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Market Commentary - December 2023

Q4 2023 Market Update


It makes a pleasant change to be able to look back on a month during
which both bond and equity investors prospered. We will investigate
the reasons for that in a moment, but first it should be noted how
quickly the market’s mood changed. We have long counselled that
trying to time turning points in markets is almost impossible, and there
are plenty of studies illustrating how much of the compounding benefit
of investing can be lost by missing out on just a few of the more
positive days. It is one reason why we have recommended maintaining
only a marginally underweight position in equities even when there
seemed to be a dearth of good news. After two years of lacklustre
returns while markets readjusted to a higher interest rate environment
(which also required a lot of froth to be blown off the top of more
speculative valuations), we continue to believe that we are much
closer to the end of this cleansing process than to the beginning. It’s
time to look ahead, not back.

Market historians had a field day with the November data. Amongst some of the statistics
that we saw were the following: the S&P 500 index enjoyed its eighteenth best month
since 1950, which might not sound that impressive until you work out that there have been
886 months over that period, putting that gain at around the ninety-ninth percentile.
That sounds more impressive. For the record, the index gained 8.9%.
Bonds also had rip-roaring time. US Treasuries had their best month since May 1985,
whilst global bonds had not experienced a better month since 2008. The US 10-year yield
fell from 4.93%% to 4.32%. The UK 10-year Gilt also delivered a nice capital gain as the
yield fell from 4.51% to 4.17%.

Unsurprisingly, then, balanced portfolios also did well. Michael Hartnett, the Chief
Investment Strategist at Bank of America, pointed out that a US 60:40 portfolio (60%
equities; 40% bonds) gained 9.6%, the best month since December 1991, a month which saw
the collapse of the Soviet Union. While it might be tempting to see that event as the
primary catalyst for such a strong rally thirty-two years ago, we would point that the
month also featured two interest rate cuts delivered by the Federal Reserve, the first
being 0.25% at the beginning of the month and the second being a punchier 0.5% just five
days before Christmas. Such an aggressive move appears to have signalled that the
central bank was satisfied that it had tamed a nasty outbreak of inflation and was
willing to unleash animal spirits once more. For the record again, and to emphasise once
more the potential benefits of a patient long-term investment strategy, the S&P 500 Index
ended 1991 at 417 versus the current level of 4567. Indeed, with dividends reinvested,
the total return of the index over the period is a noteworthy 1,955% (or an annualised
return of 9.93%).

And what links the performance of December 1991 with November 2023 most strongly is
interest rates. In the former case it was actual cuts; in the present day it is more
about expectations of future cuts, the horizon for which shortened dramatically during
the month. It is not long since investors were worrying that interest rates had further
to rise, a view that was given credence by a hawkish tone from central banks. At
September’s meeting of the Federal Open Market Committee, for example, members indicated
in their quarterly Dot Plot that they had not yet finished tightening monetary policy,
with the message being reinforced during chairman Jerome Powell’s post-meeting press
conference. Andrew Bailey, Governor of the Bank of England, and Christine Lagarde,
President of the European Central Bank, adopted the same stance. The commitment to
fighting inflation was unanimous.

And what changed? We would observe two key factors. The first is that the central banks
started to soften their tone. At the last Fed meeting, Powell conceded that tighter
financial conditions (a function of rising bond yields, wider credit spreads, a stronger
dollar and weaker equity markets) had been doing some of the Fed’s work for it and that
it might be appropriate to pause at current interest rate levels and assess the economic
outcomes. Secondly, and perhaps even more importantly, inflation levels continue to
subside, and somewhat faster than expected. The last data we have is for October, and
this showed the US headline Consumer Price Index (CPI) to be +3.2% over a year, the
lowest reading since March 2021 and well down from the June 2022 peak of 9.1%. Eurozone
inflation similarly fell below expectations to 2.4%. Even the UK, a country that tends
to have a more stubborn inflation problem than many, reported a fall from 6.7% to 4.6%.
And while none of these figures are yet close enough to the central banks’ 2% target,
all of them are trending down in an encouraging fashion.
There has also been an unforeseen helping hand from energy prices. Despite concerns that
hostilities in the Middle East could escalate to bring Iran into the fray, thus
threatening both oil production and vital crude oil shipping lanes. The oil price is
lower not only than it was before Hamas’s attacks on Israel, but also than it was before
Russia invaded Ukraine in February 2022. Analysts seem to be struggling to pin down a
single reason for the weakness. Indeed, there are several candidates, some cyclical,
some more structural: a weak global economy is not good for demand; the OPEC+ cartel is
struggling to find unity on production policy; oil continues to be exported from
sanctioned countries; and the transition away from fossil fuels is curtailing demand at
least to some degree. Even so, while welcoming the effects, we would not be complacent
on this front. Experience shows that it can take only a small shift in the balance
between supply and demand to have a big influence on the oil price.
The speed of market moves was exaggerated by a big swing in sentiment and positioning. At
the end of October, there seemed to be maximum pessimism, especially in bond markets.
Fear of burgeoning supply was rife, especially in the US as the government’s large fiscal
deficit needed to be financed. But there seems to be a price for everything, and buyers
were finally enticed by 10-year and 30-year yields rising above 5%, a level that we
believe offers decent long-term value. Matters were further improved when the quarterly
US Treasury auctions concentrated supply in short-dated Treasury Bills, thus taking
pressure off longer-dated issues. Meanwhile in equity markets, bearish sentiment,
indicated by the AAII Bull/Bear balance falling to a low -51, swung back up to -2.5 (it
rarely strays into positive territory and never stays there for long). Not only were
long positions added to, but short positions were aggressively squeezed.
Momentum-following hedge funds were net buyers of $225bn of shares during the month, the
fastest ever such accumulation according to traders at Goldman Sachs. They have now
largely spent their ammunition.

