The economist and author tells our sister title Portfolio Adviser there is a “tug of war” debate as to whether rates will return to near-zero levels as inflation falls, then revert to a ‘new normal’ of 2% or lower; or whether the past two decades of ultra-low interest rates were an anomaly, and that they are set to return to a more normalised range of 3-5%.

Depending on which scenario comes to the fore, she says there will be significant ramifications on which asset classes will outperform, and which will struggle, over the medium-to-long term.

“Anything where the opportunity to generate returns is based on a low rate is going to suffer. So, anything that relies on leverage or on taking outsized bets – I believe venture capital falls into this space, for example,” she says. “This is why I don’t think the Targeted Absolute Return sector is winning right now, either.

“Of course, there is a debate as to whether we will return to a low rate environment, in which case these opportunities could become interesting again. But given what happened to markets in 2022, 2023 was a case of going back to basics and asking: ‘in a higher cost-of-capital environment, where will the genuine returns come from?’”

Over the last three full years, equity and corporate bond market returns have varied widely. In 2021, the MSCI All-Country World index achieved a total return of 19.6% while the Bloomberg Global Aggregate Corporate Bond index fell 2%. Then in 2022, global equities suffered with the MSCI ACWI falling by more than 8%, while global corporates also lost more than 6%. Both asset classes achieved positive returns last year at 15.3% and 5.5% respectively, according to data from FE Fundinfo.

These returns coincide with varying moves from developed market central banks in a bid to curb rising inflation. When central banks embarked on interest rate rises at the end of 2021, bonds suffered while economic uncertainty weighed on equities. Rate hikes continued throughout the course of 2023, with inflation beginning to fall by varying degrees across the US, the UK and Europe.

“In 2023 there was a lot of discussion about value investing returning to the fore,” Baroness Moyo says. “If we consider the businesses which can survive over the long term and generate real returns above the cost of capital, these types of businesses certainly do look interesting. Which is why what happened in 2023 was odd, because the performance of growth stocks such as the Magnificent Seven was an anomaly in terms of the mood music of markets, given the interest rate moves we had seen.

“In short, it has been too easy to make good returns in bog standard, traditional multi-asset portfolios. You didn’t have to go into long/short portfolios, or venture capital, or anything that required a lot of leverage to make returns. And in fact, it is those areas which have now become higher risk. So, for now, I would argue that it is still very difficult to make the case for people to allocate capital to absolute return strategies.”

See also: Morningstar: Are basic allocation strategies still relevant?

The economist says that, while investors started 2023 “excited about credit”, given interest rate expectations, they are now beginning to hold off and question longer-term themes, given continued economic uncertainty.

AI and decarbonisation

“I would argue that there are two huge key themes. One is AI; hence the Magnificent Seven breaking out of that value anomaly last year. The second one is decarbonisation,” Baroness Moyo – who is also co-principle at the Versaca Investments family office – says.

“The last time we had a catalytic move in the economy on a structural basis was the 1980s, when we saw tech investment opportunities. This is the next one.”

These two themes spell a “real fundamental shift” in how economies will work in the future and therefore which assets will perform well, the economist says, although she adds that the cost of capital “obviously matters” in terms of how people will play these markets.

In addition to historically higher rates, Baroness Moyo says geopolitics have become more volatile – at a time when markets are pricing in interest rate cuts.

“I don’t think anyone over the last year would have accounted for two wars, the announcement of 11 countries joining Brics, swing states – real issues that could now be re-inflationary,” she warns.

“US inflation still stands at 3.1%. Germany is in a recession and Europe is weak, which could signal that rate cuts could be on the docket.

“Geopolitics could be incredibly disruptive, and could mean we live a ‘higher for longer’ environment and that is set to continue.”

Finding dislocations

Alongside moving out of leveraged plays, this uncertain backdrop has also led Baroness Moyo to play equities more “opportunistically”, holding out for market dislocations in favoured sectors such as healthcare, or more attractively-valued companies set to benefit from AI.

“We are mostly looking at AI on a ‘wait-and-see’ basis for the reasons that I mentioned. But if we start to see real productivity gains and genuine possibility for disruption from AI, I think it will be an opportunity.

“What does this mean for us? It means a skew towards taking money out of equities and putting it into cash or bonds, and waiting for opportunities in these much more structured bets such as AI.

“If it is true that, over the next 20 to 30 years there will be a fundamental shift in how the world operates, we want to be a part of that. So, the best thing to do is to dip in and take some money out of markets where we could be losing and put it into bonds, which are earning us 5.5-6%, until there is more clarity around how best to play the AI space.”

That being said, Baroness Moyo has “taken a nibble” at some less widely-held stocks she believes are attractively valued such as US healthcare provider HCA and cloud-based software company Salesforce.

Not-so-magnificent Seven?

