In an environment of falling inflation but rising geopolitical risk, what should investors expect from global equities this year and where should it fit into their asset allocation plans?

In this head to head, Alison Savas (pictured right) of Antipodes looks at the factors that drove performance in 2023 and explains her cautiousness to begin 2024, while Rathbones’ David Coombs (pictured left)  explains why his equity portfolios will continue to be dominated by the US in coming months.

Alison Savas, investment director, Antipodes Partners

Global equities had a strong 2023 driven by the seven largest tech stocks for most of the year, until the back end saw an increase in breadth.

The 2023 laggards have begun to lead the market on the view that inflation has been vanquished, meaning rates will fall while economic growth and employment can remain intact. This is one possible outcome, though we see greater uncertainty ahead with risks around an inflation wall, tightening liquidity and the delayed ramifications of tight policy. We expect greater volatility around the economic cycle and lower equity multiples.

The pathway for inflation is down but the last mile may be harder to achieve than expected. We see core inflation getting stuck around 3% mid-year, owing to a sticky shelter component resulting from a large and continued undersupply in US housing.

We expect some rate cuts over 2024, but with the market already pricing in around 140 basis points in cuts, the risk is disappointment over the pace of loosening. If the Fed cuts too early it could reignite inflation. Investors need to be open to rates staying higher for longer.

We also expect liquidity to tighten from Q1 as the very large fiscal deficit in the US will increasingly need to be funded via issuing long-dated bonds. With the Fed out of the market (adding to supply via quantitative tightening), banks, insurance companies and households will need to soak up this issuance, which means less capital available for holding other assets.

A supportive liquidity environment in 2023 disproportionately benefitted a narrow set of winners, so a deterioration will have implications for equities. Investors should focus on finding tomorrow’s winners rather than wedding to yesterday’s success stories – and paying a fair price for the quality of a company and its growth profile, not any price.

Our base case remains a mild recession in the west. The US has been more resilient as the transmission of tighter monetary policy to the real economy has lengthened largely due to the prevalence of fixed rate mortgages, but the threat of tight monetary policy may not have passed.

The labour market continues to loosen and nominal wage growth is slowing. The US could still experience a downdraft in activity, for which US equities are not priced. At 21x, earnings valuations are expensive relative to history and other regions like Europe (11x) and China (9x), which have already experienced an earnings downgrade cycle.

‘Picks and shovels’ play

The Antipodes global portfolios remain relatively defensively positioned with exposure to attractively priced healthcare stocks (such as Merck and Sanofi) and consumer staples (Diageo, Tesco). We’ve been selectively adding to global cyclicals that have attractive supply/demand dynamics (TotalEnergies) or are exhibiting bottom-of-the-cycle characteristics and are priced on low multiples.

But despite the risks, opportunities exist. We’re finding beneficiaries of emerging investment cycles in energy transition and cloud/AI monetisation that remain mispriced. Companies such as Siemens, a global leader in factory automation, energy efficiency systems that manage power consumption and rail signalling equipment.

Siemens not only benefits from the move to a lower carbon world but also onshoring. Also, Taiwan Semiconductor Manufacturing Co, the ‘picks and shovels’ play of the AI age. TSMC manufactures chips for semiconductor companies globally, with a near monopoly at the leading edge.

We’re also finding opportunities in emerging economies like Brazil, Mexico and Indonesia. Fundamentals are improving, inflation is under control and there’s scope for policy rates to fall. Examples include one of the leading private sector banks in Brazil, Itau Unibanco, and the dominant convenience store operator in Mexico, Fomento Economic Mexicano.

If it becomes more apparent that the Fed can engineer a soft landing then we will lean into our cyclical exposures – mature cyclicals and beneficiaries of long duration investment trends – and ex-US listed multinationals are an attractively priced way to play a soft landing.

David Coombs, head of multi-asset investments, Rathbones

We broadly left our equity positioning unchanged over 2023, despite the macro noise, but did take the opportunity during the summer to trim our positions in the five members of the ‘Magnificent Seven’ we held.

We also added to our medical-technology names in Q3 as they sold off on concerns relating to falling demand for their products as weight reduction drugs cured obesity for all – according to the prevailing narrative at the time.

It is easy to overgeneralise, but I think it is safe to say our focus has been on quality and growth with a significant bias to the US, given our view that the US would avoid a recession in 2023. This is despite the negatively sloping yield curve, due to fiscal stimulus offsetting higher interest rates.

