News & Insight • Market Insights
03 January 2024 | William Buckhurst
2023 A Year in Review - Market Commentary
Economic forecasters have had another bad year of it.
There’s a scene in the film Groundhog Day which pertains. Phil Conners, the weather reporter speaks on camera: “You wanna forecast, Princess? I’ll give you a forecast. It’s gonna be cold. It’s gonna be dark. And it’s gonna last for the rest of your life.” Most economists employ an equally downbeat view of the future. Throughout most of 2022 and the start of this year, we were all told that a global recession was imminent. Yet here we are at the end of 2023 with US GDP growth running at around 2-3%, the unemployment rate low at 3.7% and a housing market that has been remarkably resilient in the face of higher interest rates. Stock markets have cheered in response – global equities, in sterling terms, finished the year up 17%.
The glass half-empty approach feels particularly applicable here in the UK where projections have been far too pessimistic. As with the US, the UK unemployment rate is low, hiring intentions remain elevated and wage growth remains strong and now in excess of the inflation rate. The draw-down of Covid savings, long underappreciated by the Bank of England, has acted to power consumer spending through the last year. Meanwhile, the average household is largely protected from higher interest rates thanks to the prevalence of fixed-rate mortgages, and indeed record outright home ownership. Rishi Sunak’s target of halving the rate of inflation by year-end has been more than met including, at 3.9%, a much lower figure than economists had expected. Despite some slight softening in the economic data towards the end of the year, and, once again, some gloomy predictions for next year, it is now clear that global economies – the UK included – have proven to be far more resilient than most had expected.
Nonetheless, financial markets spent much of the year being rocked back and forth by inflation and interest rate expectations. Markets hinged on the next monthly inflation report, searching for hints from central bankers that they were done with rate hikes. In the spring, the ugly demise of Silicon Valley Bank and the near collapse of Credit Suisse triggered premature hopes that rates had peaked and that central bankers would need to start cutting to prop up an ailing banking system. By late summer the market had turned and went all in on the notion that rates would be “higher for longer”, while angst over the US debt ceiling in the autumn sent bond yields up to 5%. But the year ended with a series of weaker inflation prints culminating in a US Personal Consumption Expenditure (PCE) number, the Federal Reserve’s preferred inflation measure, showing the six-month annualised rate at 1.9%, below their 2% target. It was a similar story in the UK and Europe as inflation rates eased and asset classes sensitive to lower rates rallied. Chairman of the Federal Reserve, Jay Powell, signed off on the party in mid-December as he signalled a surprise pivot towards a much more dovish tone, saying that the Fed would need to start cutting rates “way before” inflation returned to its 2% target and even that failing to do so could lead to an overshoot and slow activity too much. Only three months ago, 10 members of the of the Federal Open Market Committee (FOMC) thought that the fed funds rate would still be above 5% by the end of 2024, now only three think that. Both the Bank of England (BoE) and European Central Bank (ECB) have been notably less dovish. The BoE continue to tow the party line of "too early to speculate" on rate cuts, while the ECB followed suit saying, "we don't think that it's time to lower our guard". Regardless the market believes it will all come out in the wash by the end of 2024 with all banks cutting by a similar amount.
Markets should not rest on their laurels though. Inflation is not falling as fast as some hoped for and the core (so-called “sticky”) element, which excludes food and energy, is still hovering around 4%, twice the Federal Reserve’s target. There are concerns that we have been here before: during both the 1940’s and 1970’s, the rate of inflation slowed only to return with a vengeance. Yet markets have priced in an end to the inflation scare – the difference between the yield available on the long-dated UK index-linked gilt and the conventional (non-index-linked) gilt is currently around 2%, the so-called “break-even” rate. This suggests a very complacent view of where inflation will settle at over the longer-term. The market may well be right: some of the long-term disinflationary forces that characterised the last twenty years have not gone away – digitalisation and the potential for AI continues to result in higher efficiency and lower wage bargaining power of workers. But it is not an assumption that we want to overly rely on and so some inflation protection remains an important ingredient in our portfolios.
From a geopolitical perspective the year proved to be a rocky one but had little long-term effect on stock markets. Hamas’s surprise dawn assault on southern Israel and Israel’s ferocious response, a devastating earthquake in Turkey and Syria, and Ukraine’s floundering counteroffensive against Russia all did little to upset the pace of equities moving steadily higher.
But within that ascent it was another year of narrow leadership as equity market returns were once again dominated by the largest companies in the index, although there were some tentative signs of this balancing out as the mega-cap (predominately US technology) companies underperformed a strong cyclical rally over the final two months of the year. Nonetheless, Apple became the first $3trillion company commanding a market capitalisation in excess of the combined value of the UK’s 100 leading shares. The popularly named Magnificent Seven (Apple, Microsoft, Alphabet, Amazon, Tesla, Meta and the new kid on the block Nvidia) accounted for around two-thirds of the S&P 500 Index’s 25% return over the year. Put differently, there has seldom or never been less reward for taking the risk of investing in stocks outside the biggest mega-caps and many active managers underperformed global equity indices during the year. Although we greatly admire many of these businesses, and own some of them in our portfolios, we (only half-jokingly) observe that in the original 1960’s film only three of the Magnificent Seven survived.