When it comes to the Magnificent Seven stocks – many of which have become synonymous with investing in AI such as Nvidia, Amazon and Alphabet – Baroness Moyo is less tempted and says valuations are “too rich”.

“I understand the whole euphoria; it’s the New Year, let’s all get excited. But the market has sold off a fair amount already, coming into the year.

“But when it comes to the Magnificent Seven, which are trading on high price-to-earnings multiples… We had a bad 2021, a mixed 2022 with a big skew to certain stocks. In 2023, my sense was that people were waiting and seeing. And now, I think people are waiting for that first rate cut, then they are going to bank as much of that return as possible.

“So if anything, I’m worried that markets are going to sell off. Not initially, but I think institutional investors could be waiting for a rate cut and a market rally, at which point they will bank their gains tactically.”

The other risk with the Magnificent Seven stocks, says Baroness Moyo, is that they account for a very significant proportion of the S&P 500. According to data from Yahoo Finance, this handful of companies accounts for 29% of the US index’s entire market cap.

“If I look at the Magnificent Seven versus the 493 remaining stocks in the index, and I had to take a bet on either a bigger rally among the Magnificent Seven, or a revenue catch-up from the 493 others, I am going to bet on the catch-up,” she reasons.

“Do I believe that tech is the future? Absolutely. But we are talking about a numbers game here. I am looking at multiples and margins, the ability to grow top-line revenue and the ability to cut costs.

“On that basis, I think it will be harder for those very efficient larger companies, which achieved enormous gains in 2023, to continue that growth. I think a lot of value has been squeezed out of the Magnificent Seven, and a lot of that value is now dependent on how they execute on AI.”

Value in energy

In contrast, Baroness Moyo says the energy sector offers attractive valuations. “Why? Because we’re consuming 100 million barrels of oil every day across 8 billion people. People need energy to live – whether that is from fossil fuels or from renewables. That is an area where I think there have been relatively bad returns, but there is real opportunity for upside.

“For me, value investing is about a compelling sector-based narrative that is based off of basic needs, such as food, energy and transportation. But these companies have to be well-run. You have to be able to look at the margins, the fundamental demand and what that might mean for long-term opportunities, in order to generate risk-adjusted returns above the cost of capital.”

For the economist, this could mean investing in companies which provide fossil fuels and are looking to embark on the transition to net zero, as well as those leading the charge on reducing our dependence on carbon.

See also: Canada Life’s Sriharan: The rules of engagement on asset allocation have changed

Zambia-born Moyo says: “When you have been raised in an environment – like I have – where electricity and water is not automatic, you have a very different understanding of how difficult it is to deliver energy and deliver water.

“In the west, there are a lot of people who have good intentions for us to move and transition into this new equilibrium, which is renewables-based. That’s fantastic. I don’t know anybody who is against that.

“However, we have to be sensible about what the costs of that journey are and how easy it is to execute. It’s 2024 and there are many countries around the world which cannot create energy on a sustainable basis. And I’m not just talking about desperately poor countries – this includes middle-income countries like South Africa. Even California has suffered from energy disruption.

“This, to me, is precisely the dislocation that presents investment opportunities. The vast scale of our energy requirements, the need to transition, and the requirement to find the best companies at actually providing this.”

Has Japan turned a corner?

On a regional, macroeconomic basis, Baroness Moyo is positive on the US and Japan. When asked whether Japan has become a consensus trade, given its recent stockmarket rally, Baroness Moyo says there are two key reasons the market has performed so well. “One is technology and the other is energy – the two big long-term trends driving markets. These are massive pivot points for the world, and I think people see Japan as very much at the coalface of that.”

But people have been predicting a “new dawn” for Japan for decades – since its economy slumped throughout the nineties. Is the recent recovery the real deal? The economist does indeed believe the country has “turned a corner”.

“It’s extremely difficult to run an economy, to get a slow economy moving, and to get businesses and companies to work efficiently. There is a whole potential system of errors – a lot of things have to go right, and we have seen in the past how quickly things can fall apart. Germany was a huge economy doing well, and look how quickly it has come off the rails,” she explains.

“Japan has a lot of things going right for it. It has strong levels of high education, it has a business sector which is sharp and knows how to innovate. It is difficult for a country to put these things in place.

“We have seen it in the UK – I often talk about how, 15 years ago, business was a big piece of the story. Business accounted for a large part of the UK economy; everyone was talking about the banks, Rolls Royce, Marks & Spencer. Today, that is less the case.”

Home market

Indeed, while the Topix has gained 9.2% over the last six months alone, according to FE Fundinfo data, the FTSE 100 has achieved less than one quarter of these gains over the same time frame, at just 1.3%. It has also achieved less than half of the gains of the MSCI All-Country World index over the last five and 10 years. Does the UK market present a value opportunity?

