Macroeconomic backdrop

US inflation continued to ease, reinforcing investor sentiment that the Fed was finally transitioning to a more dovish stance. The central bank indicated that interest rates were unlikely to rise further, and markets are pricing in 75 basis points of cuts during 2024. In contrast, the European Central Bank remained hawkish on rates. This was in response to the high wage growth across the bloc, causing inflation to pick up in December after seven months of decline. The Bank of Japan remained the key outlier. It maintained its ultra-accommodative stance, despite coming under growing pressure to normalise monetary policy. In sharp contrast to other major markets, China experienced its second consecutive quarter of gross domestic product deflation. Moody’s downgraded the country’s A1 debt rating outlook to negative. 

Market update

Global equities closed the final quarter of 2023 sharply higher, spurred by hopes that interest rates would be cut in 2024, led by the Fed. The S&P 500 ended 2023 close to its all-time peak, with returns driven by tech companies focusing on artificial intelligence. While positive, Japanese equities lagged, on expectations a domestic rate rise would undo the benefits of a weak yen for exporters. Chinese stocks struggled. Bond markets in both the US and Europe rose on the belief US interest rates were unlikely to rise further. Spreads tightened in both US and European investment grade bond markets, while high yield bond markets were also lifted. The US dollar lost ground, on hopes of early interest rate cuts by the US Federal Reserve. The Japanese yen continued to rally against the US dollar, driven by expectations of narrowing interest rate differentials in 2024.

Our view

The strong finish to 2023 brought double digit gains for many equity markets and the largest monthly gains in US bonds in a long time. Better data and less hawkish commentary from central banks supported the rally, helped by investor enthusiasm and seasonal year end sentiment.

We are likely to take advantage of our recent positioning on equities to realise some profits. Markets have risen rapidly and so may be vulnerable if macro news flow does not support expectations for easing monetary policy and interest rate cuts. It is also difficult to identify the catalysts driving equities materially higher in the near-term; indeed, they may well be poised for a period of reflection and consolidation. With growing risks elsewhere - including increasing unrest in the Middle East with its potential to impact oil prices; continued woes in the Chinese property sector; and a slowdown in global economic growth as the effects of higher interest rates take hold, we view it prudent to reduce some risk across portfolios.

We have reverted to a neutral position on equities by reducing our overweight in the US, following its strong outperformance led by the ‘Magnificent 7’. In the near term, we do not envision material equity performance differentials between the main regions. While some issues in China are a cause for concern, given the steep valuation discount emerging markets are now trading at, we retain our neutral positioning here given the potential for this region to deliver an improving performance.

Across fixed income, while the recent rally in bond markets has been exceptional (and may have gone too far in the near-term), given the improving outlook for monetary policy and the potential for rate cuts in the coming quarters, it is hard to see bond markets selling off dramatically in this environment.

Having reduced risk within equities, we upgrade our exposure to high yield corporate bonds and emerging market debt to neutral once again, in order to balance the risk profiles across our portfolios.