7 February 2024
Abating inflation gives markets a breather
2023 ended far more optimistically than it began, with an ‘everything rally’ in equities, bonds and alternative asset classes, such as infrastructure. Commodities were an exception, nevertheless, continuing a dismal year.
The trigger for all of this has been inflation, with the UK Consumer Price Index (CPI) falling to 4.5% in October from 10.1% in January. That slowing seems set to continue in the UK, while price pressures will be contained in other major regions too.
While the fastest rate-hike cycle since the era of Fed Chairman Paul Volcker (1979 to 1987) seems to be over, it would be premature to price in rate cuts. The messaging from central banks is ‘higher for longer’, with an eye to core inflation that remains stubbornly high at over 5% in the UK. Conversely there is still a heightened risk of recession and, if this is the case, rates can fall dramatically even if inflation is still too high.
Added into the 2024 mix is geopolitics. With war in Ukraine and now Gaza, continued tensions between the US and China, and elections due for 40% of the world’s population, there is certainly scope for turbulence. Possibly the most contentious element is the prospect of another Trump presidency with an agenda of aggressive protectionism.
It is also an environment in which valuation matters; the sell-off seen in 2022, as discount rates rose, demonstrates the danger of overpaying. Overall, we would view current equity valuations as fair. The US market does trade on a premium but this is concentrated in a handful of very large names, the so-called “Magnificent Seven” tech stocks which have outperformed. The strength of these stocks reflects both a recovery from 2022’s de-rating as well as impressive relative earnings growth. However, as they now account for almost a third of the US index and collectively trade on a forward price-earnings ratio of 27 times (at end-November 2023), they may not be so dominant in 2024.
Stock picking through uncertainty
This chequered backdrop continues to favour a quality strategy, especially as cyclicals have largely priced in a soft landing. Companies with high returns on capital and robust profit margins are better placed to deal with slowing demand as well as lingering inflationary pressures. A properly capitalised balance sheet, avoiding excessive leverage, is also important as higher interest rates steadily feed through into corporate borrowing costs. Furthermore, a slower growth environment favours businesses that do not rely simply on the economic cycle to drive earnings, so businesses with a structural growth driver behind them should benefit.
For this reason, one of the sectors we favour is healthcare. An ageing population in the West and even China means greater demand for healthcare, while innovation in areas such as genetics, robotics and biotechnology is providing better treatment outcomes. However, alongside this is the need to provide better value for money as healthcare systems and governments plan for strong future demand. In the US, the managed care providers such as Humana and United Health have improved the efficiency of a fragmented healthcare system. They achieve this through their scale, but also by facilitating ‘value based care’ versus the traditional ‘fee for service’ model which tends to incentivise procedure volume yet prompt little interaction between providers.
2023 has been a tougher year for some life-science tools companies, where profits were hit by post-pandemic destocking and slower biotech spending. We would expect this to start to flatten out in 2024 and valuations are looking attractive.
The explosion of demand for data, the need to store it, analyse it and use it more effectively supports investments from cloud to AI companies. We would continue to favour providers of proprietary data, particularly companies like credit bureaus or rating agencies hit by higher interest rates and therefore lower credit demand. This should favour holdings such as Experian and S&P Global. Similarly in semi-conductors, while Nvidia has had an extraordinary year, other players have had more difficulty with slowing demand for PCs, phones and autos following the pandemic. As the cycle bottoms out, this should be supportive for companies like TSMC, Broadcom and NXP.
We would stay cautious on stocks that we see as low return, highly cyclical or facing structural headwinds. For instance, we have very little exposure to banks; rates have peaked, net interest margins are under pressure and credit conditions are tightening, indicating the possibility of higher provisioning requirements. Commodity sectors have had a difficult 2023 and with record oil supply from the US, a slowing Chinese economy and the long-term shift away from hydrocarbons this is an area we would continue to avoid.
We are also very selective in consumer stocks, with cost-of-living pressures still a real issue for lower income consumers and luxury and travel likely to slowdown after the pandemic-induced spending spree.