Stock Market & Economic Commentary - January 2024

“The man who reads nothing at all is better educated than the man who reads nothing but newspapers.” Thomas Jefferson 3^rd US President March 1801 to March 1809.

Economic Update

According to the most recent Deloitte business survey, the UK’s largest companies started 2024 in a surprisingly positive mood. The latest CFO survey, which was conducted in a two-week period to 12 December, shows sentiment among the chief financial officers of large UK firms rising for the second consecutive quarter to well above-average levels. CFOs’ risk appetite has risen to an 18-month high.

These findings may seem at odds with the sluggish pace of growth seen in 2023. Part of the explanation is that inflation and interest rates worries that have dominated CFO thinking have eased markedly. Inflation and interest rates have dropped down the CFOs’ list of worries and CFOs also expect wage and price pressures to continue to ease.

Nonetheless, CFOs continue to see near-term risks. Perceptions of external financial and economic uncertainty have risen and are running at above-average levels with geopolitics seen as the greatest external risk over the next 12 months. CFOs foresee growth ahead – but not imminently. Companies are focused on cutting costs and building up cash rather than capital spending or M&A.

Three long-term themes emerge from the survey.

First, CFOs expect labour costs to remain elevated, something that helps explain why CFOs also expect to see sustained business investment in new technology.

Second, CFOs expect interest rates to average 3% over the next five years, far higher than the average of 0.5% that prevailed between 2009 and 2022.

Third, CFOs believe that we are in an era of big government that will be associated with rising levels of regulation and taxation.

Overall CFOs start 2024 in a positive mood, but one tempered by high levels of uncertainty. Most economists expect UK GDP growth to pick up from around the middle of this year. CFOs see better times ahead, but based on their defensive balance sheet stance, not just yet.

A separate survey by Price Waterhouse Coopers (PwC) found that almost half of UK chief executives planned to increase their workforce by at least 5% this year. This compares to only 38% of US Companies who are planning to take on more staff.

Prospects for jobs are even worse in Germany with less than one third of companies thinking about increasing their workforce. The chairman of PwC suggested that economic forecasters such as the Bank of England are far too gloomy about the outlook for the UK.

Stock Markets

“If you are not a little confused about what’s going on, you don’t understand it”. Charlie Munger (I924-2023). American businessman, investor, philanthropist and vice chairman of Berkshire Hathaway.

After a sparkling rally in stock markets at the end of last year, investors started the new year in a more downbeat mood.

Last October markets were mired in pessimism as inflation remained stubbornly high and investors feared that central banks would keep interest rates higher for longer.

By December those same markets were gripped by euphoria, thanks to US Federal Reserve Chair Jay Powell pivoting the message on interest rates from “higher for longer” to “lower sooner”, projecting three rate cuts in 2024.

But then in the first weeks of the year pessimism returned and stock markets got off to a rocky start.

The key to understanding these extreme swings in sentiment is to be found in the mechanics of data dependent monetary policy. This causes investors to continually revise and re-revise their trading strategies based on intense parsing of central bank rhetoric and on expectations of how incoming data of variable quality will influence central bankers’ interest rate settings.

Within this backward-looking shaky policy framework, short termism is endemic, and the risk is that investors overlook long-term fundamentals. Investors are confident that interest rates will fall this year, but they become impatient and switch their focus to the pace rather than the path.

Why the turbulence?

A raft of economic, unemployment and inflation data didn’t quite meet investor expectations. This led to a rise in bond yields and prompted investors to reassess the scale and timing of interest rates cuts.

Looking at the change over the last few weeks, markets are now pricing US interest rates of around 4% in twelve months’ time, a rise of 25bps from the levels that prevailed in December. The picture is similar in the Euro area and the UK where rate cut expectations are now being pared back although still showing material reductions through the year.

However, in the later part of the month investor sentiment changed yet again. The trigger this time was the belief that central banks could contain prices without restricting economic growth and so the optimistic “soft landing” narrative became predominant.

Central banks are treading a difficult path. They need to kill the inflation bogeyman using the blunt weapon of interest rates but also need to maintain economic momentum. It is akin to navigating a narrow mountain path on a foggy day with a dangerous drop on either side. Investor sentiment sways from side to side in the stiff breeze.

So, what does all this mean in terms of economic and market outlook? More of the same: economic growth but a little on the sluggish side, some further disinflation and volatile markets as investors focus on the precise timing of interest rate cuts and the health of the economy.

Not quite a Goldilocks scenario but not a global recession either. Interest rates will come down, but not as fast as markets thought in December and inflation, although lower, will not return to the levels seen through most of this century.

