In 2023, the global economy proved more resilient, and inflation fell faster than many feared. Yet the turbulence felt along the way proved more than enough to prevent the big picture throughout the year.
A wise man once pointed out that the stock market is not formed by thousands of clever men and women independently arriving at their own views.
It is much more like a school exam hall where two bright kids at the front – one an optimistic bull, and one a pessimistic bear – pass back the answers to the rest of the class. Ultimately each investment has a buyer and a seller and so views form into two basic groups, even though the world itself is far more nuanced than this suggests.
This was never truer than in 2023. At the start of the year, inflation enthusiasts argued for a generational shift in inflation expectations – forecasting a return to the malaise of the 1970s, as growth proved stubbornly high.
Meanwhile economic pessimists foresaw an avalanche of consumer and business failures resulting from the higher interest costs.
Thankfully, neither outcome came to pass, and inflation slowed meaningfully even as the world economy continued to grow at close to 3%. This year is a reminder that the volume of the debate is often a poor indicator of the likelihood of outcomes.
Source: Office for National Statistics (ONS).
Financial markets price in uncertainty, which dampens valuations and helps enhance the long-term returns for patient investors. At Albemarle Street Partners we aim to deliver consistent returns for clients by focusing on a broad assortment of data, rigorous diversification, and pragmatic alignment of portfolios based on the balance of risks.
As we entered 2023, we recognised a shift in this balance due to a decline in global energy prices. Natural gas prices fell rapidly as alternative supply and lower demand helped meet Europe’s needs.
Interest rate rises quickly delivered price stability as consumer demand started to slow. Today US and European headline inflation is near 3% and even core measures, which respond with a lag, have declined. Even the UK, a laggard in the inflation fight, has made some notable progress in recent months. On the downside, economic growth in the UK and Europe has ground to a halt and market participants expect interest rate cuts as early as the second quarter of 2024.
The US economy has surprised the sceptics by delivering 2.5% growth in 2023. Buoyed by a resilient labour market consumers dipped into pandemic era savings. US companies have started to grow their earnings, delivering 4% earnings growth in the most recent quarter. This has helped support a more positive economic narrative.
Portfolios have outperformed peer benchmarks year to date, delivering low to high single digit returns across a variety of growth mandates. Past performance is not a guide to future performance. Recognising the prevailing gloom in markets, the heightened expected returns on offer, and the need for safety, we sought diversification seasoned with a healthy dose of downside protection.
We favoured larger companies, neutral duration investment grade bonds and a lower-than-normal allocation to emerging markets and smaller companies. During the year, the higher sensitivity of our bond holdings helped protect portfolios when there was risk of a banking crisis. The largecap passive funds we used in the US, Europe, and Japan not only helped lift portfolios during market rallies but did so with greater reliability than active equivalents. We increased high yield bond allocations at the start of the year, which proved to be an apt decision.
In terms of equity performance, US and Japanese shares generated the strongest returns driven by their technology and consumer discretionary exposure. Smaller UK Mid Cap companies significantly lagged the broader UK equity market. Across fixed income, riskier high yield debt strongly outperformed top-rated government bonds year-to-date. Meanwhile inflation-linked UK debt produced poor returns.
As we think about the coming year, we are excited by elevated expected returns across a range of assets. While the debate on the depth of the upcoming recession is likely to rage for some time, we have pragmatically positioned portfolios for declining inflation and a slowdown in economic growth.
Neutral duration bond holdings and our equity exposures to large cap quality equities will help portfolios participate in market rallies as we gradually increase allocations to beaten down areas such as smaller companies, emerging markets, and higher yielding debt. A mild US recession, which is now the base case for many investors, could still prove challenging for earnings from cyclical sectors. We anticipate earnings growth in these sectors to bottom in the first half of next year. As we think about the opportunity set for 2024, we will start allocating to a variety of cyclical sectors in a controlled and gradual fashion with a keen eye on the direction of data.