Q1 Market Review

We entered 2024 on the back of a strong last quarter of performance. Inflation all around the world was on a downward trajectory and we felt that the ‘peak’ of interest rates had been reached. Despite the anticipation at the start of 2023 that the global economy would be fighting a recession, most major economies had managed to avoid it and were looking quite resilient, particularly in the US, which has a significant influence on setting the mood for investment markets.

A quarter on and the story remains largely the same. The world’s largest economy (the US) continues to show little sign of slowing and is supporting global equity markets as they gain confidence that a significant economic problem isn’t round the corner. At the same time, despite European economies being decidedly weaker, and the UK now in a technical ‘recession’ (defined as two negative quarters of GDP), we haven’t seen anywhere near the blow ups that were expected as a result of interest rate rises (up 5% in 18 months). The UK housing market is a good example of that, with data from Halifax, Bank of Scotland and Nationwide showing house prices fell somewhere between 0.6% and 4% between June 2022 and the end of March 2024. When you compare that to average forecasts of between 10% and 30%, it paints a picture of how much better things have been compared to expectations.

At the same time inflation has continued to fall progressively. The UK has lagged its global peers consistently across the last 18 months, though we are now right in the pack with an annual rate of 3.4%. There has been really good progress in this respect across the last three months, and as we will outline in our outlook, we are expecting that trend to continue, and that should therefore benefit our portfolio’s.

From a market point of view, although the trends are positive, if economies run too hot, then Central Banks can be fearful of cutting interest rates too soon (they don’t want to then do a U turn and revert to increasing). It is not a surprise therefore, that as we have progressed through the quarter, and data has remained good, the number of interest rate cuts that were forecast have been revised down. This has led to a volatile period in fixed income markets, albeit after a very strong run in Q4 2023.

From a stock market perspective, falling inflation and a strong consumer is good for earnings. Just as forecasted interest rate cuts have been reduced in number to counter the resilient data we have seen, stock markets have benefited via a positive revision of expected corporate profits.

In summary, coming into the year markets were expecting interest rates to be cut to below 4% in 2024, whereas now they are expected to end the year around 4.5%. Company earnings were expected to increase by a mere 5% this year, whereas now 12% is expected. All in all markets are now pricing interest rates to stay “higher for longer”, inflation to settle between 2% and 3%, and economies not to head into recession. This is generally good news, though things still need to play out this way.

Against this backdrop in Q1, equity markets have had a strong start to the year. The MSCI World and FTSE 100, which represent reasonable proxies for global and UK equities, are up 10.07% and 3.99% respectively. There have been better and worse areas to be invested in, though most geographies and sectors are positive for the year, the standout being anything technology related with money flowing to try to get ahead of further AI developments.

Bond markets have had a tougher time, as the expectations for lots of interest rate cuts have started to be rolled back. UK gilts for example are down around 1.5% so far this year, with corporate bonds fairing a bit better and finishing around flat. It is a quarter that has suited.

Higher risk portfolios over lower risk therefore, albeit all have delivered a strong result in absolute terms and built on the results of last year.

Q1 Portfolio Review

We came into the year positively. We thought valuations looked quite attractive, markets were worried about several issues (inflation and recession) that we felt would improve as the year progressed. In addition, our strong underlying income yield remained in place, and that would support our portfolios in most scenarios. Despite this, over Christmas and New Year, we reduced our exposure to bond markets which we felt had got a little carried away with interest rate expectations and had performed very well in the fourth quarter. We added to some equity ideas where we had conviction.

The portfolio range returned between 1.16% (Very Low Risk) and 7.91% (High Risk) in the first three months of 2024. The higher risk portfolios naturally benefited from a larger equity allocation, with the bond allocation in the lower risk portfolios tempering the returns delivered (albeit to a lesser extent given our reductions). That said, in many ways we were happier with the results in the lower risk portfolios, with the DB Wood Fixed Interest bucket up 1% over three months despite most bond markets being down. Being able to deliver a positive outcome in a challenging environment for the biggest asset class is a testament to the activity conducted across recent months as well as the performance of the individual funds chosen. It also leaves those portfolios in a great position should inflation fall quickly, which remains our central case.

