Monthly Market Commentary - December 2023

November saw a remarkable turnaround in US stocks as investors increased their bets that the Federal Reserve was through with interest rate increases and that cuts would arrive as early as spring next year (after favourable inflation prints). This is clearly a big deal for risk sentiment, though we remain uneasy that the slowdown in the US economy (which can now be seen not only in areas like bankruptcies and credit card delinquencies but also in areas of the labour market) will mean cuts might not coincide with further market gains. As we have written before, the US labour market has confounded expectations, but it is possible to discern subtle cracks – temporary workers are finding the going tougher, overtime hours are down and more people are working second jobs.

For now, though, the market is in celebratory mood after the dreadful October for stocks and the hope is that this will continue into the traditional ‘Santa Rallyʼ period. Mega cap technology companies have been the main driver of returns this year but there has also been surprising strength from consumer discretionary and services companies. After the massive outperformance of the rest of the market by the ‘Magnificent 7ʼ stocks, it is hoped more breadth will be seen in the market next year but apart from some signs of this in November, this does not look like becoming well established yet. Weakness in small cap stocks has been notable this year (true, they are often weak in the year before the Presidential election), and this continues to reflect concerns about the underlying economy and their greater exposure to higher rates.

New Year in New York City sees the ‘dropping of the ballʼ in Times Square. With a possible recession, fractious US election and strained public finances, investors had better not drop the ball themselves in 2024.

For us, the story is largely unchanged. There are pockets of value in the US market we choose to play via thematic investments and we do have our eyes on opportunities eclipsed by the larger names. Still though, the US market remains expensive on a host of metrics and a rotation into other markets by global investors is not the impossibility that some make it out to be. And is the mighty US equity market really immune to a potentially chaotic Presidential election in 2024 at a time of stressed public finances? We think not.

We retain our discipline and investment outlook, and continue to treat the US market with scepticism.

We have long feared that the European economy would struggle under the effects of higher rates and falling money supply, and this has transpired. The extent of the weakness in the German economy has probably surprised many but other countries such as Spain have found themselves as beneficiaries of the post-Covid-19 tourism spend. The EUʼs Next Generation recovery package has been an important aid to many, and not all countries have been as adversely affected by the higher energy prices earlier this year and last. Indeed, dispersion within the EUʼs economic sentiment index is running at elevated levels. There are also significant differences within sectors that are sending conflicting messages to investors. Certain areas within industrials do not look especially cheap but then you look at chemicals, which appear to be fully pricing in a recession.

Of course, the degree of sensitivity to higher rates varies across countries and sectors but it is the case that European companies as a group are more exposed than their US counterparts. Exposure to floating rates is several times greater in Europe than in the US and at a time when investors are hunting around for the least vulnerable, it is unsurprising this has made the region a laggard. On the positive side, there is the prospect  of  interest rate cuts here, as elsewhere, with some of the recent member state inflation data being better than expected. Indeed, if the region has more to benefit from a loosening of conditions, investors may yet switch out of the US to some degree, which will clearly help European equities after a tough run. Earnings growth has been reasonable on a relative basis, but multiples have been pressured and an improvement here would also bring some relief.

Though not celebrated anymore (?) Saturnalia was the ancient Roman festival honouring Saturn and was held on 17 December (under the Julian calendar). It was a time when normal rules were inverted, with gambling permitted, masters waiting upon slaves etc. They even went in for gift-giving, often exchanging wax figurines and pottery, the Nintendo Switch being unavailable. 

Europe is another area where acumen is extremely important. We have both risk-on and more cautious, income- oriented options available with which to play the European story.

November was a positive month for global equities; however, China was once again the standout region for the wrong reasons. As measured by their respective investment association (IA) sector averages, which include the impact of active management, the average IA Global fund was up 5.32% over the month.

The average fund in the IA China/Greater China sector was down -2.32%.

Asiaʼs largest economy remains the biggest disappointment of the year with the anticipated Covid-19 reopening momentum failing to gain traction. Notably, concerns around the Chinese property sector and the debts of major developers have depressed investor sentiment. The most notable of these is Evergrande Group, which has been fighting off liquidation for just over two years and has recently been given a reprice by a Hong Kong court, postponing a petition until January to restructure its debts. This case is of particular importance for an estimated 1.5 million buyers whose homes are yet to be finished, but more widely has weighed on investor confidence.

This new year will mean a little less to people in South Korea following new laws that took effect in June this year standardising  peopleʼs  ages  with  the international system. Rather than adding a year after every birthday, the traditional Korean system had people deemed to be one at birth with another year added every January 1. The change aims to end confusion around peopleʼs ages, especially around when they become eligible for pensions, and align citizens with the majority of the world. It must also have been nice to wake up two or three years younger, although it will have little impact on South Koreaʼs struggles with its ageing population. 

