good quality companies, offers significant international revenue exposure, and is priced at a notable discount to other markets whilst offering an attractive dividend yield and potential for corporate takeover interest.

Within international equities the US remains the dominant market, having benefitted greatly over the last decade from their above average exposure to growth and technology stocks, the strength of the dollar, resilient consumer spending and substantial fiscal packages. As a home to many excellent companies the US continues to form a significant part of our global portfolios, but with a significant election looming and valuations above all other regions, we look to diversify exposures towards other more attractively valued equity markets.

Despite its previous reliance on cheap Russian gas and exporting goods to China, Europe has coped relatively well with challenges in these areas, and alongside Japan offers reasonable valuations and saw positive market performance in 2023. Emerging markets contain a wide range of countries with different attributes, but despite fewer inflation and interest rate headwinds they underperformed in 2023. This was driven by weakness in China due to their disappointing economic recovery from Covid, property market weakness and tensions over their relationship with the US. Emerging markets overall continue to see elevated risks, but still offers superior economic growth and the potential for longer-term outperformance at relatively attractive valuations.

The 2024 outlook for UK property is one of stabilisation. Investor sentiment should improve as property yields and valuations stabilise as inflation and interest rates fall back. Scope for valuation improvement is expected to be limited and further negative pressure is anticipated across the office sector, but overall property total returns are expected to be strongly influenced by income, with mid-single digit returns forecast for 2024.

After fourteen increases, UK interest rates have been held at 5.25% since August and as confidence grows that inflation is under control forecasts now suggest rates will see a number of cuts in 2024. Rates are not expected to return to the exceptionally low levels of recent years, so although the returns available on cash deposits are likely to reduce, they should still provide a useful low risk option for savers alongside other investments.

In conclusion, there remain many potential challenges such as risks to economic growth from higher borrowing costs and also elevated geopolitical risks which could impact energy prices. However, economies so far have been surprisingly resilient, and if inflation continues to subside, we should see a number of welcome interest rate cuts. The previous increase in interest rates sees both returns on cash and the yields available on fixed income assets offering much improved value and they provide useful attributes alongside equities in mixed asset portfolios. The strong run for equities has perhaps lessened some of their shorter-term potential, but many UK and international equities remain relatively attractively valued and the corporate environment should improve in coming years. Turning points in interest rate hiking cycles that don’t coincide with recessions can be useful catalysts for market sentiment across many investment asset classes, and from current valuation levels suitably diversified portfolios containing equities, fixed income and property (where available) offer the potential to deliver reasonable medium to longer-term investment returns.

Paul Glover
Chief Investment Manager
January 2024