We continue to see long-term opportunities in med-tech and, more controversially, in industrials benefiting from the US spend on infrastructure. Both do come with challenging valuations and the promise of more volatility as sentiment swings from ‘soft to hard landings’ and back.

Legislation such as the Inflation Reduction Act and the Chips and Science Act are encouraging investment into manufacturing through incentives worth many billions of dollars. We also believe the trend towards onshoring, where companies look to move some of their manufacturing operations closer to home is benefiting a whole ecosystem across industrial America.

This should continue whoever is elected president at the next election as the US aims to shore up its supply chains and encourage further investment into strategically important sectors.

Working hypothesis

As we head into 2024 we think that with rates having risen so far and so fast, this will weigh on economic growth. But inflation is likely to continue to trend down, which is probably what prompted Fed chair Jerome Powell’s December ‘Pivot press conference’ with interest rate falls back on the agenda, resulting in a relief rally for interest rate sensitive sectors such as Reits and retailers.

We remain cautious in this regard, with a working hypothesis that rates will stay higher than the more optimistic commentators are predicting. This keeps us away from more highly leveraged areas or deep-value cyclicals. So our equity portfolios will continue to be dominated by the US this year.

Elsewhere we have concerns around UK growth, and while the impact of economic policy may not have a material effect on the FTSE 100, which is largely full of global businesses, we maintain limited exposure to companies with significant revenues from the UK economy in the portfolios. The Bank of England, at the time of writing, seems hell bent on creating unemployment and a recession to reduce inflation – mostly caused by external factors – while the government and opposition looks to squeeze businesses and the consumer through a high tax regime.

Europe could be interesting if there is a resurgence in the Chinese economy, which seems more likely than it has since Covid. We see value in many mid-cap industrial names, which have had a torrid few years. We also expect the European Central Bank may turn more dovish by Q2. Asian and emerging markets could benefit from a weaker dollar if US rates start to fall. However, within a multi-asset context – or from a risk/reward perspective – we still prefer to own businesses in the US and Europe with customers in the region, rather than owning local companies.

In 2024, we expect there will be greater dispersion in share price movements and a broadening out of performance leadership. This is due to the impact of multiple years of higher costof-capital starting to feed through into operating margins. Forget geography, access to cheap capital is the key to success – together with sector dominance and markets where the consumer still has money to spend.

This article was written for our sister title Portfolio Adviser’s January magazine.

This was the highest monthly increase since April 2021 and the eighth highest inflow on record, signifying a return in confidence from investors. Fund flows were also positive in November in December after six months of net divestment, taking in £449m and £1.2bn respectively.

Funds investing in US equities were the main beneficiaries of this upward trend in January, raking in £1.4bn of fresh capital throughout the month. Global funds came in at a close second as investors poured £1.1bn into the sector.

A main driver for the popularity of these sectors was the resurgence of ESG funds. They took in £1.6bn in January – the first positive inflow since April last year, during which time investors removed £3.7bn.

Declining inflation and a peak in interest rates has brought some much-needed sentiment back into equity markets, but Edward Glyn, head of global markets at Calastone, said the renewed popularity of ESG funds “should be treated with caution”.

“Strong markets are good for ESG inflows, particularly if the market rally is driven by US technology companies, but none of the bigger questions about the sector such as the greenwashing debate has gone away,” he said.

“The FCA’s new rules on ESG fund marketing will help, but are yet to take effect. Longer term, greater clarity and better disclosure will be good for the sector, but the road is likely to be bumpy in the short term.”

See also: Platforms call for UK government to resist launching ‘retrograde’ British ISAs

However, not all sectors benefited from rising investor confidence – funds investing in UK equities were the worst hit in January, losing £673m in the 32^nd month of consecutive outflows. This was higher than the £649m monthly average that was removed from UK equity funds in 2023.

Glyn noted that the UK has the same tailwinds as other equity markets, but UK investors have yet to find confidence in their home market.

“The UK is also experiencing a sharp disinflation, but the doom and gloom over the UK stock market seems firmly lodged in investors’ minds,” he said. “UK equities are exceptionally cheap by historic and international comparisons, but buyers are nowhere to be found.”

Other markets such as Asia Pacific also suffered outflows in this otherwise positive month. Funds investing in the region lost £211 in January, making it the fourth-worst month on record for the sector.

