Markets in wait-and-see mode
The rally that drove global stocks and bonds higher at the end of 2023 has lost some momentum this year. However, markets are holding onto earlier gains as they continue to anticipate a “Goldilocks” scenario of falling inflation, reasonable growth and lower interest rates. Recent data has been broadly supportive of this narrative. The latest inflation readings from the US and UK were slightly higher than expected, but they continue to suggest that inflation is moving in the right direction. Meanwhile, the US economy is estimated to have expanded at an annualised pace of 3.3% in the last quarter of 2023, once again defying forecasts of a sharper slowdown. Activity data from the UK and Europe has also been encouraging. However, this economic strength means that central banks will be wary of cutting interest rates prematurely and risking another rise in inflation. Schroders’ economists now expect the first Fed rate cut in June.
Fed rate cuts have historically been good for US stocks and bonds
The US stock market suffered its steepest fall since September after Fed Chair Jerome Powell indicated that an interest rate cut in March was unlikely. Stocks have since rebounded, but the episode highlights the fact that the outlook for inflation and interest rates remains a key risk for markets this year. More reassuringly, historical data suggests that US stocks and bonds have tended to perform well once the Fed cuts rates. Schroders’ analysts have looked at 22 interest rate cutting cycles since 1928 and found that US stocks delivered an average return 11% ahead of inflation – and 9% ahead of cash – in the year after the first cut. Government bonds generated an average real return of 5%. You can read the research in more detail here.
Geopolitical risk continues to rise
The situation in the Middle East remains perilous and could escalate at any time. Like the previous crises of the 2020s, a broader conflict in the region could trigger supply chain disruption as well as significant energy shortages. Even if major conflict is avoided, continued tensions could lead to further rises in shipping costs and higher oil prices, jeopardising the progress that has been made in the battle against inflation. Investors are not currently pricing in a high probability of escalation, but we are mindful of the risks. In practical terms, this means understanding what different scenarios could mean for the economy and markets and how portfolios may need to be adjusted in response to developments.
Positioning
We increased our equity exposure in the second half of 2023 and now have a broadly neutral stance on the asset class. This reflects our view that the outlook for monetary policy is becoming more supportive for growth and corporate profits. However, buoyant market sentiment and relatively rich valuations keep us somewhat cautious. We remain overweight fixed income but have focused our exposure on shorter-duration bonds with less interest rate risk. We continue to see the appeal of alternatives, which can provide valuable diversification benefits, especially in light of rising geopolitical risks. However, we have been trimming our exposure to take advantage of more attractive opportunities in equities and fixed income. High levels of inflation in the UK have made meeting inflation-plus return targets more challenging in the near term. Despite this, we remain confident in the ability to meet inflation-plus targets over the longer term.
Key
🟢 Positive
⚪ Neutral
🔴 Negative
Outlook
| Economics | Global growth continues to be resilient, driven by consumer demand in developed markets. However, the full impact of rate increases to date have not been felt and risks remain.We continue to expect inflation to moderate, though it remains above central bank targets for now.Interest rates have likely peaked but hopes of imminent rate cuts may be premature. |
| Valuations | After rallying strongly towards the end of 2023, global shares look somewhat expensive compared to their long-term average.Government bonds also rallied late in 2023 and yields fell. However, bonds still offer relatively attractive levels of income and could help to protect portfolios if economic growth slows more meaningfully.Valuations of both equities and credit remain vulnerable to a meaningful deterioration in corporate earnings. |
| Sentiment | Investor sentiment improved significantly in the final months of 2023 and remains optimistic.Consumer confidence remains weak compared to history, though is showing signs of recovery in the US.With sentiment at bullish levels, markets are more vulnerable to a pullback. Higher bond yields, a pickup in inflation and geopolitical escalation could all stoke market fear in the near term. |
| Risks | Persistently elevated levels of inflation, which would warrant continued hawkish central bank policy.Escalation in geopolitical tension e.g. Middle East, Russia/Ukraine, US/China.Labour market weakness and falling consumer demand could challenge the developed market growth outlook.Potential spillover effect from slowing growth in China on the global economy. |
Asset Classes
| Asset classes | Current positioning | Current views |
| Equities | ⚪ | Falling inflation and a peak in interest rates have prompted us to add to equities. However, elevated valuations and buoyant market sentiment mean we have a neutral stance entering 2024. |
| Bonds | 🟢 | Overweight fixed income given more attractive valuations and defensive characteristics. |
| Alternatives | ⚪ | Higher interest rates require greater selectivity in alternatives. Commodities remain attractive as an inflation hedge, but we are neutral on alternatives overall. |
| Cash | 🔴 | Cash has a poor track record of preserving real wealth over the long term. However, available rates are higher than in the past and holding some cash allows us to take advantage of tactical opportunities quickly. |
Terms
Spread: the difference in yield between a non-government and government fixed income security.
Duration: approximate percentage change in the price of a bond for a 1% change in yield.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
