While global economic growth has continued to moderate, recent sticky inflation prints highlight that the mission of central banks has not yet fully been accomplished. Fixed income markets have relinquished most of their prior hopes for an aggressive central bank easing cycle this year, while renewed excitement over the ’blue-sky’ potential of generative artificial intelligence (AI) has propelled equity markets to fresh record highs across the US, Europe, and Japan.
With heightened market volatility, increasingly heroic valuations, and the ongoing backdrop of key political risk events that are expected in 2024, it may appear difficult to identify high conviction investment ideas at the macro level. However, we believe significant opportunities lie beneath this uncertain surface, awaiting the prudent and nimble investor. This month, we highlight tactical opportunities within fixed income, equities, and alternative assets that still offer the potential for outperformance in today’s uncertain environment.
At a headline level, the global macro-economic and market backdrop has not shifted significantly over the past month. The US economy, while moderating, continues to stand out against its developed market peers, with European growth remaining stagnant and Japan and the UK entering technical recessions. Australia continues to be propped up by population growth, with signs of softening as the impact of prior rate hikes eats into household budgets. On the other hand, China continues to face cyclical and structural challenges as it enters the new Lunar Year of the Dragon.
Meanwhile, bond markets have continued to gradually price out an aggressive rate-cutting cycle by major central banks. This has led to a back-up in global yields to levels which are now more in line with central banks’ guidance for a more modest easing in policy settings from mid-year. Equity markets have largely shrugged off higher yields and have continued their march higher, fuelled by increasing excitement over the ‘blue-sky’ potential of generative AI, headlined by an increasingly macro-relevant NVIDIA.
Looking across the major asset classes, it may appear difficult to identify high conviction investment ideas. Fixed income assets have given back some of their historic rally from Q4 2023, though they remain attractively priced and we continue to favour them from a tactical perspective. Equity markets appear relatively expensive in general and priced for a very benign outlook. This is particularly the case in the US, where there remains profound uncertainty (in both directions) around the ultimate broader economic benefits of AI.
However, significant opportunities lie beneath this surface-level view. As we noted last month (and in our 2024 Outlook last December), we believe that a focus on quality and tactical opportunism within asset classes may prove to be rewarding this year. This month, our team has run the ruler over the fixed income, equity, and alternatives complexes to uncover high conviction tactical opportunities that still offer the potential for outsized returns in today’s uncertain environment.
While high conviction ideas appear scarce at a macro level, we believe there are still significant tactical opportunities within asset classes.
Our base case remains that global central banks have reached the end of their tightening cycles and rate cuts will come later in the year, supporting lower bond yields from here. Volatility may persist in the short term, so investors will benefit from being more tactical and detailed in allocating their fixed income investments.
Domestic government bonds: Domestic government bonds have been far less volatile than their US counterparts. The Reserve Bank of Australia (RBA) has lagged the global tightening cycle, but the local yield curve remains positively sloped, and the Australian Government’s fiscal position is more sustainable than that of the US. As a result, we view the domestic market as the best place to invest in fixed income this year. Tactically, investors should look to increase duration by locking in current yields for domestic securities with maturities of four to seven years. This will allow them to take advantage of higher rates and less expected volatility.
Domestic fixed income has experienced noticeably lower volatility than in the US and remains attractive on a relative basis.
Domestic corporate bonds and hybrids: The domestic corporate bond market has also performed well this year, with tightening secondary spreads offsetting the impact of rising government bond yields. Issuers are taking advantage of tighter spreads and even offering a new issue concession, while investors are finding outright yields attractive. There has been approximately AUD 40 billion of issuance so far this year, dominated by the financial sector. The recent AUD 1.25 billion Macquarie Bank Subordinated Tier II offer received just under AUD 5 billion of demand split equally across fixed and floating-rate tranches, evidence that demand is strong.
When allocating to this sector, it is important to diversify between fixed-rate and floating-rate exposures, which should provide protection against short-term volatility. We remain broadly balanced on the ratio between the two, with the split dependent on timing, outright yields and portfolio construction. We believe hybrids are attractive for those investors looking to increase their floating-rate exposure, with initial coupons of around 7%. This has been a popular sub-asset class, with over AUD 4 billion of demand seen in the recent ANZ Capital Notes 9 issue.
Issuers are taking advantage of tighter spreads
We continue to favour locking in domestic fixed income at current attractive yields, and adopting actively managed strategies within high yield.
High yield: While spreads have compressed, high yield credit still offers attractive all-in yields, particularly if the ‘soft-ish’-landing narrative prevails. To hedge against downside risks, we favour actively managed strategies that can tilt their allocations towards the higher quality end of the high yield universe.
