<p>Will income and quality shine through for equity investors in 2024? Portfolio managers from our investment firms assess the lie of the land.</p><p> </p><p><a class="link-style-default link-page" href="#!/page/6572d4152f2fc4daf258ae59/1" link-style="Default" data-link-target="New tab" target="_blank" data-link-type="page"><b>Return to Contents</b></a></p>
Jon Bell, global equity income portfolio manager, Newton Investment Management
As we stand, inflation continues to be a long way above central bankers’ targets and interest rates remain at elevated levels. Despite this, leadership in equity markets has come from a narrow group of growth companies which one might have expected to underperform in a higher rate environment.
Looking ahead, we think there is an opportunity for income stocks. Valuations are low and, in a more inflationary environment, income stocks are able to raise their dividends which can help to protect investors from the impact of inflation.
In 2023 the best performing sectors were communications services, consumer discretionary and technology. This was driven by the so-called ‘magnificent seven’ tech companies following a reversal in the derating that we saw in 2022 on the back of a higher discount rate. We think the valuations of these companies are now very elevated. This is thanks in part to excitement around generative artificial intelligence but also the fact that economies have remained robust, keeping employment high and boosting pension fund contributions into passive strategies that systematically buy those largest companies.
As such, looking ahead to 2024, one of the key threats to an income strategy is that the market continues to be dominated by these companies. However, the situation now is very reminiscent of the late 1990s/early 2000s when the Nasdaq bubble burst, and if growth slows, the valuation risk in those businesses may become more obvious.
We continue to see the most pertinent macro themes being great power competition/geopolitical risk and governments playing a more direct role in economies. There is no sign of geopolitical tension abating, and that is likely to be inflationary because it results in higher levels of protectionism, localisation of manufacturing and defence spending.
In this environment, central banks will have to continue downward pressure on inflation by keeping interest rates higher for longer. In turn, this is likely to lead to slower economic growth.
Elsewhere, the energy transition is likely to be an interesting theme in the year ahead. Momentum appears to be stalling as governments are seemingly pulling back and we are hopeful that this reduced support and slower economic growth will create opportunities in industrial companies exposed to the energy transition.
Overall, to get on top of inflation in 2024 central bankers will have to keep on top of growth, slowing it potentially to the point of recession. As growth starts to slow, flows into pension funds should also start to slow which we think could lead market participants towards opportunities in the valuation of areas of the market outside the magnificent seven that led markets in 2023.
Murdo MacLean, client investment manager, Walter Scott
Over the coming year, equity markets may risk being caught in a vice between an uncertain economic outlook – as inflation continues to squeeze incomes – and elevated interest rates. We have witnessed a reset. Gone are the days of cheap money and fiscal largesse that have largely characterised central bank and government policy for the past 15 years, wheeled out at times of economic crises and calamities.
The world will have to get used to a higher cost of capital for governments and corporates alike. The ‘TINA’ (There Is No Alternative) argument has lost its lustre, with high interest rates providing a test for heightened equity market valuations in some sectors, as well as for businesses that have binged on debt.
Taking a more positive view on the equity environment, inflation has been easing, and may recede further as world economic growth slows. Although there is little possibility of a return to cost-less money, (and nor should that be welcomed), the prospect of interest rate cuts later in the year would likely rekindle the animal spirits of equity markets.
However, from our long-term, bottom-up perspective, we have another take on the opportunities arising in 2024 and indeed beyond. There are many growth trends that will endure despite near-term headwinds.
Enterprise and innovation never stop. Not just in the fields of technology and healthcare but across a range of sectors, opportunities will arise for the patient investor, whether they be in enablers of artificial intelligence (AI), or consolidators in the convenience store market.
But not all companies are equal. Against a backdrop of economic uncertainty and the reset in the cost of capital, market-leadership, the ability to adapt and innovate, strong balance sheets, good cash generation, and excellent management will be of paramount importance, in 2024 and in the years ahead.
George Dent, client investment manager, Walter Scott
Europe’s flirtation with recession and the possibility that the European Central Bank (ECB) may stick to its monetary tightening mantra, represent a potential headwind for equities as we enter 2024.
Economic indicators remain subdued, with inflation and higher interest rates taking their toll on business investment and hitherto resilient consumer spending. The financial history of the post-global financial crisis world has been one of monetary ultra-laxity and fiscal blow-outs as countries seek to avert crises. That is a policy playbook that is not likely to be exhumed anytime soon.
From a macro perspective, a potential source of good news may arise from a further ebbing of inflation in the face of slowing growth. Aside from the alleviation of the burden on consumers, it may prompt the ECB to cut interest rates, although investors should get used to the new norm of money actually costing something. Such cuts may nonetheless be helpful to equity market sentiment.
But our view of opportunity is based on a fundamental, long-term, bottom-up perspective. Despite current headwinds, many European companies remain well-placed to take advantage of enduring growth trends.
Europe remains home to many of the world’s leading businesses – companies in the fields of luxury, healthcare and technology that compete and thrive on a global stage.
But economic uncertainty lingers, and corporates are facing a higher cost of capital. In this environment, the ability to sustain market leadership through strong product offerings and by investing in the business, balance sheet strength, robust cash flow generation, and good management, will be points of differentiation in 2024 and beyond between leading companies and corporate also-rans with weak and debt-laden business models.
