Frayed Expectations

The past year again confirmed that investors are compensated for taking on risk. Looking back, 2023 turned out to be an exceptional year for equities. In US dollar terms, the MSCI World global stock market index closed the year up 24 percent, fully recovering the previous year’s losses caused by central banks imposing a restrictive monetary policy.  

Faced with its array of economic and geopolitical uncertainties, 2023 was not an easy year for investors. The full effects of tightened monetary policy on economic and inflation trends were, and remain, unclear both in terms of their extent and the pace at which they will unfold. Adding to the general disquiet were some worrying events in the US and Swiss banking systems last March, Russia’s ongoing invasion of Ukraine and the explosion of violence in the Middle East in October. In addition, until mid-year, the stock markets themselves were largely being driven by a one-sided development powered by the AI hype and the outsized influence of a group of major tech stocks, the so-called “Magnificent Seven”. 

Investors who recognized the risks of this lop-sided market and underweighted equities, or who reduced their exposure to the expensively valued mega caps within their equity allocation, had to accept some underperformance. A similar situation transpired with bonds. Although they suffered from the high level of uncertainty on the interest rate outlook and corresponding high volatility until mid-October, they then staged a late but energetic rally when the markets began to price in an imminent Fed policy turnaround towards lower interest rates. 

As a result, in hindsight, investors fared best with simple exposure to broad equity and bond market indices without the targeted management of specific risks. Accordingly, the simple sixty/forty portfolio formula, which was declared dead in 2022, experienced a stellar revival. We regularly compare the performance of multi-asset portfolios of various banks and asset managers with the sixty/forty benchmark and not one of them managed to outperform sixty/forty in 2023. On the contrary, the median of both groups lagged far behind the sixty/forty formula. 

We do derive some satisfaction, given the year’s abundant uncertainties and mixed outlook, that we maintained our neutral equity allocation throughout 2023 while gradually increasing our allocation to fixed-income investments, a positioning that enabled us to participate in the rallies in both these asset classes. That said, in aggregate, through the portfolios of the equity managers we work with, we also underweighted the tech heavyweights. 

Despite moving from an underweight to a neutral equity allocation in December 2022, the extent of the stock market rally in 2023 surprised us. Nor did we fully anticipate the resilience of domestic demand in the major economies, particularly the continued strength of US consumers. In the end, we didn’t experience the economic watershed moment we had predicted in our previous issue of MFO Investment Outlook, even though the growth trend of the major economies continues to gradually decline. 

In 2023, we were once again reminded that our capacity to make forecasts is limited. And we were also reminded that, in the long run, the fundamental investment verities – investment discipline, diversification and data-driven portfolio adjustments – are more effective than discrete portfolio bets based on confident but all too fallible predictions. In this spirit, we will spare you the usual round of predictions for the New Year. Instead, we encourage you to think concretely and strategically about what you want to achieve in the long term.

1.1            North America

• Despite signs of slowing activity, the US economy again exhibited surprising resilience in the second half of 2023. In Q3, the US economy expanded by 1.3 percent over the quarter (or 5.2 percent annualized) mainly driven by robust consumption growth, but also helped by investment demand and government expenditures. 
• Toward year’s end, the economic picture looked mixed but there were signs of stabilization in composite business confidence and consumer sentiment surveys despite headwinds in the form of waning savings buffers, a resumption of student loan payments and the increasing pass-through of higher interest rates. Consumption continued to hold up better than expected, but, in our view, still looks unsustainably strong.  
• The labor market continued to cool but, on balance, remained tight, with the number of vacancies exceeding the number of unemployed persons. The three-month moving average of the national unemployment rate rose 0.3 percentage points above its minimum of the previous 12 months, thus evading the so-called Sahm Rule, named for former Fed economist Claudia Sahm, who observed that since 1970 a recession kicked in when this data point rose above 0.5 percentage points. The growth of job openings slowed further but, at 5.3 percent year-over-year, it remained above pre-pandemic levels. Hourly earnings growth continued to slow, too, reaching a still robust 4.3 percent year-over-year in November. Given the faster decline in consumer price inflation, which fell to 3.1 percent year-over-year in November, households benefited from real wage growth. 
• Business activity remained split between sectors in Q4. Purchasing manager indices suggested a beginning contraction in manufacturing activity and a modest but increasing expansion in services in Q4, which continued to benefit from elevated domestic demand. 
• The uneven sector performance is mirrored in the evolution of inflation rates, as the prices of commodities excluding food and energy have been declining since last June, whereas price inflation for services remained clearly elevated compared to historical norms, with the average of the last three monthly readings still north of 5.5 percent annualized in November. Against that backdrop, the Fed’s most recent communications, which accompanied its decision to keep policy interest rates unchanged at 5.5 percent, sounded stunningly dovish. Especially given the rally in financial assets that preceded that decision, we would have expected the Fed to lean against the looser financial conditions priced in by financial markets.  

