Which sector is poised for growth in 2024?

At the start of 2023, China was the place to watch. Its rapid reopening after Covid would fuel a consumer boom, revive corporate investment and bring renewed vigour to its economy. At the same time, there was talk of the end of the ‘FAANGs’ trade. A rare run of weakness had led some to the hasty conclusion that megacap technology had had its day. The year did not work out like that: China has slumped, while AI has powered US technology stocks to new highs.

It was a valuable lesson in the fallibility of investment predictions.

Nevertheless, there are some opportunities for the year ahead that cannot be ignored. The first is the yields available in the bond market. While yields have moved marginally lower over the past month (and prices have risen), yields of 5-6% are still commonplace on high quality investment grade bonds*, and 4-5% on development market government bonds**.

This combination of a higher income and some potential for capital growth if interest rates start to fall is likely to have real appeal for investors. The only potential pitfall could be the possibility of a revival in inflation. How likely is this scenario? Inflation has been coming down quite dramatically in the past few months, and yet growth remains strong. Should we believe this ‘Goldilocks’ scenario? Or could inflation re-accelerate as growth picks up?

Richard Woolnough, manager of the M&G Optimal Income fund, argues that inflationary pressures have weakened considerably. “Central banks have a non-monetary framework. They believe that if the supply of labour, energy or microchips is reduced, the price goes up –– but if you increase the supply of money, its price doesn’t change. If you increase the supply of something, its price goes down and that’s inflation.

“Now central bankers are going the opposite way. They are cancelling the money, reducing the supply and it’s deflationary. All supply chain bottlenecks are gone, so we now have less money, chasing more goods. That does not sound inflationary to me. Will they keep destroying the money? If they keep destroying money, it will reduce inflation, and if they destroy too much it will be deflationary. Monetary policy operates with a lag. Maybe the surprise inflation numbers are because they started destroying the money 18 months ago.”

Asymmetric risks

If a revival in inflation is unlikely, it would be a good environment for bonds, particularly bonds with plenty of interest rate exposure. That would be developed market government bonds, or high quality investment grade, and longer duration bonds. Central banks remain vigilant and continue to warn of immediate action if inflation starts to spike higher, but there is also an acknowledgment that not all the rate increases have yet been reflected in the economic data.

Equally, the risks are asymmetric. Rates may go higher, but not much. They could go an awful lot lower if there is a catastrophic scenario, where the impact of rate rises hits progressively harder. On balance, and with high yields on offer, fixed income appears a natural hunting ground for the year ahead. Richard concludes: “When rates were near the zero bound, you needed a really good reason to own a bond. When you’re near the ceiling, you need a good reason not to own a bond.”

Mike Riddell, manager of the Allianz Strategic Bond fund, goes one step further, believing that a ‘hard landing’ for the global economy is a plausible scenario and, on balance, rates are likely to be cut in 2024. He attributes recent stronger growth to weaker commodity prices and a consumption boom in the US, but believes neither will sustain growth looking forward.

He says: “The reason growth has not weakened yet is not because economies are immune to rate hikes, but because of the lag effect. For example, corporate debt is highly elevated and will need to be refinanced. Debt is on government balance sheets and non-financial corporates. It may ultimately need to be refinanced at 7-8% … the tide is going out and there is a lot of leverage still in the system.”

In this environment, bonds could provide an important defence against weaker equity markets.

Cool Britannia?

The other area to watch in the year ahead may be the UK. The UK stock market has had a number of false dawns. There is a temptation to see it as some kind of new-model Japan, with weak growth, sclerotic politics, and dull, unlovely companies with little to excite investors. This negativity is now reflected in the price of the UK market – and may have gone too far. 

The UK mid and small cap sector has been particularly hard-hit and is already pricing in a recession. Research from AXA Investment Management shows that the UK market as a whole is trading significantly below its long-term average, while the US market is well above its long-term range. However, UK mid-caps stand out, trading below the 90^th percentile of their historic average. In other words, they have only been cheaper around 10% of the time***. 

Chris St John, manager of the AXA Framlington UK Mid Cap fund, says: “The UK stock market is trading at a material discount to its long run average, inflation is falling, and interest rates have probably peaked. Provided the ongoing conflict in the Middle East does not expand to involve other nation states, a supply shock seems unlikely and with economic demand slowing, as a result of elevated interest rates, a sustainable re-acceleration of inflation also seems unlikely. 

“UK businesses will continue to be the target of takeover activity, given their market positions, long term prospects, and valuations. At times of heightened risk and uncertainty, it is easy to focus exclusively on the macro and geopolitical news flow and lose focus on the fundamental drivers of profitability and cashflow at the corporate level.”

There is still a question over the catalyst that draws investors back to the UK stock market. After all, equities can stay cheap for a long time. However, there are a number of stars aligning: economic performance has steadied, while the imminent election may bring more stability to the UK’s volatile politics. There are a growing number of merger and acquisition deals amid smaller companies, but a couple of big deals for major UK companies could remind international investors of the value there.

Others UK portfolios with exposure to mid-caps worth considering include Schroder Income Growth and the abrdn UK Mid Cap Equity fund, managed by Sue Noffke and Abby Glennie respectively. While those preferring a multi-cap offering, with exposure to mid and small-caps, might consider the IFSL Marlborough Multi Cap Growth fund, managed by Richard Hallett.

At a time when the economic outcomes are still uncertain, investors can be reassured by value. It is not a time to pay elevated prices for companies where expectations are high and outcomes unclear. With the caveat that investment predictions are fallible, fixed income and the UK market, particularly its mid-caps, seem to offer significant value for the year ahead. 

*Source: S&P Global Developed Corporate Bond Index, as of 30 November 2023

**Source: U.S. 30 Year Treasure Bond, as of 30 November 2023

***Source: AXA IM, September 2023