“I’m afraid it will still be a case of ‘wait and see’ for the UK. There is a lot of hope that this is the home of industrial revolution; that we can get back to business and back to clarity. But the business and markets have become so intertwined with politics that there is risk,” Baroness Moyo says.

See also: Facing the inflation dilemma head on

“It is at the point with politics where business has not been able to work without a political overhang creating costs from a regulatory perspective, and from a risk mitigation attitude when it comes to investing.

“In the US, if I talk about AI or the energy transition, the first question people will ask me is how much money they could make if they invest $1 – what return would this generate? When I have the same conversation in Europe, the first question is how to mitigate any risks coming from those themes.

“Our only way out of this is to find some kind of balance between these two attitudes. I’m worried that a lot of conversation in the UK is still very top down and government led, where people would rather kill off investing in certain areas, rather than use innovation to solve any issues.”

Emerging markets

Baroness Moyo is also reticent to invest in emerging market equities, arguing there are other areas where investors can generate “considerable returns, above the cost of capital, without the inherent risk”.

“I understand the arguments on paper. The macroeconomic arguments are very compelling. But as a practical matter, life is too short,” she says. “It sounds flippant, but it’s fundamentally true. Investors only have a certain number of years to make returns. That doesn’t mean they can’t ultimately achieve gains and compound those returns. But why take the risk by putting your capital in a market with slowing growth geopolitical risks and FX problems? It’s very hard.

“In my case, I only have 20 years to compound any returns. Why would I waste my time trying to work my money in an uncertain environment? Yes there could be some outside bets but I am willing to leave that money on the table.”

See also: Top five investment themes to look out for in India in 2024

She cites India as an example which is popular among investors. According to FE Fundinfo, the MSCI India index has returned 26.3% over the last year – more than double that of the MSCI ACWI.

“Lots of people say they are going to make billions by investing in India. Good luck to you, but I am willing to reduce my basis-point returns and not have to deal with the risk,” she reasons.

“Would I ever say India is never going to make it? No, it’s not my place to say that. But what I will say is it is extremely difficult to generate predictable returns in that kind of environment. There is a lot of red tape; it is definitely skewed towards locals winning over the foreign partner. It doesn’t have a great track record.

“People have to understand it’s not free money; there are other places you can invest and generate returns with relatively little risk.”

This article was written for our sister title Portfolio Adviser

“We do not regard any of these cautionary or risk factors as likely to tip markets into a sustained and substantial drop, but each runs the possibility of triggering meaningful setbacks,” the report said.

“Taken together with the sharp run-up in markets ahead of year-end they call for some caution in portfolio construction in the shorter term.”

Inflation

Momentum calls core inflation ‘uncomfortably high’ across the US, Eurozone, and UK, where rates sit at 4%, 3.6%, and 5.1% respectively. While it said a recession has become less likely in the US, there could be periods of stagnation for the UK and EU.

“The resilience of these economies, especially the US, and the continuing tightness of labour markets, with wages now rising at above-inflation rates, are likely to mean policy will have to stay tight enough to trigger a sharp slowdown in economies,” the report said.

“Keeping rates close to current levels as inflation falls means higher real rates and tighter financial conditions, while the long lags and cumulative effects of monetary policy will be a headwind through much of 2024.”

See also: Should we still be worried about inflation?

Consumer resilience

While consumer resilience prevailed in 2023, Momentum believes this could take a downturn in 2024 as unemployment seems likely to rise and money saved during COVID-19 diminishes from personal funds, causing pockets to tighten.

“The extended period of higher interest rates will push interest payments on consumer debt to a higher proportion of disposable income and will likely result in rising delinquencies on debt repayments, including mortgages, auto-loans, and credit cards,” the report said.

China

China struggled to bounce back post-Covid and has faced fiscal troubles including regulatory clampdown, US trade sanctions, and over-leverage within the property development industry.

The report added: “China is again imparting a deflationary impulse to the global economy, and although it has gradually eased policy, its high debt levels provide limited room for stimulus.”

See also: Big trouble in China

Public debt levels

Following the Inflation Reduction Act in the US, federal deficits are expected to stay near 6% of GDP until 2030. Momentum said this stretched debt creates little fiscal flexibility and in the face of an election year, has a ‘near-zero prospect’ of being reined in.

“With the dysfunctional Congress facing a debt ceiling limit resolution in January, this is a problem that is likely to stalk markets and potentially damage confidence at times during 2024,” the report said.

Geopolitics

Momentum states Russia’s ongoing war with Ukraine presents unclear consequences for Ukraine and other former Soviet areas over time, while the Israel-Hamas war is moving closer to a proxy war with Iran and bringing in additional allies.