This was its ninth consecutive month of outflows – something Glyn credits to economic difficulties in China.

This article was written for our sister title Portfolio Adviser

However, in spite of a collective outflow of $2.5bn at the global level, European and Asia-ex Japan funds continued to see inflows, Morningstar’s Global Sustainable Fund Flows: Q4 2023 in Review reported.

Global assets also rose by 8.2% to $3trn amid a backdrop of market turmoil and geopolitical concerns, and there was a “minor uptick” in the number of sustainable funds brought to market around the world in Q4 – 121 were launched compared to 114 in Q3.

Hortense Bioy, global director of sustainability research, Morningstar, commented: “The global ESG fund flow picture in the last quarter may look bleak, but ESG funds in Europe – by far the largest market – continued to hold up better than the rest of the fund universe. Global ESG fund assets kept rising too. The disappointing reality is that active managers failed again to prevent redemptions in a corner of the market where it’s easier for them to prove their worth. By contrast, passive funds demonstrated consistent resilience.”

Quarterly global sustainable fund flows

Active managers see outflows in Europe

Despite being the biggest sustainable fund market, with 84% of the global sustainable fund assets, Europe attracted only £3.3bn in net new money in Q4, down from the $11.8bn that Europe gained in Q3.

Morningstar’s report said “the decline in subscriptions was entirely attributable to actively managed sustainable strategies” – they saw $18bn in outflows in the fourth quarter, following net outflows of $4.8bn in the previous quarter. Passives attracted net new money of $21.3bn.

European sustainable fund flows ($)

European fund flows compared with conventional fund flows

However, sustainable funds fared better than European conventional funds, which bled $25.4bn in Q4.

Over 2023 as a whole, European sustainable funds saw $76bn in inflows, down from $149bn in 2022.

“A few factors contributed to the lower inflows into sustainable funds in Europe last year,” the report said. “The challenging macroenvironment, including high interest rates, inflation and fears of recession in some parts of the world, among other implications, has led investors to favour government bonds, an area that has limited ESG products. ESG integration remains challenging in that corner of the fixed-income market – in fact, it is not feasible in the case of single-country government funds like US Treasuries or UK gilts.

“Also, it is fair to assume that some investors took a more cautious approach to ESG investing last year in the wake of the underperformance of ESG and sustainable strategies in 2022, partly due to their typical underweight in traditional energy companies and overweight in technology and other growth sectors. While the technology sector rebounded in 2023, other popular sectors in sustainable strategies continued to underperform. Renewable energy companies, for example, have been particularly affected by soaring financing costs, materials inflation, and supply chain disruptions, among other issues.”

Morningstar also flagged greenwashing concerns and the ever-changing regulatory environment as further dampeners to ESG appetite.

However, supported by price appreciation across most equity and bond markets, Morningstar noted assets in European sustainable funds rebounded to $2.5trn, a 7% increase from the previous quarter. Product development slowed in Q4 as “asset managers have been more cautious in their development of new ESG and sustainable strategies because of greenwashing accusations and the uncertainties of the regulatory environment”, Morningstar said. There were 364 launches in 2023, significantly lower than the 683 seen a year earlier.

‘Chilling effect’ in the US

Investors pulled $5bn from US sustainable funds in the final quarter of 2023, playing its part in pushing global sustainable fund flows into negative territory for the first time on record. A total of $13bn exited US sustainable funds in 2023, as the anti-ESG backlashacross the pond gained further momentum.

“In addition to middling returns, greenwashing concerns persisted in the absence of clear regulation for ESG and sustainable investing,“ Morningstar commented. “Finally, the continued politicisation of ESG investing contributed to a chilling effect on demand for sustainable funds.”

Active funds accounted for 90% of the net withdrawals and Morningstar said Parnassus Core Equity – long known as the largest sustainable fund – has been one of the 10 biggest losers in terms of outflows for more than two years straight, shedding more than $4.5bn over that period.

Despite the outflows and performance that lagged conventional peers, market appreciation pushed US sustainable fund assets higher to close out the year at $323bn. Morningstar said this is a 12% decline from the all-time high but an 18% increase from the recent low in Q3 2022.

Taiwan dominates in Asia

Excluding China, the Asia ex-Japan region recorded net inflows of roughly $1.4bn over the fourth quarter, with the highest inflows coming into Taiwan-domiciled sustainable funds.