And what could go wrong? For one, geo-politics are uncertain. The situation in the Middle East could deteriorate further, with implications for commodity prices and business confidence. The war in Ukraine may worsen or could see a resolution that is unfavourable – an outcome that could embolden China’s approach towards Taiwan.

With a pivotal US presidential election this year we could see more volatility in US policy – especially if Donald Trump is elected. And we may need to factor in an end to fourteen years of Conservative-led governments in the UK.

There will be more shocks this year. Inflation will fall but there will be bumps along the road to price stability, central bankers will be in no rush to lower interest rates having made the mistake of failing to recognise the inflation problem sooner and the geopolitical situation is fragile. In the words of a former heavyweight boxing champion, everyone has a plan till they get punched in the mouth, so investment strategies need to remain flexible enough to adapt to change.

Bonds or Equities.

After a painful rise in interest rates over the last 2 years, government and investment grade corporate bonds, and fixed term cash deposits, are now offering an alluring alternative to equities for many investors.

If Uncle Sam, and/or the UK Government, is willing to pay a risk-free income (and short dated bonds are as close to risk free as you can get) of close to 5%, why take the risk of investing in equities? The short answer is because equities provide a better return.

For the period 1928–2023 (the earliest for which reliable data is available), the annualised return on 10 Year US Treasury Bonds was 4.6% whereas the S&P 500 compounded at 9.8% with dividends reinvested. This includes the Great Depression and World War Two as well as other more recent and lesser incidents like the 1987 Crash, the Dotcom meltdown, the Great Financial Crisis of 2008–09 and the Covid pandemic.

This is unsurprising as equities benefit from a feature which no other asset class, including bonds, and especially cash, can provide. A portion of the profit or cash flow which belongs to the shareholders is reinvested each year by the company. This is the retained profit which is not paid out as dividends, and its investment is the source of compounding which underpins the returns of long-term investment.

Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it”. While some people question whether the quote was in fact from Einstein, the power of compound interest is unquestionable.

This is the least discussed and appreciated aspect of equity investment versus all other asset classes. So, if equities outperform bonds and cash why are investors so keen to hold them at the moment?

The answer of course is that whilst equities outperform bonds over long periods of time, there is no guarantee that equities will provide this superior return in any given period, and in fact they may lose value for some periods of time, as they did in 2022. Many investors do not have the appetite to invest in an asset whose price is set daily by a process which involves the periodic shenanigans of short-term trading strategies.

It requires not only a grasp of investment analysis but also an iron constitution to ignore the daily noise and volatility of the stock market and reap the rewards of long-term equity investment.

Outlook.

We are wary of making forecasts, conscious of a quote from the famed baseball player, Yogi Berra, “It is difficult to make predictions, especially about the future”.

However, as we look into 2024 it seems highly likely that interest rates will come down. How quickly rates decline will depend upon the level of inflation, the strength of the economy and central bank’s willingness to risk cutting rates. All things being equal, the expectation of declining interest rates will make mortgage and other loans more affordable and support a recovery in consumer spending. Lower interest rates will also support small to medium size business, the share prices of which have suffered over the past 18 months.

The main risk is a recession, with recent economic statistics suggesting that growth in the UK and the Euro area is already close to zero. A weaker economy and rising unemployment would impact demand in many industries, putting pressure on profitability. But after all the chatter about recessions and hard landings, investors have largely discounted a worst-case scenario and as uncertainty subsides investors, and consumers, will become more confident and markets should resume an upward trajectory.

Given the uncertainty, however, the Clarion portfolio funds continue to invest across a diversified portfolio of companies, spread between growth, defensive and cyclical industries, both domestic and international. The valuations of many medium and smaller sized businesses are very attractive, even after a decent bounce in recent months. Many companies in the portfolio funds trade on single digit price to earnings ratios, generate healthy cash flows and pay above average dividend yields.

Therefore, looking into 2024 and beyond, given the modest valuations and a gradually improving macro situation, we have grounds for optimism that the Clarion portfolios can continue to deliver steady overall returns.

As always, we thank you for your continued support and we look forward to updating you regularly throughout 2024. Please get in touch if you have any questions.

Keith W Thompson

Clarion Group Chairman

January 2024

Creating better lives now and in the future for our clients, their families and those who are important to them.

Risk Warnings

Any investment performance figures referred to relate to past performance which is not a reliable indicator of future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments, and the income arising from them, can go down as well as up and is not guaranteed, which means that you may not get back what you invested. Unless indicated otherwise, performance figures are stated in British Pounds. Where performance figures are stated in other currencies, changes in exchange rates may also cause an investment to fluctuate in value.

The content of this article does not constitute financial advice and you may wish to seek professional advice based on your individual circumstances before making any financial decisions.

Stock Market & Economic Commentary – January 2024