After two years of muted investment returns the scene is set for a recovery powered by the most rapid technological revolution in history and cheap prices in unloved areas of the global market.
The world enters 2024 laden with the political and economic traumas of the past three years.
It has suffered a pandemic which produced the sharpest economic contraction in history, the first major European war for 70 years and a painful wave of inflation which has raised the cost of living across the world.
These problems have of course taken their toll on investors. As interest rates rose to combat inflation the price of both bonds and shares fell. The role of investment managers became to preserve wealth and diversify away the damage that could be done to portfolios.
Yet many of these problems, whilst painful, are resolving themselves – setting the scene for a period of stock market recovery turbocharged by an exponentially accelerating technological revolution.
This backdrop though, however exciting, cannot fully hide the anxiety that has dominated the market over the past year. An underlying fear about the economy means that on average US companies rose just 2% in 2023. Meanwhile a 15% return was made by the stock market index which gives the largest weighting to the very largest companies.
This shows us that a handful of very large stocks have accounted for most of the market’s gains. These are principally those companies most exposed to technology, and particularly the growth of artificial intelligence.
It will be tempting for many investors to simply allocate more and more to these few companies. However, it is worth noting that periods of pessimism like the present often resolve themselves with a broadening of returns through a recovery in the laggards.
Empirical data suggests investors realise significant diversification and return benefits by introducing allocations to beaten-up asset classes with higher perceived risk. As we experience amplified fears of a global slowdown, areas such as smaller companies and emerging market shares as well as high yield fixed income may warrant consideration.
THE COMING CASE FOR SMALLER COMPANIES
Extensive academic research show that over the long-term smaller companies generate excess annual returns of 3%* above large cap counterparts due to the higher long term revenue growth. Past performance is not a guide to future performance. Additionally, the outperformance gap between small caps and large tends to prove most extreme in recessionary periods. As the economy slows, the perceived risk in smaller companies typically skyrockets - sending valuations plummeting far below intrinsic value. Smaller companies in the UK and Europe trade at a 20% to 35% discount to their larger peers, despite having higher longer-term earnings growth.
EXAMINING HIGH YIELD CORPORATE DEBT
Economic downturns also typically lead investors to overestimate the risks involved in lending money to lower-quality companies, who issue what are known as high yield bonds. The risk of investing in this area is always that companies are unable to pay their debts as an economic slowdown bites. However, these risks typically emerge early into a slowdown. As they emerge the interest paid by these bonds peaks and then begins to fall. As the price of bonds moves in the opposite direction to the yield on the bonds, this creates an opportunity for investors. Historically, some 6-12 months following the start of prior recessions, high yield bonds commenced sizeable rallies - dramatically outpacing lower risk bonds. Our expected return framework highlighted high yield assets in 2022. While the asset class has delivered high single digit returns this year, absolute yields remain attractive. The economic backdrop requires judicious debt selection as we expect default rates to rise in the coming months. We have identified suitable active funds to take advantage of the high expected returns on offer.
INCORPORATING EMERGING MARKET EQUITIES
The need to keep a diversified portfolio alone warrants some of your portfolio to be allocated to the developing world. However, at the current time attractive valuations strengthens the investment case. Despite rapid growth trajectories, Chinese and other emerging market companies today trade a staggering 60% cheaper than US counterparts when examining price to earnings ratios. Many emerging markets began tightening monetary policy ahead of the US and have been able to reduce inflation to desirable levels. As the Federal Reserve calls time on its own tightening cycle, it allows emerging market central banks to start cutting interest rates to support domestic demand. This could create a powerful revaluation dynamic for regional equities markets as investors seek to diversify their equity exposures.
THE TECHNOLOGICAL BACKDROP
Alongside the market recovery, another force is affecting the world economy and this will find its way into a wide range of asset classes. The rapid acceleration of artificial intelligence creates a backdrop which can lead productivity in the global economy to improve by 1.5% a year by 2030, according to analysis by Goldman Sachs. Ultimately it is productivity growth that drives the long-term return of stock markets. As the economist Paul Krugman once said: ‘productivity isn’t everything, but it’s almost everything.’ The productivity gains from artificial intelligence are akin to the peak gains made at key inflection points in the history of technology – such as the mass uptake of the personal computer, the advent of modern electronics and the internal combustion engine. A key goal for us is to make sure we harness this opportunity, whilst avoiding the inevitable bubbles it will create.
IMPLICATIONS FOR PORTFOLIO POSITIONING
During periods of economic weakness, investors broadly paint all risky assets with the same brush despite significantly varying long-run return prospects. However, having the discipline to allocate to fertile segments of the market requires taking a more hard-headed approach. Those able to acknowledge that pessimism sows the seeds for eventual upside, reap outsized rewards over full cycles. Our approach will always be highly conscious of risk and our approach to this market recovery will be to turn gradually into the riskier areas of the market as our level of confidence progressively grows. However, we must not forget that 2024 is a year abundant with opportunity found not just in the most obvious technology companies benefiting from artificial intelligence, but also from less loved areas of the market such as smaller companies, high yield bonds and emerging markets.
* The Cross-Section of Expected Stock Returns” by Eugene Fama and Kenneth French (1992).