The best of our rest of world regions over November was the IA Latin America sector, which was up 8.72%. The region has benefited from its closeness to the US (as supply chains shorten) as well as stronger commodity prices. Performance has been so strong that it has also become the best performing region over one year, also beating the developed North America and European markets. This also reflects how volatile this region can be and looking at the twelve months to the end of October, it was the worst region, with the commodity- led sell off in November 2022 falling out of the time period. The region will also see Brazil join the OPEC+ body of oil producers next year.

We continue to see value in Japanese equities and hold these in most portfolios. We like Asiaʼs economic story but are wary of the risks to the downside. We do not hold direct Chinese equities due to political risk and we see India as relatively expensive, although do maintain selective exposure to the latter in our higher-risk portfolios, along with some Latin America exposure for investors who can manage with the volatility.

November was an extremely strong month for fixed income assets. Through October, we witnessed the major central banks all but confirm the rate hiking cycle was complete and, as November progressed, financial markets priced in both this peak and subsequent rate cuts with greater conviction than that seen during previous bouts of peak- rate euphoria.

Taking the widely followed Bloomberg Global Aggregate index as an effective representation of global fixed income, in US dollar terms* the index delivered over 5% in November. This is the highest monthly return since the depths of the global financial crisis in December 2008 when the US Federal Reserve cut rates by a full 1% to the zero bound and the index delivered over 6% (again, in USD terms).

It is possibly worth remembering US interest rates had been at 4.25% one year prior to that and at 5.25% in June 2006. Read into that what you will for the future outlook on rates!

* We have quoted the return in US dollar terms here as it provides a much purer outcome, the GBP return, at +0.69%, is distorted by US dollar weakness versus sterling.

Where previously there was less certainty around 2024 rate cuts, financial markets are now considerably more optimistic. Markets have now priced in rates of circa 4% in the US and 4.5% in the UK by the end of next year (there still remains more belief in a continuation of falling US inflation than that of the UK). However, in both cases the timeline for the first cut still appears to be around six months away. Broadly, this suggests that after the first cuts do come, they are expected to be cut consistently from that point. That would seem likely and for all of the central bank hawkishness surrounding higher-for- longer interest rates, policymakers are likely to come under pressure to deliver significant cuts if underlying economic data displays signs of weakness.

As a result of this positive outlook for interest rates, bond yields fell significantly through November, delivering good capital returns as bond prices conversely rose. Taking the ten-year US Treasury bond, the yield fell from 4.9% at the beginning of the month to 4.3% at the end – this comes after the yield breached the 5% mark during October for the first time since the global financial crisis. Similarly, the ten-year UK gilt yield fell from 4.5% to just under 4.2%. Overall, yields fell across the whole bond yield maturity curve, delivering impressive returns after what has been a rollercoaster 2023.

We also witnessed good returns from corporate bonds this month. The spread on corporate bonds,  which represents the excess premium a corporate issuer must provide above a similar government bond, moved notably lower this month. Taking the highest quality investment grade issuance, spreads on US dollar bonds moved lower by 0.2%, to a premium of 1.1%. Even greater was the spread move on poorer quality high- yield (junk bond) issuance, spreads here ended  0.6% lower at 3.8%. A spread premium of 3.8% suggests markets are increasingly optimistic the US economy will swerve a recession – we would typically expect to see spreads higher, providing extra compensation for an increased risk of issuer default, when there is concern surrounding the strength of the global economy. As some guide, spreads on the US high-yield market have averaged 4.4% over the past ten-years, with a peak of 10.9% during the pandemic.

Summing up what we are seeing, and following comments we have made over the past few months, it is clear that fixed income looks poised to deliver good returns to holders in 2024. Peak interest rate policy looks more convincing, inflationary dynamics (mostly) appear supportive and rate hikes to date are starting to have the impact we would expect on economic conditions. Investors are being well compensated, in yield terms, for holding bonds, with positive real yields (the nominal yield minus the rate of inflation) becoming more prevalent. In income terms, you are being paid to wait and when rate cuts do come, further capital return (from lower yields) seems likely.

Our fixed income allocations currently comprise healthy exposures to a mix of high-quality US Treasury bonds, where we are actively managing interesting rate sensitivity, investment grade (the strongest) corporate bond issuers and, to take advantage of attractive real yields, exposure to emerging market debt. We added notably to fixed income through 2023 as central banks moved closer to peak rates and the apparent value in the asset class became more likely to be realised.

We note the recent sell-off in the oil market, despite the ongoing conflict in the Middle East, the price of a barrel of Brent crude oil fell to $80. This was in part thanks to an increase in US supply as well as OPEC+ membersʼ failure to adhere to production quotas.