Outside of the US, Japan continues to appear to be in a sweet spot having decisively left the deflationary environment behind but not facing runaway inflation. Japanese stock markets rose sharply this year to touch 30-year highs (although the weakness in the Yen dampened returns for UK investors). The average company in Japan is high-quality and awash with cash and, as corporate governance standards continue to improve, will return more in dividends as well as excess capital through buybacks. Much-needed corporate reforms culminated in a decision by the Tokyo Stock Exchange (TSE) to create the new JPM Prime 150 Index highlighting companies that look to improve their capital efficiency and effectively naming and shaming those that do not improve shareholder value. It is no coincidence that Warren Buffett made a rare visit to Japan in April (he famously swore off Japan after a disastrous sushi dinner in 1989 which didn’t sit well with someone whose diet does not venture much beyond his long-held portfolio companies Coca Cola and McDonalds). Further highlighting the attractive value to be had in Japan, one the funds we invest in gave a good anecdote about Hino, the lossmaking subsidiary of Toyota, which recently sold a parcel of land adjacent to its headquarters in Tokyo. The land was valued at ¥100m in its books but was sold for approximately ¥50bn, a 50,000% return on its carrying value!
India continues to be on a tear, and we feel should be well represented in portfolios via direct Indian funds and broader emerging market funds. The most recently published GDP numbers showed the economy grew 7.6% over the third quarter, following on from 7.8% in the previous quarter. Manufacturing powered ahead at 13.9% growth as did construction +13.3%. These numbers are remarkable and point to a significant upturn in growth post the Covid era. India recently overtook China to become the world’s most populous nation with 1.43bn people, representing an enormous pool of potential workers and consumers that companies — both in India and abroad — can tap into.
Yet China continues to struggle. For so long the powerhouse of global growth, China has suffered more than its fair share of problems over the last few years. Investors in Chinese stocks have been left feeling battered and bruised by a series of clumsy central government policies ranging from a crackdown on corruption, heavy handed attempts to clip the wings of the technology behemoths, and draconian zero-Covid policies. Meanwhile, China’s increased military presence in the South China Sea, technological advancements and ongoing trade tensions with the US have given rise to geopolitical tensions that have prompted many foreign investors to flee the region. Lingering in the background is the ticking time-bomb over an ageing population, high levels of debt (with very low levels of inflation, bordering on deflation), and high levels of youth unemployment (the slowing Chinese economy is now struggling to generate enough jobs that match the expectation of a new breed of graduates, whose parents would never have considered going to university).
So for a strategy that holds itself up to investing only in areas that enjoy a fair wind, why do we consider China at all? Perhaps the debt situation is not as bad as first feared. China is a creditor country, and its debts are overwhelmingly in its own currency. Potential bad debts are corporate, not household, and were made at the direction of the state, by state-controlled banks to state-owned enterprises (SOEs). This provides the Chinese authorities with the ability to manage the timing and pace of recognition of non-performing loans. The leverage of the privately owned companies that employ most of the workforce and account for most of the economic growth isn’t that high. Moreover, Chinese household savings rates are high: family bank balances have increased by around two thirds since Covid started and the net increase in household bank accounts sits at around $7trillion, which is greater than the GDP of Japan. Corporate lending rates are at all-time lows and mortgage rates are more than 100 basis points lower than a year ago.
Meanwhile, Chinese stocks have traded — quite rightly — at a discount to global peers for over a decade; but at a price to earnings ratio of around 11x have rarely been cheaper than they are now. It’s tempting to place China in the “too difficult” camp, and it does prompt us to keep overall exposure to China at modest levels, but having no exposure to the world’s second largest economy at a period where expectations are set very low could be foolhardy.
And so we end the year with the same question we posed at the beginning – will the global economy face a soft or hard landing? Arguably, this has been the most widely anticipated global recession ever that still (technically) has not actually happened. Germany did enter a technical recession (two consecutive quarters of negative economic growth) during the year while the UK looks to be just avoiding one, albeit actual economic growth has been almost non-existent. The ongoing strength of peoples’ wallets has much to do with it. In the UK, retail sales have been remarkably strong and consumer sentiment surveys remain positive. This doesn’t suggest that the UK economy will be dropping into recession at all imminently and employment data remains strong. Heading into 2024, and perhaps worryingly, the market’s perception of what the year has in store for us appears to be a “Goldilocks” one: a soft landing in the US, improving economic conditions in the UK and Europe, a continued moderation in the inflation rate resulting in a cut to interest rates and a soft US dollar. While we, as much anyone, hope that this proves to be the case, it may be overly optimistic to construct the whole portfolio around such a benign outcome.