Investor Insight, January 2024

Last month we published the HWP Investor Insight 128, reflecting on what shaped 2023. This month we publish our outlook for 2024 and the year ahead.

We believe 2024 will be the year where “you will be pleased you did not sit in Term Deposits (TD’s) at 5 per cent”, in other words you will be rewarded for being exposed to a diversified portfolio of risk-based assets.

The chart below from Bank of America highlights to us that sentiment is negative and too many investors are sitting back, comfortable with their 5 per cent yield from deposits.

The level of US Treasury Bill and Cash holdings is now at 15.8 per cent, having last reached these levels in 2009, after having got near this level in March 2020.

This suggests investors do not have the confidence that we are at or near the peak in interest rates, we belive we are!

We are also concerned that many investors are waiting for a significant equity market correction before adding to risk-based markets. Every cycle is different and there has in fact been a significant correction, in bond markets. Bonds capitulated in 2022 and have been extremely volatile in 2023.

Once investors realise this, there will be strong flows into risk-based assets, specifically global developed market equities and emerging market equities.

Our clients will have become familiar with our scenario analysis as depicted in the chart below. We are looking at a soft landing in the US however mild recessions in Europe, the UK and Australia are likely.

Markets always look ahead and this should not be a concern, in fact it reinforces our view of being at or near the peak in interest rates, with interest rate cuts expected around the end of the first quarter or start of the second quarter in developed markets. Inflation is is not decreasing at the same rate in Australia, which is likely to delay interest rate cuts and increases the risk of recession in the second half of 2024.

The ‘R’ word has been used extensively for two calendar years. Recession risks have fallen as economies have proven to be more resilient than most forecasts. Whilst the US will slow down in 2024, it may well avoid a recession and mild recessions will be evident across Europe.

The soft China economy has also been a dominant theme over the last two calendar years. China should continue a cyclical recovery, with consumer confidence increasing combined with fiscal support, but this will be a mild recovery and not like previous periods where Chinese authorities have aggressively stimulated the economy.

AI (Artificial Intelligence) has been the big theme of 2023, and we believe this will provide a boost to productivity, with technology adoption time lags having reduced significantly over time.

We close out 2024 with our tactical overweight position in risk based assets, through Diversified Credit and Infrastructure. We we expect our allocation to risk assets will increase through 2024, as we move overweight Developed Market Equities and Emerging Market Equities, for the first time in over two years.

Fixed Income

The rise in sovereign bond yields continued for most of 2023, with US and Australian Treasury yields peaking just above 5 per cent in Q3, but we have seen a significant rally since then. Whilst we are positive and Overweight bond markets entering 2024, we believe yields will reach a trough over the next year.

The rally has been in response to softer economic data, particularly inflation data, which has brought forward the market’s expectation of the timing and extent of rate cuts by central banks in 2024.

We agree that we will see rate cuts commence in 2024 but we think it is important to remember that Australia is at least a quarter or two behind the US in this cycle. Whilst we may well see rate cuts commence in the US in H1, they will be later in Australia as inflation proves harder to get down to the RBA’s target of 2.5%. The US may well have lowered interest rates by 1-1.25% before the inflation data here provides the RBA (Reserve Bank of Australia) with sufficient comfort to start lowering Australia’s cash rate.

Whilst we are bullish on Fixed Income markets, we believe there is a limit to how far yields can fall in 2024, given the above scenario. We expect to see long bond yields fall through 4 per cent but will be surprised if they test 3 per cent during the year. At some stage we will reduce our duration positions, thus removing much of the volatility from this asset class. Whist short term rates will also have fallen, there will be a point where they provide better risk adjusted returns.

Currency

We are never comfortable forecasting a level for the Australian Dollar (AUD) as no one ever calls it correctly, but we are always prepared to give it a direction.

As we have mentioned earlier, we believe the focus should be on the next stage of the cycle and the fact that Australian interest rates could possibly see only a 25 basis point or 0.25 per cent cut over the year if at all, against US interest rates where we expect at least 1.25 per cent to be cut over 2024 starting either side of the end of the first quarter of the calendar year.

There is a possibility that US interest rates cross over Australian interest rates and therefore by the end of 2024 Australian interest rates are higher than those in the US.

We therefore see the recent upward trend for the AUD continuing in 2024, with it trading above the 0.70 cent level, compared with its closing level near the end of 2023 of 0.67 cents.

Equities

We enter the year Neutral Developed Market Equities with an Overweight in mid caps, Underweight in US large caps and a bias towards going Overweight offshore equities later in the year, whilst remaining Underweight Australian Equities.

Equity markets look ahead and are driven by interest rates. Markets can stomach a weak economic reality so long as they can see the ‘light at the end of the tunnel’, with this light being lower interest rates, so given our view for more rate cuts in the US than Australia next year, we anticipate increasing our Developed Market Equity allocation in 2024.