Global equities are now trading on a 12-month forward price/earnings (P/E) ratio of 18.5x. With the exception of the 18-month period to the end of 2022, this is the loftiest multiple that investors have been asked to pay for global equities since the tail end of the DotCom crash. At an aggregate level, this is reason enough for investors to adopt a cautious approach to buying equities. However, the notion of being ‘bullish’ (positive) or ‘bearish’ (negative) equities is one that can sometimes be flawed at certain parts of the cycle – or, at least, may not always be as relevant. While tactical asset allocation can add value over shorter time frames, there should be a tendency to take a constructive view on equities. Over the past 50 years, global equities have risen by almost 8.5% per annum, despite periods of stagnant returns and, at times, harrowing drawdowns.
In the very short term, investors should also acknowledge that once new all-time highs are reached following a bear market, forward six and 12-month returns are generally positive. The next five to 10-year period is where the challenges lie. Historically, when forward P/E multiples have been at current levels, forward 10-year annualised returns have tended to be much lower, in the order of 0-5%.
Notwithstanding our overall neutral allocation to equities, we still believe there are tactical opportunities to position for outperformance.
Small and mid-caps: Both small and mid-cap equities are trading at valuation discounts to their large-cap counterparts that are three standard deviations from their 10-year average. This relative valuation discount, along with greater potential for active management to add value in this space, provide a strong set-up for small and mid-cap allocations to outperform going forward.
Domestic equities: Having underperformed global equities for much of 2023, a more supportive backdrop for domestic equities could emerge in 2024 for several reasons: There is the potential that the RBA will cut rates (domestic rate cuts have not been as aggressively priced in by the market as in other regions); the proposed Stage 3 tax cuts should support consumer spending and domestic activity; Australia’s economic growth trajectory is one of the strongest among advanced economies; the commodities sector is proving resilient, despite a lacklustre Chinese economic backdrop; investors are already positioned for deteriorating local earnings; and the domestic market is cheap relative to global equities.
Small- and mid-cap equities remain attractively priced and offer a rich hunting ground for high quality active managers.
Japan: After 30 years of investor inertia, there is growing evidence that Japanese equities may be breaking out of their rut. The Japan thesis is not just rooted in macro-economics, there is also structural reform under way at a corporate level. Buybacks are at their highest levels in almost 20 years and shareholder activism is at record levels. Higher inflation may also be sparking a once-in-a-generation shift out of cash into real assets. Some 54% of financial assets in Japan are still held in cash, with just 12% of financial assets in equities.
A supportive backdrop for domestic equities appears likely to emerge in 2024, while Japanese equities are poised to break out of their 30-year rut.
Equal-weighted S&P 500: Analysis by Schroders indicates that, based on the current concentration within the S&P 500 (i.e., the 10 largest stocks make up 31% of the index), the equal-weighted S&P 500 could outperform by more than 15% per annum over the next five years. This could particularly be the case if the benefits of generative AI broaden out beyond the ‘Magnificent 7’.
Energy and insurance: While there has been much attention on the Magnificent 7 and the broader technology sector, investors should not forget there are sectoral opportunities elsewhere:
Pockets of relative outperformance can still be found within the equal-weighted US share market, as well as energy and insurance sectors.
Much has been reported on the opportunity set for private debt. However, compared to equities, the broader credit complex is also offering attractive risk-adjusted returns, given higher interest rates. At this juncture, we see two avenues to explore:
Having navigated a volatile period of dislocation since 2021, venture capital and growth private equity may be approaching attractive valuation levels.
Venture and growth private equity: The venture capital (VC) sector has been through a tumultuous period since Q4 2021. Net asset values (NAV) have declined around 25%, while growth equity NAVs have declined approximately 7% through Q3 2023. However, these aggregate numbers mask significant dispersion in returns across managers, as well as the excesses in late-stage VC, which saw the deepest declines. The valuation environment is, however, beginning to stabilise, with only modest declines in the last year. The fundraising and competitive dynamic has shifted to a more appropriate stance compared to pre-2022.
Tactically, the VC market remains dislocated, driving significant discounts to the VC secondary market, as shown in the chart below. This provides greater structural inefficiencies when compared to its buyout equivalent. Valuation methodologies are often opaque and there are significant information asymmetries, as well as specialised buyer knowledge and relationship factors to navigate. According to Preqin, there is approximately USD 1.4 trillion in unrealised NAV across 2010 to 2018 vintages. This follows a dearth of exit activity, which implies that the opportunity set is ripe. Broad asset level intelligence is essential to underwrite deals across VC secondaries, so manager selection is as critical as ever.
2024 will likely favour investors who are able to dive beneath the surface in the pursuit of tactical opportunities.
Financial markets have had a volatile start to 2024, and investors considering broad asset classes may struggle to find high conviction investment ideas amid stubborn inflation, record-high equity markets, and key political risk events still to come. However, we believe that significant tactical opportunities for outperformance still abound for investors who have the capability and flexibility to dive beneath the headlines and leave no stone unturned in the pursuit of their investment objectives.
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