While the recent OPEC+ meeting promised further output cuts, a lack of clarity pointed to friction within the group. OPEC+ members have agreed to make additional voluntary cuts to oil production in 2024 in an increasingly fraught attempt to bolster the price, but the absence of a concluding press conference and final communications provided a slightly confusing set of numbers that left traders puzzling over the exact deal. The alliance announced roughly 900,000 barrels a day of additional oil output cuts from January, but crucially these curbs are largely voluntary, and Angola has already rejected them. The size of cuts will be announced by individual members in due course rather than the OPEC+ secretariat as normal. This news fed into growing market anxiety that strains are emerging in the OPEC+ coalition.

The 1980s brought with them many changes but for the oil market, it was especially memorable, perhaps not for the right reasons. During the 1979-1980 period, crude oil prices were rapidly increasing, reaching a peak in April 1980 at over $35/bbl. Naturally, oil production increased and oil producing countries found themselves fighting for market share leading to what is widely known as, ‘the 1980s oil glutʼ.

Saudi Arabia has a powerful incentive to keep prices elevated as the country needs an oil price of closer to $100 a barrel to fund the ambitious economic reform programme of Crown Prince Mohammed bin Salman. This agenda puts the country at odds with the United States as President Biden is focused on moderating fuel prices for American consumers with one eye on the 2024 Presidential election. Generally, these conflicts make balancing the market a difficult task and tend to result in additional price volatility from which investors in energy can often benefit.

We see geopolitics and tight markets pushing oil prices higher with temporary spikes until Q1 2024.

The MSCI Global Alternative Energy index has lost an eye-watering 38.15% over the year to end November, compared to the broad global equity index, MSCI ACWI, which has gained 10.79%. The funds we use within portfolios to access this theme have held up better, returning -7.27% and 1.24% but this is still disappointing for a theme that is said to benefit from long-term drivers of demand growth. Why is this theme not playing out and why would we maintain even a small position here?

Rising interest rates have weighed on the shares of clean energy utilities and other renewables-focused companies. In the latter case, market participants are concerned that the economics of renewables are less viable at a higher cost of capital. This assumption has created pessimism across the industry and contributed to flows moving away from the decarbonisation universe and towards other areas (typically US mega cap technology, which is now the consensus trade and veering dangerously close to bubble-territory).

The innovative nature of the industry is part of the problem here, as misconceptions still shroud the space, which has become something of a political battering ram.

The reality is, across the climate solutions universe, ‘cleanʼ technologies such as wind and solar power are still generally much cheaper than ‘dirtyʼ ones. UK electricity prices are currently trading at high levels due to elevated gas prices (as you may know, gas generation sets the marginal wholesale price). This is still significantly more expensive than the cost of building and running electricity from renewables in the UK.

In many countries, the new year is marked with a dazzling fireworks display. However, not everyone enjoys the bright colours and startlingly loud noises – in particular, our four- legged friends are often disrupted and frightened. For this reason, Whitelee Windfarm in Ayrshire, Scotland hosts a ‘Nae Fireworks Night’ for dogs, where you and your pet(s) can enjoy a peaceful walk around the farm that is isolated from most noise. Currently it is only offered on 5 November, but we are hopeful it will extend to New Year in the future and many other farms will follow suit!

The long-term fundamentals for the area remain intact and, despite some political noise, we continue to see funding and financing moving in the right direction, at higher levels than fossil fuel funding. There is still a massive funding gap if we aim to limit global warming to 1.5°C. Although utilities have been out of favour for the past few years as developed market central banks have raised interest rates aggressively, we anticipate a comeback from the sector when there is certainty that rates have peaked. Utilities have inbuilt mechanisms that allow these businesses to generate returns in a rising rate environment to offset higher financing costs, something market participants appear to have overlooked so far.

Pessimism around the space has created opportunities to acquire shares in companies that are contributing to decarbonisation cheaply. The markets that climate-solutions companies are selling into remain robust. For example, while electric vehicle (EV) demand in the US has been somewhat disappointing, it continues to accelerate in China (which is c.60% of the global EV market, vs. 15% in the US) and elsewhere. As for US politics, although there is a lot of heated rhetoric, it would be extremely challenging to get a wide scale roll back of the US Inflation Reduction Act (IRA), which we have written about previously, through Congress – not least because a lot of its benefits in terms of jobs and growth will occur in Republican states. The IRA is a game- changing piece of legislation, and we continue to see it supporting climate solutions sectors in the US. The headlines, however, could well be alarmist, which for seasoned stock pickers are exciting buying opportunities.

The allocation to this theme within core portfolios is small and is balanced with exposure to traditional forms of energy.