Relative to benchmarks it was another good quarter as well, with average outperformance across the risk profiles of 1.77% in just three months. Anyone can do a good job in a single short period, though it is much harder to do that repeatedly and deliver a great long-term outcome. More pleasing than just the recent history is that it adds to a number of years of comparably good results. Using our largest portfolio, Low to Medium Risk as an example, over 5 years we have now delivered a return 8.8% higher than the average comparable benchmark.

After average planning and platform costs that’s now a five-year return outcome of 3.4% per annum, compared to 1.7% for the benchmark average on the same basis. Our target return for Low to Medium Risk has historically been 4%-6% per annum, so although we are still below target, we are starting to converge back towards it. When you take into account the fact we’ve had a global pandemic, war in Ukraine, 10% inflation and the fastest increase in interest rates in many decades, the outcome could certainly have been different, and happily comparative to our peers, we can show significant outperformance.

Overall, we are pleased with the results delivered in the last few months, especially so in the lower risk portfolios given it has been a difficult quarter for lower risk assets. When added to the returns delivered in recent years, we are starting to see client outcomes get back to our targets, and we remain substantially ahead of our peer group. In addition, despite the positive outcomes in the last 6 months, we remain cautiously optimistic heading into the remainder of this year and beyond.

Market Outlook

Economic theory would tell you that economies and markets move in cycles. At some point there is a boom, followed by a bust, then a recovery, and then a boom again. The job of policymakers, and in particular those that set interest rate policy, is to try to smooth that journey. In periods where economies are improving and inflation is rising (such as after Covid), they will raise interest rates to cool things off. Similarly, when economies head towards recession they reduce interest rates to stimulate spending and investment, helping to fuel a recovery.

Investment markets follow this with keen interest. They want economies to be doing well but inflation to stay relatively low. This is a very difficult balance in practice, but one that prior to the last four years, was achieved with some consistency. It is referred to often in the press as “goldilocks”, as it represents an ideal backdrop for investment returns.

Generally speaking, policymakers have done a reasonable job at cooling everything off in this cycle (they didn’t help by fuelling inflation in the first place but that’s for a different blog!). Interest rates have moved from close to 0% to 5.25%, and as noted before, the fallout has been muted. Even here in Europe where we currently have mild recessions, we haven’t seen an uptick in unemployment or any contagion, and inflation in all the developed economies is slowly closing in on Central Bank targets of 2%.

So, looking forward, the market backdrop looks positive. We have reasonable economic conditions and lower inflation, which should continue to help portfolio values. The concerns that dogged markets through 2022 and much of 2023 were around where inflation and interest rates would peak, and this looks behind us for now.

As always there are risks to watch. Those that are known are mostly geopolitical, with more people heading to the polls this year than in any year in history. A key factor in those elections will be foreign policy, with factors such as the US’s relationship in China and the future of the Russian war in Ukraine in particular important. We have no edge in anticipating what will happen there, but we are already thinking through the various ways it could play out and what we will do in each scenario.

We also continue to consider the possibility that the real effects of the interest rate changes are yet to be felt, and that economic growth could significantly slow from here. Based on recent data that is looking less likely, but at a time when markets are discounting it completely, we are watching carefully. Our central case remains for economies to provide slow though improving growth against a backdrop of falling inflation. In this environment, we expect our portfolios to perform well, especially at the low risk end.

Conversely, the opposite is also true, in that if economic growth is too strong too soon, we could see further delays in interest rate cuts to offset the possibility of inflation rearing its head again. Just like 2022, this would be a challenging environment for all asset classes, and so even if we think the probability is low, we again have to be alive to it. This scenario is a concern, though because we know inflation will come down over the coming months, we have some time before this problem gains momentum. We are again already thinking through how we would position if this scenario became more likely.

Excluding those factors and any unknown changes, the environment should continue to be supportive of returns we have seen in the last quarter. Bond returns should be better from here as they have now repriced the number of future rate cuts, and equity markets would likely see continued growth, albeit not necessarily a repeat of this quarter. Steady and improving economic growth and low inflation is our central case, and with portfolios still providing income yields of between 4% and 6.5% per annum, we’ve got an underpin that should continue to drive positive returns.

All put together it feels to us like a solid backdrop and one that is supportive of good returns. We will of course remain diligent and are cognisant of the risks and their ability to change direction.