We finished 2023 with a very strong 2-month rally in stocks and bond indices/prices as investors bet that big central banks have finished raising interest rates and will cut them rapidly this year. The MSCI World index, a broad gauge of global developed market equities, surged by 16 per cent in between late October and the end of year and the US 10-year Treasury yield, a benchmark for global financial assets that moves inversely to bond prices, fell to 3.87% annual yield. Equities and bonds around the world followed this trend.
The markets were buoyant and open to disappointment as we started 2024. And in some ways disappointment is what we have had…although bonds and stocks have behaved differently.
Inflation in the US cooled less than expected in January at 3.1% (Central Bank target is 2%).
January employment data (called Non-Farm Payroll) came in at +353,000 new jobs which was double expectations.
Both leading to expectations around US interest rates cuts being significantly reduced (current Fed Funds rates 5.25%-5.50%).
So this is bad news for markets…right? Well not necessarily.
To understand this let’s look briefly at Classic Portfolio Theory which most Fund Managers have been following for the last 50 years. The idea is you split your investment portfolio 60% stocks / 40% bonds.
The idea being;
If the economy is strong, stocks will do well but bonds will underperform with the threat of higher interest rates.
If the economy is weak, stocks will underperform but bonds will do well with the promise of lower interest rates.
Either way: Your portfolio is balanced and diversified and should lead to a decent, if modest, positive investment performance.
The problem with this is, that with a significant inflationary threat, this classis portfolio led to a 17% loss in 2022 and significant gains in 2023 as bond prices and stock prices rebounded.
Well since the start of 2024…classic portfolio theory is back!
So far this year Wall Street (the US) has led a 3.8% gain for developed market stocks, while an index of global bonds has seen a 2.8% decline as investors have dialled back their expectations for interest rate cuts.
This shift is likely to come as a relief to the many investors holding the 60/40 portfolio.
Analysts believe that the shift in correlation has been driven by the market focus switching from fears about inflation and the timing of the next move in interest rates to concerns about the strength of the economy (the main S&P 500 index is now at an all-time-high).
That has come as markets have become more comfortable that inflation is heading back down (inflation in the US was circa 9% …it is now 4%) to central banks’ target levels, whilst also gradually starting to accept that policy makers will not be cutting interest rates as quickly as investors had been hoping.
Investors are also rethinkng whether they need to be quite so focussed on monetary policy, given that the buoyant US economy so far appears to have shrugged off much of the impact of higher rates, which have been held at a 22-year high of between 5.25 per cent and 5.50 per cent since July last year. Welcome back Classic Portfolio Theory!