1.2           Europe

• Europe remained the global laggard in Q4 in terms of economic activity. After already contracting slightly in Q3 thanks to shrinking capital expenditures, the latest data suggests the Eurozone economy likely continued to weaken in Q4, thereby meeting the technical definition of a recession – two consecutive quarters of contraction.   
• Entering Q4 2023, industrial production fell while purchasing manager indices continued to signal slowing business activity in services and manufacturing. Consumer confidence also remained below its historical average despite the support of persistently high demand for labor and continuing disinflation. 
• The retreat from the high consumer price inflation rate accelerated in the autumn and the latest data surprised to the downside. Month-on-month, consumer prices fell by 0.5 percent in November, which helped the headline and the core inflation rates decline from 2.9 to 2.4 and from 4.2 to 3.6 percent, respectively, year-over-year for the month. 
• Nevertheless, despite the much weaker economic situation, faster monetary policy transmission and accelerated disinflation, the ECB did not echo the Fed’s dovish tone in December, with ECB President Lagarde energetically refuting that interest rate cuts had even been discussed. But, in our view, the signaled policy pivot by the Fed will facilitate a similar move from the ECB since the Fed’s actions will likely contribute to tighter Eurozone monetary policy conditions by strengthening the euro versus the US dollar, which would in turn dampen demand for European exports and lower import price inflation. We think the ECB would counter these effects by also lowering interest rates, or at least signaling that such a move is being considered.  
• The Swiss economy is also expected to remain sluggish in the coming months and to expand at a below-trend pace, given restrictive financing conditions and lackluster external demand. The Swiss manufacturing sector and external demand have remained weak, which is dampening investment demand, while the services sector and consumption have continued to expand. 
• Consumer price inflation continued to fall further below the critical 2 percent threshold, down from 1.7 to 1.4 percent in November, and the Swiss National Bank projects inflation to remain just below the level consistent with price stability over its three-year forecasting horizon, despite some expected fresh upside pressures in the first half of 2024 from higher rents, electricity costs and an increase in the VAT, which rises from 7.7 to 8.1 percent in the new year. 

1.3            Asia and Emerging Markets

• Emerging market economies continued to outperform their developed market peers in economic terms throughout Q4 2023. The EM Composite PMI remained in modestly expansionary territory in November thanks to expanding activity in both the manufacturing and the services sectors. As we see elsewhere, the services sector is exhibiting a more dynamic development in comparison to the sluggish growth in manufacturing. 
• Among the BRIC economies, India kept its leading position. And Indian purchasing manager indices signal a solid expansion of business activity in the months to come, while consumers have turned increasingly optimistic, too, with consumer confidence climbing above pre-pandemic levels in the autumn. 
• Lacking the deep pockets of their developed peers during the pandemic, EM economies avoided the pitfall of fiscal overstimulation and the subsequent problems with inflation, although Russia, with its overheated wartime economy, remains the exception here. Accordingly, EM economies mostly did not have to tighten monetary policy to a comparable extent as developed peers. In some cases, even the contrary was the case. The People’s Bank of China, confronted with its troubled real estate sector and persistent economic weakness, has kept policy rates at a historically low level.  
• Russia has increasingly switched to a war economy, which is leading to signs of overheating. After shrinking by 2.1 percent in 2022, Russia’s GDP expanded by 5.5 percent year-over-year by the end of Q3 2023, driven by a massive expansion of capex and a pickup in consumption growth. This has largely been driven by high military spending and subsidized lending, which is mirrored in growing budget deficits of the Russian government. The labor market is tight, and the unemployment rate has fallen to a historical low as a substantial fraction of the labor force has been enlisted to fight in the war. As a consequence, countering the deflationary trend in China and the disinflationary trends in the large, advanced economies, Russia’s consumer price inflation accelerated rapidly in 2023, reaching 7.5 percent year-over-year in November after a low of 2.4 percent year-over-year in April. 