Momentum said: “Perhaps most important of all, the great power rivalry between the US and China has the potential to be the defining issue of our age, with little prospect of a material thawing in the relationship in a US election year and in the face of President Xi’s tough line and domestic political dominance.”

Elections

At least 50 countries will hold elections in 2024, including seven of the 10 most populous countries. Momentum also noted Taiwan’s election, taking place during a tenuous period with China.

“The US Presidential election in November is by far the most important, and although we would not normally regard an election as a significant event for markets, in this case there could be more meaningful repercussions than usual given the choice which is likely to be presented to Americans, namely Biden v Trump,” the report added.

Tightening cycle

The tightening cycle is under watch especially given the mini-banking crisis in March 2023, however Momentum said households, companies, and banks come in with “generally strong balance sheets”.

“We do not envisage systemic risks, but some damage on a narrower basis in over-leveraged parts of the economy facing structural problems, such as commercial real estate, and idiosyncratic events such as the SVB collapse, cannot be ruled out,” Momentum said.

This article was written for our sister title Portfolio Adviser

During 2023 sentiment has oscillated widely between two different investment scenarios, the glass-half-full camp and the glass-half-empty camp. The challenge is to construct portfolios while recognising that either scenario could occur and given that uncertainty is prevalent, we believe that maintaining balance is key.

See also: Markets can still thrive with higher interest rates

2023 has been a year in which investment markets have encountered cross winds. On the positive side, equity markets have benefitted from a new age in technology, driven by generative artificial intelligence (AI). At the same time, geopolitical risks have heightened with ongoing conflict across the world and the China-US relationship remaining fraught.

Inflation is forefront of policymakers’ minds and, with interest rates clearly in restrictive territory, certain observers are waiting for the full impact of higher interest rates to see whether consumers and companies remain solvent while policy makers wait for inflation to fall further. As we consider the investment outlook, the challenge for asset allocators in 2024 is how to take a calculated position to keep exposure to more than one economic scenario materialising.

The age of generative AI

After a bruising 2022 for both equities and bonds, 2023 has seen a recovery in equity markets. This improvement was driven by the impressive performance of a small number of technology-related names which are perceived to be beneficiaries of AI.

See also: Tech funds top the rankings for 2023

The exciting question surrounding AI is the size of the productivity gains it can enable across the whole economy. The US National Bureau of Economic Research looked at a staggered introduction of a generative AI-based conversational assistant and found that access to the tool increased productivity by 14% on average. Clearly gains of this magnitude will help keep a lid on the effects of higher interest rates and wage costs.

Corporate earnings growth remains robust

After the post-pandemic recovery boost, corporate earnings growth expectations are lower but still in positive territory. For Q3 2023, with more than 99% of S&P 500 companies having reported results, 82% of S&P 500 companies have reported better than expected earnings. Looking ahead to 2024, current consensus estimates point to a healthy expected annual US company earnings growth rate of over 11%. The operating environment is also becoming more favourable: post pandemic supply chain disruptions have ceased and trade volume growth of 3.3% in 2024 is expected, compared to 0.8% in 2023.

Economic growth picture still mixed

Central banks continue the fight of bringing down inflation and ensuring financial stability, while avoiding a recession. The three main regional drivers of growth are the US, Europe (including UK) and China. The US reported annual real GDP growth of 4.9% in Q3 2023, while in China the IMF forecasts real GDP growth in 2024 of 4.6%. However, the picture in Europe and the UK is less rosy, with the IMF forecasting growth of less than 1% in 2023 and only a modest recovery in 2024. These differences illustrate the importance of using an asset allocation framework that can adjust for regional differences.

Investors face three outcomes for economic growth: first, a hard landing; second, a soft landing; and third no landing. The first outcome would imply a reduction in equities and added longer duration bonds, however if the third were to materialise, it would be the opposite. Over the course of the year, the soft landing outcome has become more likely but far from certain.

Bonds: Income is back

Over the course of the past two years, the rise in bond yields has meant that bonds can once again provide a counterbalance to other asset classes within portfolios. However, in our view, it is too soon to increase duration significantly, given the risk that inflation may persist for longer. Within corporate bonds we continue to prefer higher quality investment grade bonds over the more speculative high yield, as we believe the additional yield available does not adequately compensate us for the additional risk.

The equity barbell remains in place

Since the pandemic, the leadership style of the equity market has changed more frequently and become more pronounced. For this reason, we have implemented a barbell approach to equity portfolios, whereby we aim to achieve an equal weighting of both value and growth investment styles.

Given the range of possible economic scenarios together with current heightened geopolitical risks, the barbell approach remains. In conclusion, there is currently insufficient visibility for us to back a single sustained outcome. Instead, staying invested but keeping balance continues to be the goal.

This article was written for our sister title Portfolio Adviser by Henrietta Walker, head of the investment specialist team at Brooks Macdonald