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Investor Insight 130

Investor Insight, February 2024

Over the holiday period, we wrote in our Insight and in The Australian about our optimism towards investment markets in 2024, in particular Developed Markets equities and Emerging Markets equities.

We would like to explain this further, as many are understandably cautious given the economic uncertainty and also the geopolitical events in front of us, be they the wars in the Middle East and Ukraine, disruption in the Red Sea or the elections which will be taking place in many countries, including the US. The temptation is to sit in cash and “wait it out” but we disagree and in this Insight we will discuss in more detail why we believe offshore equity markets will provide solid returns in 2024.

Readers will be familiar with the “economic outlook” table below:

The debate continues to be between those expecting a hard landing (recession), a soft landing (growth slowing but no recession) and no landing (no slowdown, solid growth). This debate has been ongoing since interest rates started increasing in 2022, and we continue to support the soft landing outcome.

The “R” word, or recession, continues to be thrown around, but we do not see a credit crunch, we do not see a major energy crisis (yes, energy prices have risen sharply over the last two years, but this is not a crisis or crunch), and COVID is behind us, therefore economic expansion is the next stage of the cycle.

On the geopolitical front, the potential escalation of conflict in the Middle East and the threat of higher inflation through the disruption of shipping routes in the Red Sea are the dominant risks at the moment.

We appreciate that our view is not the consensus, and that the majority of market participants are more cautious, especially with respect to the timing and extent of interest rate cuts in the US. We believe rate cuts in the US will commence by early in the second quarter 2024.

Capital Economics believes that central banks are underestimating the extent to which inflation will fall. They point out that three month annualised inflation rates show that core inflation is already broadly in line with central banks’ targets (and less than 2% in the Eurozone) and that PCE inflation in the US, which the US Federal Reserve targets, was already at 2.2% in November.

We do still expect volatility though, as sentiment related to geo-political events fluctuates, and economic data releases will no doubt provide some surprises as the impact of the current high interest rates continues to flow through the economy.

After the strong rally in the last quarter of 2023, it would not surprise us to see markets consolidate during the first quarter of 2024, but we do not expect a reversal in direction.

Markets never travel in a straight line and the S&P500 in the US rose nine consecutive weeks and circa 15 per cent from its low point in October to the end of 2023, the longest streak since 1989.

We are at peak interest rates, yet, despite market strength at the end of last year, sentiment has not turned, and this will come as interest rates decrease.

We remain convinced that while there are short term risks, inflation is on the way down in major Developed Markets. Central banks will cut interest rates and bond yields will rally as a result.

Last year the talk was all about the strength of the “Magnificent Seven” large technology companies in the US, but there are another 493 companies in the S&P500. We expect the strength to extend to this broader market as it benefits from falling interest rates and earnings expanding.

Artificial Intelligence (“AI”) will drive significant productivity growth. We believe any boost to GDP from AI is some years away, but markets are forward looking. History tells us that when transformational technology takes hold (for example the introduction of rail and the internet), investors look to “bank” these benefits upfront. AI enthusiasm will continue in 2024, however the broader market will also rally.

We still expect Australia to lag the other Developed Markets. We simply have not tackled the macro issues. Inflation will be slower to fall here, and productivity gains are doubtful. The International Monetary Fund called for additional rate increases in Australia, as real interest rates are not high enough to tackle inflation properly. We don’t expect another interest rate increase, but we do believe rate cuts in Australia will be much later than in the US.

We expect rate cuts to commence in Australia late in the third quarter or early in the final quarter 2024, but we may only see one cut before year end as opposed to potentially four cuts by year end in the US. Yesterday’s CPI release in Australia was encouraging though, so it is possible that we see rate cuts here sooner than we currently expect.

We do see strong gains in offshore equity markets, and we will be moving to an overweight position in Developed Markets and Emerging Markets equities over the coming months. We don’t expect to see momentum accelerate, however, until the concerns over an economic downturn from higher rates pass, rate cuts in the US commence and markets look towards the next stage, being signs of a recovery.