Reflections of the CIO… February 2024

The second month of 2024 was another positive one overall, with strong returns in equities overpowering the impact of falls in bond markets. As in January, the overall positive tone was encouraged by the absence of meaningfully bad news and the delivery of some positive surprises. The main source of these were in the earnings reports of companies, particularly in the US, where the leading technology sector again delivered on high expectations, helping to spark a wider rally across the broader US stock market.

The latest economic data, particularly on inflation, was more mixed. On an annual basis the big picture remains positive with sharp year on year declines in headline readings. However, the three- and six-month trends are now pointing upwards in the key US market, implying that the easy part of inflation killing has now passed and a harder period lies ahead. It wouldn’t be surprising for this data to enter a sticky patch for the next few months, feeding uncertainty about the future path of interest rates. This potential uncertainty was felt in bond markets during February, which overall produced negative returns, as investors pared back their original, over optimistic estimates on the scale of interest rate cuts for the year as a whole. Current expectations have now swung back much more in line with the Federal Reserve’s guidance, which we would take as a net positive, because the losses from these moves were offset by gains in riskier assets elsewhere.

Whilst overall equity markets have been strong year to date, there do remain significant differences in regional performance, which were again evident in February. Japan remains a particularly strong region at the moment, with equity markets regaining multi-decade highs, powered by increasing evidence that Japan may finally be exiting a long period of deflation. Consumer confidence, wages and corporate earnings all have significant momentum and the region is gaining steadily in investor inflows. We have been well exposed to Japan for several years now and that is likely to remain the case, as strengthening fundamental trends provide strong justification for ongoing upside.

Closer to home, UK equities remain notably weak when compared internationally, with a long list of macro top down factors and bottom up technical issues combining to drive consistent outflows. There aren’t many obvious near term catalysts to reverse this underperforming trend and UK equities remain a big consensus underweight for global managers. However, we do see pockets of significant value which we are happy to take an anti-consensus view on. This is mainly in specialist areas, such as investment trusts in the infrastructure and private equity arenas. The returns on offer are attractive for the risks, particularly if we are prepared to look beyond the current very near term time horizons of stock markets. Both these sectors have stepped up their efforts to demonstrate that they are materially underpriced. This is evidenced by M&A activity taking place at valuation levels far above where public markets are currently pricing assets. It is also evidenced by ongoing, material buyback activity. Both factors we feel will eventually have an effect in turning around share price performance and as these new, still relatively small positions build up, we will write in more detail on them in our forthcoming reports.

It is important to keep in mind time horizons when considering our asset allocation. Over the last few years, as central banks became more and more ‘data dependent’ in deciding their monetary policies, market time horizons have inevitably shrunk to align themselves with monthly economic data. This overwhelming focus has had the effect of putting many longer term risks out of sight and out of mind. For example, the impact of a US election is not yet really a feature in market movements, but it undoubtedly soon will be as we head into the summer months. Perhaps more importantly, the size of existing and prospective government spending deficits hasn’t really yet been a big feature in directing bond market performance, which is something of a puzzle to say the least. We suspect that, ultimately, since the long term is really only a series of successive short terms, that we will get to a point soon enough when this particular issue starts to impact prices and sentiment more directly.

For the moment, the year is off to a solid start and although we continue echo that positivity will be tested in months to come, we would expect to be buying into any weakness that presents. Ultimately, we think that the positive tailwind from the interest rate cycle turning down in the West will prove strong enough, in the end, to offset the multiple headwinds coming from other areas.