The Big Picture (8 Feb 2024)
Welcome to 2024 from the team at Blackadders Wealth Management…
Whether it’s the upsurge in armed conflict in the Middle East, the redrawing of the global energy-resources map or rapid progress in artificial intelligence, the world is changing! From the situation in the Middle East to the adoption of electric vehicles to the treatment of obesity, things look very different from the way they did just a few years ago, in the post-Covid era.
A new economic landscape may be taking shape. Major Central Banks around the world seem prepared to keep interest rates higher for longer. An election super cycle is about to unfold against a backdrop of elevated geopolitical risk. Simultaneously, megatrends including disruptive technology and sustainability are rapidly transforming industries.
Embracing change is never easy and it requires resilience and action to avoid being left behind, even when finding the way forward is difficult. Most investors have adapted of late to rising geopolitical risks, soaring inflation and the disruptions caused by the pandemic. Further adjustments may be necessary in a world of greater growth volatility, higher capital costs and geopolitical instability.
Overall, we believe active investment strategies, a focus on diversification and management of risk will be key to navigate beyond 2024 and deliver positive portfolio performance. We firmly believe in enhancing diversification and performance potential by considering both traditional and alternative investments. Focussing on long-term disruption from sustainability trends and technological innovation, including artificial intelligence (AI), can help position portfolios for the global economic transformation.
Every year, including 2023, brings with it many uncertainties and surprises and we seek to position portfolios so that they are capable of weathering whichever environment the market presents. In one decade after another, something big and largely unexpected has occurred: the great inflation and oil shocks in the 1970s, the disinflation of the early 1980’s, the fall of the Soviet Union and the rise of China in the 1990s, the financial crises in the 2000s and the pandemic, post-pandemic inflation and wars in Ukraine and the Middle East in the 2020s.
Generally speaking, our overriding aim is to provide real returns above inflation and cash. Over the longer term the stock market has a proven history of delivering this when looking back over the longer-term. We believe our balanced approach, seeking a return from a combination of cash flow growth and dividends, alongside a focus on quality characteristics means portfolios remain well placed whatever the future market direction in 2024 and beyond.
Over long periods, the growth in dividends matches, and often exceeds, that of inflation – suggesting that the income stream from dividend payments can be maintained in real terms. Further, we believe that paying attention to dividend-paying, and specifically dividend-growing, companies, provides something of a natural hedge against inflation.
Since the 1940s, over rolling 10-year periods to each year end, the average growth in the S&P 500 companies’ dividends per share is 4% per year. Over the same period, inflation grew at 2% (consumer price index (CPI) calculated by the US Bureau of Labor Statistics). Indeed, looking at the correlation of dividend growth to inflation over rolling 10-year periods, we can see a strong relationship overall (here is a high correlation). This shows that investing in divided-paying companies can, over the long term, provide an inflation hedge, in the sense that the income received in the form of dividends grows in line (or often at a higher rate) than inflation.
Where does that leave us and the world economy…?
In summary, the outlook is no less uncertain than normal. As investors, what matters are future earnings and cashflows, and share prices eventually reflect fundamentals. Global stock markets move with earnings and have continued to do so over the last 20+ years, despite the ‘noise’ investors have had to absorb over that time. These include the 2008 financial crisis and of course, Covid in 2020, but also the policy response to each of those events.
That said, certain factors such as climate change, technological advance and entrepreneurship are changing for the better across the globe. The International Monetary Federation (IMF) outlined that the world economy has grown every year since 1950, except 2009 and 2020 so growth seems to be an inherent feature of our economy. So, this in itself does not suggest we are moving into a significant period of global economic stagnation. Short-term noise can easily distract us from the longer-term picture despite the potential reshaping of our world.
And for global investment portfolios we manage…
We continue a collective belief that strong company fundamentals trump macroeconomic headwinds. In other words, companies which demonstrate higher than average returns on capital and operating margins combined with strong cash flow generation have a better chance of outperforming in the long run. Our focus remains on finding these high-quality growth companies which are expected to grow their cash flow under any economic circumstances.
History shows that short-term market cycles will not always be conducive to strong performance. However, as long as we believe that the companies in which we invest can create economic value and of compounding returns to shareholders, we will remain confident in our approach.
It is far too easy to concern ourselves with “short-termism” when considering longer term investment decisions. Statistics show that investing in the stock market is an excellent long-term strategy and unlikely to be surpassed by other asset classes. Cash is never King, other than for short term emergencies, immediate need requirements and despite attractive interest rates, it cannot realistically offer inflation proofed returns.
So, interest rates look set to fall this year but estimating exactly when they will be cut, represents an inefficient use of time. An infinite number of wholly unpredictable variables can affect inflation, economic growth and interest rates. Instead, we focus on ensuring portfolios can overcome today’s temporary economic challenges and remain well placed to thrive over the longer-term. Ultimately, equities offer a sustainable advantage over other key assets over the longer-term.
Looking back….
The international economy has displayed remarkable resilience. Since 2020, it has endured a global pandemic, war in Europe and supply chain chaos – which together triggered the highest inflation and most aggressive interest rate-raising cycle in decades.
As is now carved into history, 2022 was a dreadful year for investors because both bonds and equities fell in tandem. There was no place to hide in “traditional” assets, save cash. The global equity benchmark (MSCI All-Countries World Index) fell 8.1%, while the fixed income benchmark (Bloomberg Global Aggregate Bond Index) fell 15.3% (£, total return). The reason for this was that inflation expectations rose sharply, dragging interest rates and bond yields up with them. Growth expectations declined at the same time, creating a nasty cocktail of negatives for equites – falling earnings expectations and a higher cost of capital.
