Many expected 2023 to be a very challenging year for both the global economy and stock markets, due to the impact of higher interest rates. As a result, most market commentators and economists were pessimistic. This view, however, turned out to be wrong and 2023 delivered a better outcome than many anticipated. There are several reasons for this. Firstly, inflation has fallen dramatically and continues to trend lower. This has enabled central bankers to end their interest rate hiking programmes and signal that they do not need to further increase rates. Economic activity has been more resilient than anticipated and recessions have been avoided by major developed market economies. Finally, companies' earnings have also held up well. All of this combined to provide a solid foundation for a pick-up in both equity and bond markets in the final quarter.
As we begin 2024, we expect a similar level of caution from investors as that seen at the beginning of 2023. This is due to several factors. Firstly, 2024 is going to be one of the biggest years in history for elections, with 76 countries potentially going to the polls. This means nations with more than half the world's population, more than four billion people, will be holding elections. The resulting uncertainty has the potential to create short-term volatility. Of the elections with the most significant global market implications, the first was held on Saturday 13th January when Taiwan elected a new president, Lai Ching-te, of the Democratic Progressive Party (DPP). Of the three main parties, the DPP has the strongest stance against China, which claims sovereignty over Taiwan. Investors will be closely watching developments in the relationship between China and Taiwan. The US presidential election will take place in November and is likely to dominate the headlines and leave investors feeling on edge. Finally, we have the UK general election, which must be called by 17th December at the latest.
Another issue occupying investors' minds will be the expected slowing in economic growth. We can already see signs that higher interest rates are having an impact on consumer behaviour and spending on big-ticket items is declining. Additionally, household savings are falling and credit card balances are rising, which provides further evidence of the potential for a slowdown as we enter 2024. However, we do not anticipate a dramatic slowdown.
Our central case is that falling inflation will lead to interest rate cuts, and we will see a modest rather than dramatic slowdown in economic growth. This paves the way for government bonds to take the spotlight from cash as investors seek out attractive sources of income. In equities, we expect to see a more broad-based recovery, rather than the picture being dominated by a limited number of technology mega-caps. In this scenario, with bonds and equities performing positively, we would expect stronger returns from 60/40 portfolios.
The annual inflation rate in the UK slowed to 3.9% in November 2023, this was well below forecasts of 4.4% and the lowest inflation rate since September 2021. Lower transport costs were key to the downward move, along with reduced costs for recreation and culture, and moderating food inflation.
Despite this encouraging picture, the Bank of England (BoE) retained its hawkish stance, with three of the Monetary Policy Committee members still voting for a further rate increase at the December meeting. Much of their caution revolves around the potential stickiness of wage inflation. Interest rates therefore remained on hold at 5.25% for the third consecutive month and the BoE said monetary policy is 'likely to need to be restrictive for an extended period of time'. Markets, however, have been less cautious and have already moved to price in a number of rate cuts in 2024.
In December we may have seen the Federal Reserve signal a pivot, when its Chair, Jerome Powell, talked openly about the potential for cutting interest rates. Before this, ‘higher for longer' was the phase commonly used, with the argument being that the economy appeared stronger and the consumer more resilient, so there was no immediate need for interest rate cuts. Powell's comments were interpreted by investors as his strongest signal yet that interest rates would be cut in 2024, and this helped markets end 2023 on a high.
US technology giants led the way with strong returns in 2023. In our view, these companies are likely to continue to perform well in 2024, with the prospect of robust earnings once more. However, we believe the most attractive opportunities will come from other sectors, as a wider range of companies benefit from the improving interest rate outlook. In our view, large and mid- cap companies may outperform the tech mega-caps this year.
Inflation in the euro area started the year close to double digits but has gradually eased. This led to the European Central Bank (ECB) pausing interest rate rises in October after 10 consecutive increases. As we draw closer to the ECB's 2% inflation target, all eyes will be on whether price increases continue to slow.
GDP growth forecasts remain subdued for the region, given the drag of higher interest rates and geopolitical uncertainty. Higher borrowing costs continue to affect businesses, with both services and manufacturing Purchasing Managers Index (PMI) data remaining in contractionary territory. However, consumer confidence is now at its highest in five months and many households are still to unwind their pandemic savings. From a valuation perspective, Price-to-Earnings (P/E) multiples are also below their long-term average and look interesting.
The Bank of Japan's announcements on monetary policy have been slightly disappointing for investors, offering no alterations to forward guidance or signs of any potential changes in policy. The bank has the world's last negative interest rate, -0.1%.
Japanese stocks ended the year on a muted note with performance in December that, in yen terms, was slightly negative. However, over the year, Japanese equities produced one of their strongest calendar-year returns on record, with the TOPIX index up over 28%.
Two new initiatives are being launched in January. One is to name and shame companies that are not yet participating in changes brought in under corporate reforms. The other is to encourage retail investors in Japan to invest more in the domestic stock market by tripling contribution limits on savings products.
China continued to underperform the rest of Asia and other emerging markets in December, despite some signs that stimulus measures are beginning to support growth. Industrial profits were up 29.5% in November compared with the same month in 2022. Meanwhile, industrial earnings fell by 4.4% in the first 11 months of the year, an improvement on the 7.8% fall in the 10 months to October.
In Brazil, we saw another 50-basis point interest rate cut in December leaving the benchmark rate at 11.75%, and the central bank signalled more rates cuts of this size this year. Mexico held rates at 11.25%. Emerging market currencies performed well in December as investors anticipated rate cuts in the US in 2024.
Overall, in 2023 emerging markets and Asia lagged other markets, with the MSCI Emerging Markets index up 3.63% and MSCI Asia Pacific ex-Japan up 1.31%. This anaemic performance was largely due to China's drag on returns. Investors remain concerned about the Chinese economy, despite a brief rally in confidence at the start of the year when Beijing began to relax its zero-Covid policies. The government has introduced several stimulus measures to support the economy, but investors remain concerned about the property sector, deflation and lack of domestic demand. Only strong returns from other regions, such as Latin America, enabled emerging markets to edge into positive territory.
The sharp bond market rally in the final two months of 2023 left government bond yields largely unchanged on the year. Credit spreads also tightened to leave all-in yields on corporate bonds modestly lower on the year. Bond markets now represent broadly fair value given the likely path of a slowing global economy and the prospect of modest interest rate cuts later in 2024. The extended rally into year-end, driven largely by the more-dovish-than-expected comments from Fed Chair Jerome Powell, has, in our view, taken the US Treasury market into somewhat overvalued territory. We would expect a cautious start to the year for bond markets as new issuance is absorbed. Inflation in Europe has fallen faster than expected recently, but we still expect the European Central Bank to keep interest rates at current levels for the first few months of the year.
Source: Morningstar Direct
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