In Emerging Market Equities (“EM”) we enter the year with a Neutral stance to strategic benchmarks but expect this to change to Overweight during the calendar year, with anticipated volatility providing opportunities.

Later in 2024 as global growth picks up from its first half lows, along with interest rates having started to fall, this will benefit EM. Markets such as India which are experiencing high growth should be a primary beneficiary along with China as interest rate differentials shift in its favour.

Property

We expect a continued slowing in commercial property throughout 2024, as markets have yet to find a consensus clearing level. As we discussed at the start of this Insight, investors are favouring the certainty of 5 per cent term deposits over the less certain, albeit more attractive yields (and potential for growth) now available in commercial property.

Rental incentives will continue to eat into real commercial property yields. Incentives are close to 40% in Melbourne and 35% in Sydney, as landlords pay up to secure tenants in a tougher commercial rental market, where vacancies have hit 15% in Melbourne and 12% in Sydney. Domestic unlisted commercial property sailed through 2022, as valuations are unable to adjust in our market without comparable sales, unlike offshore markets where sentiment alone is enough for valuers to act. Transactions have lifted in 2023, resulting in lower valuations, and we anticipate this to continue throughout 2024 – providing more attractive entry points for illiquid commercial property. We see more value in offshore markets, where commercial property fell faster and deeper and where lower interest rates in 2024 provide a better relative value proposition.

Overall we have a Neutral stance towards property and cannot see that changing through 2024.

Alternative Assets

We see these asset classes as crucial to both portfolio returns and risk management.

We are however very concerned with the proliferation of offerings in both Diversified Credit and Private Equity around the theme of “Democratisation of Private Assets”, which we think is a ridiculous term.

The disparity in quality concerns us, along with the fact that fund managers are creating so called “liquidity” in what are fundamentally illiquid asset classes.

Knowing what you invest in, having full transparency around this and being rewarded for the risk you are being exposed to is crucial.

We do however believe that opportunities will present themselves in Property, Diversified Credit and Private Equity.

Many investments we hold in Alternative Assets are in harvest stage and we do believe 2024 vintages will prove to be vintages that over time will provide superior returns.

Infrastructure has delivered superior returns in 2023 and whilst we remain positive, we have tempered expectations during reviews as to what to expect in 2024.

Whilst we have attempted to maximise Alternative Asset strategies in client portfolios since 2018, liquidity must be considered as it is an issue for some of these strategies. That said, providing a weighting that is suitably conservative and in line with a client’s risk profile, we continue to be of the view that they will provide attractive returns with reduced volatility and low correlation to traditional markets.

What concerns us about the democratisation of private assets and the attempt to bring liquidity into an illiquid asset class is the similarities this has to fifteen years ago.

As markets entered the Global Financial Crisis back then, portfolios were overweight hedge funds, which were designed in theory to reduce volatility and enhance returns in periods of instability.

Wealth managers are now falling in love with another trend, being private assets. We repeat our long-held view that these assets have reduced volatility and enhanced returns, but it is important that allocations to this asset class are correctly weighted and that there is full transparency of the underlying exposures and accurate  knowledge of the risks.

Just as hedge funds proved to be illiquid, detrimental to portfolios and capital destroying 15 years ago, it will be interesting to see if the lower quality private assets provide similar issues in the next few years and how these assets are negotiated.

Finally

2024 will be dominated by elections not only in the US and UK but also in India, Indonesia, Mexico, Pakistan, Russia, South Africa and Taiwan. Therefore, four of the five most populous nations in the world will hold elections in 2024. These countries account for greater than 50 per cent of global GDP (Gross Domestic Product).

Few elections in history have had a significant impact on the global economy’s general performance, but elections can impact domestic performance and lead to short term volatility.

Whilst the long-term economic influence of elections is overstated, the US and Taiwan elections are particularly significant, the former due to the candidates likely to be endorsed and their differing stance towards reform, monetary policy and geopolitics, the latter due to the candidates’ differing approaches to China and the US.

In late 2023 we attended several conferences in Australia, and we could not get over the collective negativity of those present. We do not share this negativity.

As the full effect of higher interest rates comes through, core inflation, economic growth and corporate earnings will slow, but as we have said throughout this document, markets always look ahead.

We see an opportunity to further add to risk-based assets in 2024 and we do believe equity markets will rally, as the reality of interest rates having peaked will improve sentiment, but we also see Australian equities lagging with the headwinds that they will encounter relative to those offshore.

As wealth managers we always concentrate on fundamentals, but investing also requires optimism.

We must be careful to ensure our views do not become biased or anchored to the most recent market environments. Volatility is the lifeblood of markets and successful investors never forget that managing this volatility is a critical component of investment strategy.

We wish you and your families all the best in the New Year, and we look forward to a successful 2024.