A new year, a new perspective…
We start the new year with gusto, but with a stark reality check, casting our sights on World affairs and outlining the global risks clearly evident. The war in the Ukraine trundles into its third year and with no sign of closure, remains a threat to the status quo of the European Union and indeed the NATO alliance. Any escalation could have dire consequences on the human and macroeconomic side. The attack on Israeli citizens by Hamas and the subsequent invasion by Israel of the Gaza strip razing it to the ground, has the potential to severely escalate conflict in the wider Middle East. The long admired decade of growth of the Chinese economy has halted and the current macroeconomic & property market correction in the World’s second biggest economy is currently disrupting global trade as Chinese citizens adapt to their new macroeconomic climate. Speaking of climate, the ever increasing threat of climate change culminating in 2023 being the hottest year on record globally, will continue to drive changes in food production, energy consumption and population movement and finally, we have the imminent US election with the very real possibility of Trump being the next US president with all “that” entails….. let’s see how it all plays out throughout the course of the year. Some of the headline data which we track is shown in the table below.
|US 10 Year
Looking back in December, we see that EU annual inflation ticked up slightly from 2.4% to 2.9% in December which was mirrored in Ireland with an increase from 2.5% to 3.2%. Underneath, we see that although energy prices did by in large decrease. The big increases were observed in the food & beverage(5.6%), recreation / culture (10.3%) as well as restaurants & hotels (6.6%) sectors. Once again Belgium showed the lowest inflation at 0.5% while Slovakia the highest at 6.6% for the same period. In Ireland, this jump was higher than the European average from 2.5% to 3.2%; the biggest contributors being the higher rates of price increases for food, transport, recreation and hotels.
It’s fair to say that while the current interest rate policy is having an impact on inflation, it’s is also very fair to say that we are not done yet as evidenced by the slight uptick during the festive holidays. Core inflation is notoriously difficult and stubborn to get back under control & Christine Lagarde’s team is cognisant that any changes in the reduction of the interest rate from 4.5% at this stage may only serve to rekindle the inflationary ambers forcing us all to re-tighten the preverbal belts once again for another 18 months. More time is needed…they don’t want history repeating.
Across the pond in the US, we also saw inflation increase, though at a lower rate from 3.1% in November to 3.4% in December. Although not ideal, it should be encouraging to the Federal Reserve interest rate policy makers that their policy of 5.5% interest rates is actually working (bumps along the road aside). US inflation in December 2022 was 6.5% and so with almost a 50% reduction in 12 months, it’s fair to say that the slow grind to bring inflation under control and closer to the 2% target, will become exponentially more difficult and sensitive to the afore mentioned global threats, most notably in energy commodities.
Like European Central Bank rates, US rates have remained unchanged, however, I would suggest the markets did misinterpret (or ignored) FED president Jerome Powells comments at the very end of last year and in anticipation of rates falling, led to a rally in US equities (S&P 500) which allowed them to finish the year with a return of at 21.3% in Euro terms. Even more amazing was the performance of the tech heavy NASDAQ which finished up 56.2% in USD terms.
While great for investment portfolio’s yearly performance, it is a sign of pent-up energy within the market to re-allocate investment capital, something which must be viewed with a note of caution. In January, when the realisation occurred in the market that actually the battle for control of inflation was not yet over, interest rates were unlikely to be reduced as early as anticipated, we see a bond sell off.
While the US 2 year treasury has hovered at the 4.3% level, in January, the 5, 10 and 20 years treasury yields have increased to 4.04%, 4.14% and 4.48% respectively. This represents a sell-off in the treasury market which is likely to be an interpretation that markets are now re-assessing their original thesis of six rate reductions in 2024.
As I mentioned in the December note, both the ECB and Fed expressed their desire to hold interest rates higher for longer, as inflation approaches the 2% mark. While it is entirely plausible that we could indeed see rate cuts in 2024, it is not guaranteed, and a fair assessment would be not to expect those cuts to be implemented until later in the year when there is robust inflationary data signalling the desired trend is being achieved.
