Interest rates look as though they are starting to level off, catalysing the emergence of a new investment environment with opportunities that have not existed for a long time. Diversifying portfolios remains essential as performance diverges between different companies, themes and asset classes. This week, Investment Analyst Nick Harrington considers what 2024 might hold for investors.
This has been the mantra of most investors since the end of 2022, the worst year for most fixed-income markets in a century. The result has been a decline of around 16% in the typical “60/40” portfolio of equities and bonds. With a yield of slightly less than 3.90% at the end of 2022, the US 10-year Treasury offered fixed-income investors a compelling chance to finally lock in some bond income.
Had yields decreased in 2023, there could have been additional capital return. But this did not happen: economies managed to withstand a rise in the cost of capital, and the US 10-year Treasury reached 5% at the end of October. The COVID stimulus packages have continued to support consumer spending in the US. Additionally, a significant percentage of the US population locked into 30-year mortgages in 2020 and 2021 at rates somewhat below 3%. As a result, GDP growth in the US has remained strong, leading to bond investors being punished and bond yields being driven up.
There are signs of economic weakness that strengthen the case for giving high-quality bonds more weight in a portfolio. After peaking at over 10% during the COVID stimulus in 2021, savings as a proportion of US GDP are currently negative. Mortgages currently account for 28% of the population’s expenditure, up from 15% in 2021. Corporate earnings from the most recent season suggest that demand across the S&P 500 will decline as 2024 approaches, so we believe that now is a good time to take advantage of the attractive yields on offer. Investors would receive a guaranteed income stream, but may also profit from price adjustments should economies experience disinflationary shocks in the upcoming year.
We therefore think that high-quality bonds should form a core component of portfolios in 2024. Investment-grade corporate bonds are particularly appealing at the moment because the credit quality is still excellent and the returns are even more alluring.
If we are more optimistic about the outlook for bonds in 2024, it is because central banks have hinted that they are nearing the end of their rate-hiking cycles. Also, even though the UK's cash rate of 5.25% is very appealing, we are aware that it won't last forever. At the end of a rate-hike cycle, bonds have always fared better than cash, so we think that holding high-quality bond funds as opposed to cash is wise.
Quality is a vague term that can be applied to almost any investment, but for our fund managers, it means businesses with outstanding balance sheets that have the right debt-to-equity ratio, healthy cash flows and robust assets. They tend to invest in distinctive, high-profile brands that have the ability to maintain their margins through pricing power during uncertain economic times. If the world’s economies do indeed contract in 2024, we want our managers to choose companies that can continue to grow in spite of these challenges. Given that many of the companies that make up the funds in our portfolios have a long history of thriving in a variety of market conditions, we can sleep easy: they have strong and stable earnings, growing return on capital employed, and strong free cash flow ratios.
Income is another theme that we think will be crucial for investors in the equities space going into 2024. In an unpredictable economic environment, high-quality income funds like Jupiter Asian Income, Evenlode Income, and Liontrust Global Dividend can act as a stabilising force in an investor's portfolio. All of these funds are in a strong position to keep generating increasing income streams, even if corporate earnings start to decline because of higher-for-longer interest rates. Companies have recently made efforts to reward shareholders by buying back shares or increasing their dividends, even if payout ratios are still low (many companies withdrew or postponed their dividend programmes due to uncertainty during the pandemic). This year, many businesses have chosen to reward shareholders in preference to taking on additional debt. This trend is likely to continue as businesses try to safeguard their margins and reduce their cost structures.
Even though “thematic investing” has drawn criticism in the last two years due to the overabundance of funds that were introduced in 2020 and 2021 during the COVID boom, we still think there are many opportunities that should be included in investors' portfolios, with artificial intelligence being the most significant.
AI now permeates pretty much every aspect of modern life. The markets have recognised this, as evidenced by the fact that the “Magnificent 7” stocks—many of which are the primary beneficiaries of such technological advancements—account for 82% of the MSCI Index's returns this year (as of mid-November). Such a disparity in returns demonstrates the degree to which these companies have been acknowledged as AI architects. What matters more to us as we head into 2024 is how willingly industries across the board adopt these innovations. In their Q1 earnings calls at the start of 2023, 110 S&P 500 company CEOs made some mention of AI; this number will continue to increase significantly in 2024.
At Investment Quorum we certainly do not view AI as a fad. It has featured in our portfolios for some time now, both during years of high market success and in years of poorer performance. Our personal and professional lives are dominated by algorithms – for making purchases online, for streaming films and music and for planning a traffic-free route when we are driving through town. Here at IQ, we use it to complement our research skills for investment analysis. While there are undoubtedly continuing opportunities in the infrastructure and design of these technologies, we are also interested in the businesses that can most effectively use these changes to improve their offerings in order to grow their own clientele and sources of income. Numerous funds that we own – including Lindsell Train UK Equity, Artemis UK Select and Liontrust Global Innovation – are invested in such companies – companies that are less commonly associated with tech.
For us, such examples of AI integration are arguably even more fascinating than investing in the technologies themselves. Even though we are not directly investing in these companies, we can rest easy knowing that our fund managers will never waver in their commitment to high-quality enterprises. These are the companies that can spend money on R&D to improve their artificial intelligence and wider technological integration. Companies that don’t invest in AI are likely to fall behind! All of this calls for patience, forbearance and a long-term perspective.
