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The most profitable point to invest in duration is when the Fed stops raising rates.

  • Monday, December 4, 2023

The USA continues to drive the global economy and across leading economic indicators, the US shows the clearest signs of expansion and current levels of growth above trend. This expansion has been led by improvements in consumer sentiment, rising new orders and a robust labour market despite a recent dip in new job openings. GDP growth in Q3 was 4.9% and as the US economy moves further into an expansion phase, growth will continue above trend. We have therefore further increased our allocation to US equity as markets are expecting an economic recovery and the US is especially well placed. We have holdings in US large cap corporations, the S&P 500 index, and US tech stocks.

With inflation now falling significantly, central banks are likely to have hit the peak of their policy tightening. This is particularly true of the UK and Europe as the economies could do with an easing of interest rates.

In the UK there are signs of improving consumer confidence and manufacturing activity. Attractive equity valuations, earnings improvements and the unloved nature of UK stocks should see improvements in UK markets in 2024. UK inflation has reduced to 4.6% and expected to surprise on the downside. Interest rates are likely to have peaked and rates expected to fall from Q2 2024 so mortgage rates and borrowing cost will reduce. The FTSE 100 index is well placed to benefit from global growth and the FTSE 250 benefit from internal UK improvements.

The Eurozone has continued to decelerate with weakness in consumer sentiment, housing surveys and under performance in manufacturing. Likewise, the underperformance of China is wide spread, but the housing and manufacturing sectors have been impacted most. The easing of monetary and fiscal conditions is expected to result in improvements in the property and credit markets.

We have in the past raised our allocation to Japanese equities. The Japan funds have done well even after the ¥ to GB£ currency conversion. We will continue to support the Japanese stock market; however, it is possible that the Bank of Japan (BoJ) could raise interest rates from its current -0.1% as Japanese inflation is now at 3.3%. If this happens the ¥ will strengthen. Japanese equities have shown a strong performance this year but this has been driven by a weaken ¥.
We have raised our exposure to select emerging markets particularly India and have also invested in emerging market bonds as returns are attractive.

Markets that are expected to grow above trend are US, UK, Japan, and Emerging Markets. We have therefore either maintained or improved our allocation to these regions while Asia Pacific, China and Europe have been reduced.

As far as credit markets are concerned, over the next year we can expect interest rates and bond yields to fall so bond prices to recover and offer attractive returns. We are at a point where fixed income yields are offering good value compared to other asset classes. If UK inflation now surprises on the downside falling rates and yields will drive a price recovery.

We have moved from inflation linked bonds to conventional bonds as inflation is on the decline. We have increasing duration over our fixed interest holdings. Government bonds and investment grade credit should do well in the year ahead. Historically, the most profitable point to invest in duration is when the Fed stops raising rates. US treasury yields are strong but expected to decline providing capital returns that are enhanced on duration.

The outlook on property is mixed. The falling demand for office space and therefore yield is a headwind but the fact we have likely now reached peak interest rates, despite tightening credit conditions should aid the sector. Property funds have endured significant falls over the past 18 months but there is an expectation that real estate equities can start to recover. We have maintained our investments in infrastructure but reduced our property holdings due to reduced occupancy hitting demand.

Cash deposit rates are currently attractive so we have retained a full allocation. Government gilts and investment grade credit should benefit from falling interest rates. Gold and commodities are expensive and we have not included these assets in our portfolios. US, International, UK, emerging markets and Japanese equities are either maintained or improved while Europe, Asia Pacific and China are underweighted.

One reason to expect a slowdown in economic activity is that of a reduction in money supply. This will be the result of high interest rates and quantitative tightening that central banks have actioned over the past 18 months. Inflation remains a key indicator and central banks will continue to assess whether they have done enough to bring down and keep down inflation.

With a halt in rate rises from the Fed, ECB, and BoE there is a collective belief that rates have peaked and that the first-rate cut will occur in Q2 2024. Given the expected fall in interest rates then lending and money supply should improve. Stock markets have already looked beyond any slowdown to a falling inflation and falling interest rate environment.

The recent improvements in equity and bond prices are typical at the start of an economic upswing. Financial markets are anticipating a recovery that is yet to occur and so could lead to disappointment.

We believe that the global economy is decelerating which brings risk. However, over the next 6-12 months, we expect some central banks most notably the ECB and Fed to start easing which will help markets recover.

We have balanced our style risk between both value and growth and blended active and passive funds to access markets. Overall, the expected returns on gold and commodities are negative while cash, corporate bonds, government bonds, equities and real estate are positive.

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Chris Davies

Chris Davies

Chartered Financial Adviser

Chris is a Chartered Independent Financial Adviser and leads the investment team.

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