Asset Allocation Focus in Spring 2024

Communications

The telecoms sector has benefitted from above-inflation price rises as many contracts are structured to account for inflation increases, yet this will abate now as global inflation rates are falling. Rising debt costs remain a headwind as companies are forced to refinance at higher levels. Areas of the sector more exposed to consumer discretionary spending can struggle in a recession. We are also concerned about the direction of advertising spend in this environment.

Consumer Discretionary

Inflation has been falling, but the performance of the sector is likely to continue to be driven by macro considerations, as the sector remains pinned to the economic cycle. The non-essential element of discretionary products/services makes them less resilient to a downswing. Since the pandemic, businesses have been supported by excess consumer savings. With savings now depleted, the risk of higher rates for longer looms over the sector and underpins our underweight stance. 

Consumer Staples

Economic growth in 2024 will likely be slower than 2023 and tighten the purse strings of consumers. Input costs have been a headwind for the sector, however pricing power has been resilient. As consumers are more wary of budgets, growth will likely be suppressed. It is reasonable to expect 2025 to provide a rebound in growth and it would remain wise to focus on the longer term.

Energy

Last quarter we saw oil majors move a touch higher on the back of stronger oil prices. In December Brent bottomed at US$75 per barrel and is now at US$82. At low oil prices Shell and BP are highly correlated with the oil price. But above US$90 the relationship progressively breaks down because the share price starts to anticipate demand destruction from higher costs. Share prices are discounting expectations for weaker GDP growth and lower demand.

Financials - Banks

US banks have outperformed those in the UK, which was linked to the prospect of fines and restitution from the unfair pricing of car loans. Pressure from credit losses and an end to net interest margin growth persists. Prudential continues to suffer from woes emanating from slowing in China whilst Legal & General and Aviva climb higher on expensive insurance premiums. Given the sector weighting to banks we conclude with underweight.

Multiple profit warnings in the sector have dampened sentiment. A combination of continued disruption to procedures, funding issues in biopharma, and concerns about a regulatory crackdown in China have impacted the short-term outlook for the sector. Longer-term demand remains resilient and the structural drivers associated with an ageing population are unchanged. The pressure in the sector makes valuations more attractive. Healthcare can also be expected to perform well in a recessionary environment. 

Whilst industrial indicators weakened in the back end of 2023, a soft landing appears increasingly likely. Industrial valuations generally look reasonable and at discounts to longer-term averages. If the soft landing happens, we expect industrial indicators to be around trough levels, at which point economic theory suggests is the time to buy industrials. In this instance we would expect interest rate cuts and GDP growth to be supportive of earnings growth later in 2024. 

Sector performance has been strong as hope relating to the potential of AI has driven share prices and valuations. The sector is interest rate exposed though, so passing the peak of the rate hiking cycle should be a positive for valuations. Debate remains around whether the sector’s demand can be considered discretionary and demand may be affected if we enter a recession. The lack of margin for error provided by valuations drives our neutral rating. 

China is still the largest single driver of the sector and Chinese economic data has consistently underperformed. The economy is now in deflation as the country tries to export its way out of trouble. Longer term, supply/demand dynamics in metals look attractive and demand from the metal intensive energy transition remains. Company balance sheets remain strong, however we still expect underperformance in a recession. Our neutral rating is driven by the uncertain macroeconomic outlook.

2023 was a challenging year, due to persistent inflation and a 15-year high in interest rates. High rates saw commercial real estate transactions plummet, as valuations fell with heightened borrowing costs. 2024 could see rate reductions kick in and stimulate activity, helping investors to reduce their ‘risk off position’. The market remains fragile, but we believe an uptick in the real estate sector is due because of easy comparatives and an improving economic landscape. 

Index-linked regulatory earnings models continue to offer protection to utilities companies even amid slowing inflation. A key component of the UK’s energy transition will be reform of energy infrastructure, which should aid earnings growth for UK power transmission names. In water, proposed allowed investment returns are relatively unattractive and we expect heightened environmental regulatory scrutiny going forwards. We prefer power utilities, which currently have a more attractive regulated earnings profile and operating environment than water.

UK

The UK market continues to look cheap relative to the US and Europe, albeit with lower earnings growth expectations. Inflation at 4% is getting closer to the Bank of England’s target of 2%, supporting the market’s expectations of rate cuts in the summer. With the economy in a technical recession, a key focus of the next government needs to be generating better GDP growth amidst challenging economic conditions.

North America

The Magnificent Seven tech companies have been joined by added breadth in the rally which saw the S&P500 reach a new all-time high. Traders scaled back rate cut expectations after US inflation cooled by less than expected to 3.1% in January, with cuts now expected by the summer. Nevertheless, GDP and unemployment data continues to be supportive of a ‘soft-landing’, a potential positive for corporate earnings in the region.

Europe

The earnings of European equities have delivered encouragingly against expectations in the recent reporting cycle. With inflation moderating, the expectation is that the European Central Bank will be the first major central bank to start cutting rates. Generally, key EU nations, including France and Spain look well positioned economically as we enter the rate cutting cycle. The exception is Germany, where conditions appear more challenging.

Japan

Inflation unexpectedly slowed into the end of 2023, whilst GDP contracted for a second consecutive quarter in Q4 2023, putting Japan in a technical recession. These data points raise questions as to whether central bankers will be able to switch from controlling interest rates along the yield curve to rate hikes in order to shore up a weak Yen. Despite this, Japanese equities continue to perform well, with the Nikkei225 at a 34-year high.

Asia Pacific

Asia Pacific mostly revolves around China. The Chinese economy is still growing but does appear to be slowing from previous levels, with lesser contributions from global exports and the troubled real estate sector. Domestic markets continue to see international outflows and volatility on the back of seemingly sporadic regulatory crackdowns by the ruling Chinese Communist Party. Trade tariffs mooted by Trump should he re-enter the White House make for potential added complexity for investing in the region.

Emerging Markets

A weakening dollar when US interest rates are eventually cut should be a tailwind to dollar-exposed emerging markets, though ongoing weakness in the Chinese Renminbi will be a drag on this benefit. We have started to see interest rate cuts in emerging  markets, though hotspots of inflation and political risk in the region lead us to take a cautious view.