And so can this rally be extended? Maybe. Seasonal factors remain supportive, but there
is some concern that interest rate expectations have become overoptimistic. In the US,
the futures market is suggesting as many as five cuts of 0.25% during 2024, with the
first one being in May. In Europe the corresponding number and month are five and March.
In the UK they are three and June. We have been here before: as many as seven times
during the current rate increase cycle, according to Deutsche Bank, with hopes dashed on
every occasion. The cuts will probably only be made as expected in two central
circumstances. The first and best would be the scenario that saw inflation fall to
around 2% and remain there without the effects of past interest rate increases having too
detrimental an effect on the economy – the so called “immaculate disinflation”. We still
deem this to be a low probability outcome, almost in the realm of wishful thinking. The
second would be a much weaker economy, possibly falling into recession in the key
regions of the US, Europe and the UK, which would undermine corporate earnings. This
remains our most probable scenario and informs our tilt towards more defensive companies
and our overweight position in fixed income.

In a nutshell, the big question is this: will central banks cut interest rates because
they can or because they must? The first reason would certainly be preferred by all,
while the second offers a bumpier ride. However, we would emphasise that we are still
discussing potential interest rate cuts in both scenarios, and they usually end up
providing the fuel for better investment outcomes.

Markets – US

We spotted an intriguing article in a recent edition of the Financial Times. The FT
commissioned its own survey of more than 2,000 adults in the US to see how greatly their
opinions of various economic indicators differed from the facts. The results were
eye-opening. For example, 90% of people thought that prices had risen faster than wages
over the last year, when the opposite is true. 73% thought that the rate of inflation was
above where it was a year ago, when it is, in fact, a lot lower – 3.2% vs 7.7% to be
precise. Only 13% thought that the median American household was wealthier than before
the pandemic, which turns out to be the case. Maybe they would rather see Bill Clinton
back in the White House. On a similar range of questions comparing the present to thirty
years ago, there was the same level of faulty perception. For example, just over half of
the respondents reckoned that unemployment was higher today than in 1993. The
unemployment print for December 1993 was 6.6% vs 3.7% today, and the rate was never
below 4% during the whole decade – indeed it was above 5% more most of it. Given that the
Federal Reserve will be looking at such anomalies, it makes for an interesting job in
terms of managing monetary policy. It also highlights the difficult task that Joe Biden
has in convincing the US electorate that he is the right man to occupy the White House
for another four years. It could also help to explain why US consumers continue to spend
so much despite appearing to be so miserable, at least in terms of consumer confidence
surveys. Let’s just say this is the most challenging economic cycle that most of us have
ever experienced given the lingering effects of Covid and the massive fiscal and
monetary response, not to mention geopolitical issues ranging from trade wars to ground