2.           Financial Markets

2.1           Equities

• Christmas came early for equity investors in 2023 and Fed Chair Jerome Powell starred as Santa Claus. The initial trigger for the year-end rally was a fairly dovish Fed press conference at the beginning of November, which, combined with a milder than feared Treasury funding plan and soft economic and inflation data, helped propel equities higher. The final gift arrived in mid-December when the Federal Reserve indicated that three rate cuts were expected in 2024, sparking another spurt in the year-end rally and bringing equity volatility back down to pre-Covid levels. 
• The year-end rally was particularly impressive for stocks that had not done well for most of the year. The equally weighted versions of the MSCI World Index and the S&P 500 Index were flat to slightly negative at the end of October but finished the year up 16.7 percent and 13.2 percent, respectively. Stocks listed in the Russell 2000 Index enjoyed the steepest climb. After being down 4.5 percent through the end of October, the index rallied nearly 22 percent in a couple of months to close up 16.9 percent for the year. Interestingly, the Magnificent Seven could not keep up in the final few weeks of the year, most likely because they had already had such a stellar year, producing a return of 107 percent in 2023, but perhaps also because investors saw more upside potential elsewhere. 
• Given that the Magnificent Seven are all US-based companies, US equity indices dominated the league table in 2023. The Nasdaq Composite Index was up over 44 percent while the S&P 500 Index recorded a gain of nearly 26 percent. In comparison, Europe’s Stoxx 600 Index gained almost 16 percent while the MSCI AC Asia Pacific Index gained 11.5 percent and the Swiss Performance Index rose 6.1 percent. Japan was the exception in Asia, where the Nikkei 225 Index gained 30.9 percent as the Bank of Japan remained highly accommodative despite inflationary pressures. Swiss equities suffered from their exposure to flagging European and Asian economies as well as from the strong Swiss franc. 
• The outlook for equities in 2024 depends on how the effects of still-tight monetary policy feed through to the real economy. If the major central banks are indeed able to engineer soft landings in their respective economies, then equities can be expected to drift higher. If hard landings occur and earnings start to tumble, we will most likely see a correction in equities. However, central banks again have room to cut rates aggressively should such a scenario unfold, which should buffer any correction. For this reason, we keep our neutral equity allocation.  

2.2           Fixed Income

• Until mid-October, fixed income markets were very challenging for investors in 2023. US yields rose throughout the year across maturities, reaching their highest levels since 2007 – at least for two-, five- and ten-year US Treasuries, as US economic data remained robust despite the significantly tighter monetary conditions. Correspondingly, the messaging from US central bankers remained hawkish, which weakened sentiment and temporarily pushed the Bloomberg Global Aggregate Index, Hedged USD into negative territory in October year-to-date. 
• A trend reversal then set in. Consumer price inflation rates weakened further at the end of 2023, thereby moving closer to central banks’ target levels, which prompted dovish communications from members of the US Federal Reserve. This triggered extremely positive market responses: yields for medium and longer maturities fell significantly, leading to price gains of 6 percent during the fourth quarter and an annual gain of about 7 percent, as measured by the Bloomberg Global Aggregate Index, Hedged USD. 
• Credit risk premiums declined throughout the year. European high-yield credit risk premiums measured by the iTraxx index reached 3.1 percent at the end of the year, compared to 4.3 percent at the end of Q3, while investment grade credit risk premiums fell to 0.6 percent, compared to 0.8 percent at the end of Q3.  
• According to S&P Global Ratings, current US high yield credit spreads correspond to an expected default rate of 1.9 percent as per September 2024, compared to the September 2023 figures of 4.1 percent. In our view, this optimistic scenario could be possible if inflation continues to fall and the US Federal Reserve manages to facilitate a soft landing by cutting interest rates early in 2024. However, we currently observe that many lower rated high-yield issuers cannot refinance at these elevated yields, which could have spillover effects on the entire market in an adverse scenario. Therefore, we are refraining from entering new credit commitments until the potential reward again becomes more attractive for the given level of risk.  
• We continued to gradually reduce the underweight in fixed income during Q4 2023 and moved our position close to the strategic allocation. Within the asset class, we continue to favor liquid, high-quality medium and longer duration bonds, which should benefit disproportionately from falling interest rates. 