So, with the transformative change in the risk-free rate having now moved to stage two, we continue to see Short dated bonds paying a higher yield than the average dividend yields for stocks, (4.34% versus 1.5% in the US and 2.1% globally) and that being the case, any future yield drops in bonds, should produce a capital return for short dated bond portfolios.
Looking at oil prices now, we are hovering around $78 per barrel mark compared to an average price per barrel of €82 through 2023. Oil is a globally traded commodity and the afore mentioned global threats here include the war in Ukraine but also the Israel’s invasion into the Gaza strip and all that that brings. I mentioned last month that Iranian backed Somali Houthi Pirates now threaten the Red Sea causing the major shipping companies to halt transportation or re-route around the horn of Africa causing delays to already tight delivery timelines. Hence, the heavy US presence and making that presence felt. Not having access to the Suez Canal is a major headache for global shipment providers as costs will increase. While the oil price has not moved that much since the invasion, the lack of significant movement is likely attributed to the current inventories and the re-negotiation of alliances on the supply side.
Setting macroeconomics aside, what does all this mean for investors?
Well, 2023 delivered positive returns across most markets and all those we track and consolidated into global equities which returned 19.5% in Euro terms. We saw some outperformance in US equities which delivered 21.3% and significant outperformance in the technology sector which delivered a staggering 59.4% in USD. European and Japanese equities delivered positive but more modest returns of ca. 16% in Euro terms, not bad though considering the European power house (Germany) is on track to hit a possible two year recession.
Looking forward, we are seeing forward price / earnings ratios (one of our measures of value) continuing to move away from long term averages with global equities trading at 17.3 times (increased from December), European equities at 12.6 times, with Japanese equities bucking the trend trading at 13.8 (reduced from 14.4 in November) and US equities now trading at 19.4 times their forecast earnings. While US equities valuations fell from the first half highs of 2023, they are starting to rise again and a correction on the US market wouldn’t be surprising given the current macroeconomic data and interest rate policy stance.
The long-term forecast for growth in global stocks has stabilised at to 10.5% with a slight reduction in the average yield of 2.1% from 2.2% in December. This puts the equity risk premium which is the Forecast growth – the risk-free rate, at ca. 6.2%. However, current conditions still continue to also drive fund flows into the money markets which are currently yielding ca. 3.9% and which are now a component of many portfolio’s.
As always, we take the long view on Investments and are happy with globally diversified portfolios. In today’s (relatively) high or normal interest rate environment, we see slightly less fair value across global equities with (fPE’s at 17.3) in comparison with early 2023, where valuations averaged 16.6 times across the year. While the markets have started on a positive note so far this year, I would suggest that as the Central bank’s Monetary policies unfold throughout the course of the year, we can expect to see volatility in those capital markets and it is imperative in these times, that the investment objective guides the asset allocation.
Our view, on global bonds has also remained as per last month. As mentioned, the US 2 year treasury is yielding 4.34%, which is attractive when compared to the average dividend yield of 2.1% for risk assets and slightly more attractive than some money market funds which are also paying the 3.9% yield but with the advantage of higher liquidity. Therefore, with bond yields at current levels, and interest rates probably plateaued but set to change, this asset class continues to look a more attractive investment, than in recent years.
Our cautious view on lower volatility portfolios continues to be implemented through the use of money market funds, currently yielding ca. 3.9% and hedge fund positions to exploit market inefficiencies; all in all, providing some degree of protection in the current volatile climate.
Sources: Central Banks: Federal Reserve, ECB, CBOI, Sharepad®. Euro Inflation is measured by the Harmonised Indices of Consumer Prices (HICP). Periodic Market updates & reading materials from Vanguard, Bloomberg, Ruffer, Davy Select & others depending on subject matter. All views and details contained are for information purposes only, are subject to change & are not advice. We recommend you seek independent clarification for your particular circumstances. Lifetime Financial Planning makes no representations as to the accuracy, completeness nor suitability of any of the information contained within and will not be held liable for any errors, omissions or any losses arising from its use.