Chancellor Jeremy Hunt presented his Autumn Statement to Parliament in November under
much more calm circumstances than a year earlier when his debut in the role came in the
aftermath of the disastrous Truss/Kwarteng “mini” budget. Even so, he had limited room
for manoeuvre. October’s fiscal deficit came in a little higher than expected owing to
the increasing cost of servicing the country’s debts, but that damage was limited by
higher-than-forecast tax revenues. One positive fiscal side-effect of higher inflation
is that nominal profits and wages tend to rise too, leading to higher nominal tax
payments. The benefit to the government has been amplified by last year’s decision to
freeze income tax bands, meaning that more people have been dragged into a higher tax
bracket, so called “fiscal drag”. We would observe that the key initiatives fell into
two categories: what’s good for the long-term health of the economy; and what grabs
votes. In the first bucket came a commitment to extend and make permanent the
£9bn-a-year tax break for business. It is directed at spending on IT equipment, plant and
machinery and allows for immediate deductibility against taxable profits. We applaud
such a pledge. One of the greatest weaknesses of the UK economy in recent years has been
the lack of productivity growth. That has been blamed variously on the extended fallout
from the financial crisis to the effects of Brexit and the chaos within government, all
of which, no doubt, have contributed. This tax break is intended to kick start the
much-needed investment in the country’s technology capital stock. Crucially, if it is, as
currently intended, a permanent feature of the fiscal landscape, it will encourage
companies to take a longer-term view of their investments in this key sector. On the more
voter-friendly personal taxation front, the Chancellor opted for a reduction of 2% in
the rate of National Insurance paid by employees which used up pretty much all his
existing fiscal headroom. Nevertheless, it is already being suggested that an income tax
reduction will be announced during the March Budget. Market reaction was limited. This is
probably a good thing, as markets have tended to react negatively in recent times to
fiscal developments.


The day after a former MP delivered a speech to an assembly of investors declaring that
populist politics was in retreat in Europe, Geert Wilders’ Party for Freedom gained the
highest number of seats in Dutch Parliamentary elections, although far from a majority.
We await the outcome of what could be protracted negotiations over a coalition
government – it took 208 days in 2017. Recent regional gains for the right-wing AfD party
in Germany are another sign of rising discontent (again) on the Continent. Even so, and
much against the expectations of many, Giorgia Meloni’s far-right (in the eyes of some
observers) regime in Italy has so far governed with a reasonable degree of
responsibility, a fact that has been recognised in the shrinking interest rate premium of
Italian bonds over German Bunds. And yet we also recognise that voting for change can
deliver unexpected and disruptive consequences. For now, the electoral calendar in Europe
threatens limited risks to investors, but it is as well to monitor popular sentiment and
how it will respond to management of the economy.

Emerging Markets

China remains firmly in the doghouse from an investment perspective. Much of the pain
stems from the ongoing unwinding of years of excess in the property sector. The
developers are encumbered with liabilities greater than their assets; individual
homeowners, many of whom are reliant upon house price appreciation for their investment
returns, are faced with stagnant prices at best. Financials and Real Estate account for
70% of the market capitalisation of the Hong Kong stock market, which is the home of
many Chinese companies via their H-share listings. As one might imagine, it is struggling
this year, having fallen 14%. The Real Estate sector is -33%. It is hard to see a
durable recovery without the real estate sector’s mess being cleaned up, despite the fact
that shares in the region are ostensibly cheap.

Fixed Income

The Bloomberg Global Aggregate Dollar Index of investment grade bonds has finally broken
into positive return territory for the year, increasing the prospect of avoiding a third
year of negative total returns (unprecedented since its inception in 1990). We continue
to emphasise the fact that selected short-dated Gilts offer risk-free yields of close to
5% with tax benefits even when not held within tax-exempt wrappers such as SIPPs or ISAs.
Low coupons mean that the taxable income is negligible. But the “pull to par” on
maturity delivers a tax-free capital gain. They remain an attractive home for surplus
cash savings, especially for higher rate taxpayers.
UK Gilts have delivered a total return of +1.6% over the last three months and -5.7% over
the last year. Index-Linked Gilts returned -1.25% and -10.6% over the same respective
periods. Emerging Market sovereign bonds produced a total return of +1.44% in sterling
over the three months to end October (+4.07% over 12m). Global High Yield bonds
delivered +2.4% (+8.4% over 12m) in sterling.

Conclusion and Outlook

Patience finally paid off in November, although investors might yet need more of it to
see them through the final stages of the current economic and interest rate cycles. In
homage to the recently departed Charlie Munger, the long-time associate of legendary
investor Warren Buffett, it seems a fitting time to include one of the many
investment-focused aphorisms attributed to him. And while our periods of waiting for
better opportunities do not extend to the lengths that he was able to tolerate while
running a business, the mindset is a useful one to have during periods when markets are
uncertain and volatile: “You have to be very patient, you have to wait until something
comes along, which, at the price you’re paying, is easy. That’s contrary to human nature,
just to sit there all day long doing nothing, waiting. It's easy for us, we have lots of
other things to do. But for an ordinary person, can you imagine just sitting for five
years doing nothing? You don’t feel active, you don’t feel useful, so you do something

*Article created in conjunction with Investec and Rathbones

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