Monday digest

Posted 15 January 2024

Overview: a bumpy upwards path ahead
The equity market’s New Year malaise lasted no longer than usual. Last week, European equities recovered the previous week’s losses while US indices moved ahead smartly. However, softness in global banks hit the FTSE 100, as did a continued pullback in energy and materials sectors (that is, the more commodity-related companies). The standout performer was Japan, where investors appear convinced a corner has been turned. The Nikkei 225 broke the 35,000 level for the first time since 1990. Meanwhile, although issuance of new corporate bonds has slowed a little, corporate bonds as an asset class overall appeared to get a big infusion of investor capital. One can conclude from this that fears about a near-term recession have not just ebbed, they have effectively disappeared.

Against this backdrop of positivity, the risk for asset prices is unlikely to be about current earnings or their future growth. Nevertheless, in terms of upside, as we enter earnings season, companies will need to report lots of surprisingly positive Q4 earnings and solid outlooks in order for equity prices to rise substantially from here. Across the world, valuations (such as price-to-earnings ratios, even when using analyst expectations which include next year’s anticipated growth) are slightly expensive within the historical ranges, and they are expensive in the US.

The last few months point to rising investor confidence. Household/consumer and business confidence is showing early signs of turning upwards, and this positive combination augurs well for risk assets. The key question though, is whether positive growth will be gentle enough to keep prices stable and allow central banks to cut interest rates before the summer as markets have thus far anticipated. The next round of central bank meetings begins with the European Central Bank on Thursday 25 January, with the US Federal Reserve and Bank of England meetings scheduled for the following week. Given how much market fortunes have been tied to interest rate and yield levels over the past two years, yet again it is the central banks, and not so much the underlying economy, that will determine the direction of market travel over the coming quarter. Central bank watchers will be very busy over the next two weeks.

Has the disinflation trend come to an end?
Inflation expectations are key to the investment outlook for 2024. But there are already suggestions that markets may have gotten overexcited about the likelihood that inflation continues to decline at last year’s pace. Last week’s release of December’s consumer price index (CPI) numbers from both the US and Eurozone were higher than economist expectations. Eurozone inflation rose to 2.9% in December. However, inflation pressures were more apparent in the US, where the year-on-year overall CPI rate ticked up from 3.1% to 3.4% in December.

While we are sounding alarms about “transitory” dis-inflation, the further course of inflation is certainly something we will watch closely as we start the year. The early winter rally – and market excitement about disinflation – has set the scene for disappointment in at least some assets. Judging which ones is crucial for the year’s investment outlook. We can say two things with confidence. First, the recent valuation driven equity rally certainly makes stocks vulnerable to a short-term correction if there are inflationary signs. These might not come – and we have argued that China’s disinflationary impulse is a huge but often-ignored factor. But if they do, current valuations look vulnerable in the short-term – even if they are fair for the longer-term picture.

Second, the answer varies dramatically by region. The US market has been investors’ darling for years, and the Fed led the way in signalling rates easing this year. Europe, by contrast, has much lower equity valuations, even after recent outperformance. Core service inflation in Europe has also been surprisingly weak – particularly compared to the US. This side of the Atlantic, services look much more likely to pick up the disinflation slack.

India’s stalling reform progress
India is something of a fan favourite for UK investors, for multiple reasons. The world’s fifth-largest country economy is growing faster than any of those above it. It has strong economic and financial ties with developed nations – a particular draw for UK investors – but its financial and corporate structures still have plenty of room to improve. More recently, India’s stock market also benefitted from Emerging Market (EM) investors dramatically reallocating their capital away from the disappointing China. This led to a 20% jump in the Nifty 50, India’s headline equity index, in 2023. The index has doubled since the start of 2019.

India’s path in the last two decades has been remarkably similar to China’s between the 1990s and 2010s – a strengthening of corporate governance, opening up of asset markets and closer alignment with western-style international trade rules. This reform agenda has been at the heart of Prime Minister Narendra Modi’s two terms in office. Modi’s second term is set to end in a few months, with Indians going to the polls in the April-May general election. Even though his Bharatiya Janata party (BJP) is overwhelmingly expected to win, it would be hard, though not impossible, for the BJP to repeat or better their landslide 2019 performance. Modi remains popular even after nearly a decade in charge and some highly unpopular policies (like the initial reaction to demonetisation) – in large part thanks to improving economic conditions. But extending political gains this far into an administration is always a challenge. And for all the talk about Modi’s reform agenda (his allies promised a slew of labour law changes and privatisations within months of his second victory) his second term has been underwhelming. If the BJP loses seats, reforms will be harder to implement. On the reform basis alone, then, foreign investors have little to get excited about in 2024. But India’s equity market success is also propelled by economic optimism – which is likely to carry on for the time being. Moreover, Indian assets are supported by production reallocation from China, whose risks are still very apparent. Whether those flows will continue later through the year is debatable. As we head into the election and beyond, investors might well re-evaluate their enthusiasm for India.