Meanwhile, India- and Malaysia-domiciled sustainable funds saw $44m and $20m in net outflows over the quarter, respectively, with the former ending 2023 with four-consecutive quarters of outflows totalling $226m.

However, and like the other regions, total assets in sustainable funds across Asia ex-Japan climbed 5% over Q4 to $61bn, with Taiwan housing 20% of the region’s assets.

There were 29 new funds launches in Asia ex-Japan – the largest amount since Q3 2022.

Japan saw its seventh-consecutive quarter of outflows, with net withdrawals amounting to $2.4bn as passives also turned into outflows after months of outflows from largely active funds. There were also no new funds brought to market in the region in which Morningstar said was a “quiet year” for product development.

All charts Morningstar Direct. This article was written for our sister title ESG Clarity

“When you have 12 years of quantitative easing and a bull market, I think a lot of behavioural biases change over that time and multi asset, to my mind, should always be dynamic – you should be disciplined about what you’re buying and selling,” he said.

“Now that we’re in a regime of higher structural rates and volatility is much higher, risk management is crucial and clients should be looking out for it.”

Sriharan joined Canada Life in 2021 and runs a range of risk-adjusted multi-asset portfolios alongside co-manager Craig Rippe.

“We find ways of adding alpha through lots of smaller positions, rather than big asset allocation calls, which has ended up being the modus operandi for many peers. Overweight equities, underweight fixed income was the classic default position for everyone.

See also: Canada Life to revamp UK operation

“If you think of the world through the lens of being more neutral, which I think is sensible, then you’re naturally focused on ideas within the sub asset classes. That, to me, is how I think you add alpha through multi asset in the long term.”

Equities are not the only game in town

A key allocation call for Sriharan came following the recent ramping up of interest rates in the US and globally, which has prompted him to consider opportunities in short duration, high yield bonds.

“For a long time, equities were the only game in town because quantitative easing was suppressing bond yields. Equity markets were going from strength to strength because of robust earnings growth and low financing costs, but now we live in a world where cash is nearer 5%.

“If you’re starting with that cash yield, you need to generate at least that in portfolios. Yes, capital will fluctuate and you might even lose money if yields carry on going up and you invest at the current interest rate. But all of a sudden, the return profile seems quite powerful.”

Sriharan points out that the yield on the short duration high yield index is at around 7.5-8%, which he finds a compelling opportunity.

“The 10-year total return from the FTSE 100 has been c.4.5% annualised, you can almost double that in a two-year high yield bond allocation. So, the rules of engagement on asset allocation have changed quite a bit.” he says.

“Despite the negative downside of high yield, and that can be quite powerful. We could own UK equities, which could generate another 5% per annum for the next three years, or you could have your bond allocation generating 8% in high yield for the next three years. The relative value story has really changed.”

“It’s easy to forget that the consistent alpha comes from getting those sub asset class calls right rather than just having a high conviction on fixed income. So we’re constantly trying to optimise that over the course of time.”

Defensive stocks

The multi-asset team at Canada Life has also recently revised its equity allocation, trimming its UK exposure in favour of slight overweights in the US, Europe and Japan over the second half of 2023.

Sriharan has also pondered upping the portfolio’s exposure to defensive stocks, through the form of sector ETFs.

“We have thought about putting in defensive ETFs and by that I mean pharmaceuticals, consumer staples, which are interesting and they provide a useful narrative and are robustly defensive.

“Those defensive sectors do really well in the eye of the storm. The rest of the time, they’re also fraught with idiosyncratic issues, such as in pharma where AstraZeneca has been great but Pfizer has struggled post-Covid.

“Novo Nordisk has been this great story and we’ve held it through our European fund which has done very well, but for every Novo Nordisk there is another peer struggling and so on. So defensive sector ETFs are not a slam dunk of an idea to protect your portfolio.

“Our approach is to be pragmatic as an idea may only work for three months or six months. And what we’d rather do is gradually rotate into more defensive assets like fixed income.”

In terms of alternatives, property is a good diversifier for Sriharan. The multi-asset team invests in property through global and UK Reits. However, the team is also considering tweaking its overall real assets exposure.

“We’re looking at what the construction of a real assets portfolio may look like. The idea for which, in the first instance, needs to be diversified from bonds and equities or have some sort of correlation in between, because REITs are great when they’re working but they behave like equities which ultimately impacts our risk budget.”

This article was written for our sister title Portfolio Adviser