Macroeconomic backdrop

The US Federal Reserve (Fed) left interest rates unchanged at
5.25-5.5% at its mid December meeting and Fed chair Jerome Powell surprised markets by stating that it is unlikely that rates will rise further. The European Central Bank (ECB) also left rates unchanged, while forecasting that their inflation target will be reached in 2025. In the US, both headline and core inflation are heading steadily lower, while the Chinese economy slipped back into deflation. US labour market data for November came in slightly firmer than forecast, lowering the unemployment rate to 3.7%. Attention turned to possible election risks for next year, not least in the US, with Super Tuesday looming.

Market update

Financial markets maintained their buoyant mood. Global equities rallied hard after the Fed chair’s comments, following strong November returns of 9.2% for the MSCI World Index. The US 10 year Treasury bond produced its best monthly return since the Global Financial Crisis in November, before yields fell below 4%, as prices rose, on expectations of early interest rate cuts. The dollar index declined further from November’s highs. The price of oil slipped to a six month low, on demand fears, while gold touched further record highs.

Our view

Markets are currently enjoying a strong finish to 2023, as a combination of improving data and less hawkish commentary from central banks provide support for a broad-based rally. While valuations are less compelling as a result of recent moves, we expect this enthusiasm to continue into year end. With few key data points and market events between now and January, it is hard to anticipate what might dampen investors’ spirits in the near term. 

In our view, the recent update from US Fed chair Jay Powell following the last FOMC meeting of 2023 should not be underestimated. The fact that the Fed has now formally confirmed that there will be no more rate hikes, along with an average forecast of three rate cuts for 2024, is a milestone event in the context of the interest rate environment of the last two years. This pivot should help underpin continued confidence in markets in the immediate future. 

As such we maintain we our moderate overweight position in equities. However, we have shaved our overweight position in US equities slightly and upgraded European equities to neutral from a moderately underweight stance. While the European Central Bank (ECB) was not as dovish as the Fed in their latest update, here too we should expect interest rate cuts buoyed by improving inflation dynamics. In addition, as market drivers are likely to broaden out from large and profitable growth companies, European equity markets are well positioned to benefit from better performance in other segments of the market. We still favour US equities, however we do not expect material outperformance here, given improving prospects for Europe and a lower probability that the mega cap growth companies that dominate the US market will deliver a further phenomenal year of returns. 

Within fixed income, we maintain our lower exposure to emerging market debt (EMD) and high yield corporate bonds for portfolio construction purposes. While the recent rally in bonds has indeed been extraordinary, given the improving outlook for monetary policy and the positive sentiment pervading markets right now, it is hard to see bonds selling off dramatically in this environment.