The path of interest rates and central bank monetary policy is a key driver of equity markets and equity valuations take their cue from bond yields. The market has essentially punished better-quality businesses whose higher valuation was predicted on a long, safe, and visible runway of profitability and cash generation. It is this sort of growth compounder that forms the core of our equity portfolios, and one could easily argue that, in the very short-term, investors have been punished for holding companies that are too high in quality.
Frustrating as this is, we would emphasise it’s a natural characteristic of the market cycle. However, the underlying businesses are in as good shape as ever. In a world of higher financing costs and where the threat of recession remains present, they are exceptionally well placed to take advantage of any downturn.
Yet, economies have adapted better than expected and that continued in 2023. In the third quarter of 2023, the world’s gross domestic product was more than 9% larger than pre-pandemic levels. Businesses re-wired their logistics, Europe weaned itself off Russian gas and higher rates did not lead to a spike in unemployment (a key recession statistic). So, 2023 has been an entirely different proposition, played out as if the pandemic had never happened and a reminder that most years turn out to be a mix of surprising and the predictable.
Overall in 2023, the global equity benchmark (MSCI All-Countries World Index) gained 15.3% (GBP), while the fixed income benchmark (Bloomberg Global Aggregate Bond Index) gained 8.0% (GBP) (both, total returns).
Thus, despite the wider uncertainties, equities saw their largest gains since 2019. For much of the year, investors were concerned with high inflation reads, the fastest rate hiking cycle on record, ongoing volatility in energy and commodity markets driven largely by the conflict in Ukraine, and latterly conflict in the Middle East. Whilst the combination of such headwinds may make the strong equity performance seem surprising, it was the emerging promise of artificial intelligence (AI) which drove equity markets higher. Namely, a handful of large-cap technology stocks, dubbed the ‘Magnificent 7’, all saw stellar gains over the year and played a dominant role in leading the index. Then, in November, a perceived dovish outlook for interest rates from the US Federal Reserve released a broad-based rally across almost all risk assets which accelerated in the final weeks of the year as recession risks diminished.
As a result, financial markets have continued their recovery from the lows of 2022. Wall Street’s leading indices neared or surpassed record highs in December 2023. Even bonds ended the year strongly. And the chance of a soft landing for the US economy in 2024, where the Fed gets inflation under control without causing recession, has risen.
Digging a bit deeper, Chat GPT became the fastest growing app of all time and the buzz over generative artificial intelligence (AI) helped to propel global stock markets. The adoption of AI by businesses in 2024 and beyond could help support productivity growth. Other innovations this year also hold promise such as Denmark’s Novo Nordisk’s Wegovy, which could help to lower healthcare burdens. Wegovy became one of the most successful drug launches of all time. After winning over patients and doctors to using its diabetes drug for obesity, Novo is now expanding access and coverage in a market where perhaps 1million people are being treated out of a patient population of 100 million in the US and 700 million globally. Novo Nordisk is now Europe’s most valuable company.
And Toyota’s progress on solid state batteries may be a game changer for the electric vehicle (EV) industry. The group have outlined they are very close to being able to manufacture next-generation solid-state batteries at the same rate as existing batteries for EV’s, marking a milestone in the global race to commercialise the technology. Solid-state batteries have long been heralded by industry experts as a potential game changer that could address EV battery concerns such as charging time, capacity, and the risk of catching fire. If successful, Toyota expects its electric cars to have a range of potentially 745 miles, more than twice the range of its current EVs, with a charging time of 10 minutes or less!
Finally, geopolitical risks are not diminishing (they have been ever present for decades in various guises). The market reaction to events in Gaza has been modest to date and the war in Ukraine is for now perceived by markets as a static regional conflict. Success in diversifying energy supplies in Europe means stable energy markets and investors have become insensitive to the risks. Nevertheless, escalation in either Ukraine or the Middle East could disrupt energy markets and supply chains, potentially rekindling inflation. Cyber security is also a growing key risk.
The recent wave of attacks on ships sailing through the Red Sea – through which around 30% of all container shipping traffic passes – has major ramifications for the shipping industry. Some shipping companies have already announced suspensions of sailing though the region, diverting ships instead around the Cape of Good Hope adding some 8 days to the journey and reduce global shipping capacity by 20%. We assume the disruption to shipping caused by maritime attacks on commercial vessels in the Red Sea will be relatively short-lived and the recent spike in sea freight prices will reverse. While there will be near-term impacts for some firms and sectors, these won’t be enough to shift our baseline economic or inflation forecasts to any meaningful extent.
That said, looking back to history once again, equities seem to be able to handle most conflicts. Over four wars starting with the Second World War, the average annualised US returns offered bigger gains during these wars than the long-run average for both large and small-caps. Likewise, US equities rose double digits, on average, during the 10 military actions they have been involved in (going back to the Spanish American War of 1898) and rose, in absolute terms, in seven of them. A CFA Institute analysis found US stocks were less volatile at times of war too. Russian equities are now above their level in February 2022. So, the analysis is positive for equities in-particular in times of stress.
Where I do see a change is in the nature of risk. Inflation and interest rates will always be important, but looking ahead we are set for more political risk. On the geopolitical side, the world must learn to live with the continuing advance of China and how to manage greater economic competition with the OECD (democratic) countries. Expect more tensions between the US, China, and Europe.
On the domestic side, the deterioration in government balance sheets means that stress will continue to rise between the aims of politicians and economic realities. This does not make me gloomy about markets. There have been many improvements in the world economy over the past 35 years (as the IMF outlined) and there are tremendous opportunities and new themes to exploit but patience is key and a long-term investment timeline. There will be ongoing ‘noise’ but longer-term, the opportunities are clear.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. The performance information presented in this document relates to the past. Past performance is not a reliable indicator of future returns. Forecasts are not reliable indicators of future returns.