John Bailer, US income portfolio manager, Newton Investment Management
In November 2021, the US Federal Reserve (Fed) dropped the word “transitory” from its description of higher inflation, but for the financial markets and economy, it continues to be a period of transition as both adapt to an environment where capital is no longer free. Businesses and investors must also learn to adapt to this new investment regime.
Warren Buffett discussed an environment where money wasn’t free in his annual letters in the late 1970s and early 1980s. He noted that the winners of yesterday may not be the winners of tomorrow as companies with longer duration earnings and stretched valuations are challenged by the higher cost of capital. As such, we think there are opportunities today in companies that have healthy balance sheets, strong current earnings, and can generate free cash flow organically.
Looking to 2024, we believe opportunities could come from companies with these characteristics, which will be able to pay and potentially grow their dividends. We think this is particularly important in an environment where inflation is going to be more of a problem than in the preceding decade.
On the other side, we are cautious on companies carrying higher debt loads with near-term maturities, as they could be forced to refinance their debt at the highest interest rates in over 10 years.
For the financial markets and economy, it continues to be a period of transition as both adapt to an environment where capital is no longer free.
We are currently seeing a large dichotomy between the cheapest and most expensive stocks in the US within the S&P 500 Index. This gap is reminiscent of the late 1990s tech bubble when growth stocks experienced rapid multiple expansion fuelled by investor exuberance around the potential of the internet. This was followed by very sudden multiple contractions as investors re-evaluated the quality of the fundamentals and sustainability of valuations of many of these companies.
Similarly, we believe the higher rate environment in 2024 could see certain faster growing companies’ valuation multiples contract. On the other hand, we think cheaper stocks, which are currently trading at a discount relative to their historical average, are less likely to experience this potential compression.
In this environment, we see opportunities in financials, in particular insurance companies where there could be idiosyncratic opportunities in areas such as property and casualty, and reinsurance. These companies stand to benefit from both higher inflation, given their pricing power, and higher interest rates.
We also see opportunities in defence businesses within the industrials sector. Geopolitical risk is the highest it’s been since the Cold War and we believe defence spending will likely move higher in both the US and internationally.
One of the biggest threats for the year ahead is a potential hard landing and interest rates moving lower. Returning to a world of low interest rates, low inflation, and quantitative easing could have an impact on companies, even those with strong balance sheets.
Another concern is the market’s determination to front-run Fed policy and look too far past the current period. As such, there is a chance of a disconnect between what the market is positioning for and what the Fed actually does, which could lead to more frequent bouts of volatility.
Zoe Kan,Asian income portfolio manager,Newton Investment Management
Over the past decade a top-down view on Asia has driven an increasing exposure to China and it has become a larger, dominating, part of the region’s benchmark indices. But the tide has turned and we’re in a new regime for both interest rates and the makeup of Asia's growth dynamic. Now it's not so much about making the right top-down asset allocation calls at country level and more about the type of strategy used to access the region.
Looking to 2024, we think the long-term structural outlook for China is poor, with the property market still unwinding, unfavourable demographics and rising youth unemployment. This view has been reflected in the levels of foreign direct investment (FDI) into China. In Q2 2023 the country saw its lowest level of quarterly investment since 19981 and in Q3 of 2023, FDI turned negative with outflows exceeding inflows2. There could be more fiscal stimulus measures on the horizon, but for now it seems policymakers are taking incremental steps that are unlikely to move the needle in a big way.
1 Bloomberg. China’s Foreign Investment Gauge Declines to 25-Year Low. 7 August 20232 Nikkei Asia. Foreign investment in China turns negative for first time. 4 November 2023
As such, we think it is important to have a diversified exposure to Asia that focuses on companies that can continue to pay dividends throughout periods of macroeconomic uncertainty. However, in the new interest rate environment with extra pressure on balance sheets, working capital requirements and supply-chain diversification issues, it is important to be selective within any dividend-focused approach.
In terms of countries, India and Indonesia have both made great strides in reforming land, labour and infrastructure, and FDI is increasing in both markets, along with efforts to bring manufacturing onshore. It is difficult to decouple China from the supply chain considering its huge manufacturing clout on the global stage, but we believe India offers significant potential thanks to factors such as its long-term demographics, strong consumption and household income growth, as well as growing levels of urbanisation.
The biggest risk to the Asian region is geopolitics, both from within and externally, and 2024 is a big election cycle for the world. From an absolute risk perspective, China and Taiwan remains a key uncertainty. Given the potential repercussions of a conflict however, it is in everyone’s interest to remain pragmatic. There is also the risk of relative underperformance against the benchmark should policymakers in China implement some kind of “bazooka” stimulus and its economy starts to thrive.
On a thematic level, artificial intelligence (AI), or more specifically companies supplying the hardware for AI, presents interesting opportunities in our view. Other companies such as integrated circuit (IC) designers, for example, have cash-generative business models while IT services companies, particularly in India have capital light business models, meaning more cash from profits to pay dividends.
Elsewhere, we see demographics in Asia from ageing populations as being supportive for income strategies because as people grow older there is a higher need for income in retirement.
Overall, as we look to the year ahead, we think it is companies in Asia that have strong balance sheets and generate cash to pay dividends that present opportunities – those with business models that we believe are most likely to be fit for the future, with good moats surrounding their businesses. We also believe in the key role we think dividends play in the total return for any investors in Asia.