2.3           Alternative Investments

Hedge funds, private markets and commodities

• The HFRX Global Hedge Fund Index ended 2023 up 3.1 percent, helped by two strong months at the end of the year, particularly for equity long/short strategies. In general, equity long/short had a good year on the long side, with the GS Hedge Fund VIP Index, which comprises the stocks that appear most frequently among hedge funds’ top 10 long positions, outperforming the MSCI World Index by a good margin. However, shorting was difficult throughout the year as stocks with high short interest were volatile. Global macro managers continued to generate positive returns in the fourth quarter of 2023, with discretionary managers mostly profiting from falling interest rates. Historically, global macro funds performed best in rate-cutting cycles, so hopefully this bodes well for 2024. 
• Gold rallied in the fourth quarter, reflecting lower interest rate expectations as well as a weaker US dollar, ending the year up 13.1 percent in US dollar terms, but only up 3 percent in Swiss francs. Although inflation seems to be under control, we retain a gold position to hedge against a re-acceleration of inflation and financial stability risks. 
• While US private equity market activity lagged behind its pace of previous years, first signs of recovery are emerging in Europe. According to PitchBook, the total deal value in 2023 is still on track to surpass the full-year total of 2019, which was the highest level recorded before the surge in 2021.  

Currencies

• Based on the communications from central bank members during the fourth quarter turned dovish, the market now expects about five interest rate cuts in the US and Europe and three in Switzerland in 2024. This should finally make hedging costs more bearable for Swiss franc investors, which, at 3.7 percent against the US dollar and 2.2 percent against the euro, are still very high. 
• Even though, the Swiss franc appreciated further against the US dollar and the euro, thanks to changing interest rate expectations towards the end of last year, we think the franc has more upside potential since it still seems undervalued relative to the greenback and the euro on a purchasing power basis. 
• The Chinese yuan and the Japanese yen remain extremely overvalued against the US dollar. An eventual monetary policy pivot by the US Federal Reserve could pave the way for a normalization of these massive dislocations in valuations, especially if the Bank of Japan would finally adopt a restrictive policy stance. 

3            Investment Views

• Economic data came in softer than expected, especially in the US, feeding expectations that a soft landing is indeed in the cards. However, we would counsel that this positive scenario already seems to be largely priced in. And given the persistent underlying inflationary pressures that contrast with the disinflation in headline inflation rates, there seems to be room for disappointments if the monetary policy pivot doesn’t occur as rapidly as is currently projected by the Federal Open Market Committee and interest rates remain higher for longer. Therefore, we choose to keep our neutral stance on equities. Yes, they would benefit from falling rates and a soft landing, but we must also keep an eye on potential downside risks from overly optimistic expectations. 
• With the sharp increase in bond yields until the end of October, fixed income became attractive, while the prospect of a near-term monetary policy turnaround has created upside potential for longer maturities. To account for this potential, we further increased our fixed income allocation towards the strategic asset allocation in November. We have kept a marginal underweight to account for the high hedging costs for investors with EUR and CHF as reference currencies, which continue to take a meaningful bite out of their yields in globally diversified bond portfolios. 
• Within the fixed income allocation, we continue to prefer high quality bonds with intermediate to longer maturities that stand to profit in the case of falling yields or a weaker economy. At the same time, we continue to avoid the segments in the credit markets that are vulnerable to rising defaults and widening credit spreads. 
• We keep our gold overweight, which we trimmed somewhat in July to realize some gains, as it still offers interesting diversification features. If USD funding conditions loosen further and the USD correspondingly weakens, this should again provide tailwinds for the yellow metal.