By Charlotte Ryland, head of investments at CCLA
Last year ended far more optimistically than it began, with an ‘everything rally’ in equities, bonds and alternative asset classes such as infrastructure.
The trigger for all of this has been inflation, with the UK Consumer Price Index (CPI) falling to 4.5% in October from 10.1% at the start of the year. That slowing seems set to continue in the UK, while price pressures will be contained in other major regions too.
While the fastest rate-hike cycle since the eighties seems to be over, it would be premature to price in rate cuts. The messaging from central banks is ‘higher for longer’, with an eye on core inflation that remains stubbornly high at over 5% in the UK. There is also a heightened risk of recession and, if this is the case, rates could fall dramatically even if inflation is still too high.
Added into the 2024 mix is geopolitics. With war in Ukraine and Gaza, continued tensions between the US and China, and elections due for 40% of the world’s population, there is certainly scope for turbulence. Possibly the most contentious element is the prospect of another Trump presidency with an agenda of aggressive protectionism.
It is also an environment in which valuation matters – the sell-off seen in 2022 demonstrates the danger of overpaying. Overall, we think current equity valuations are fair, but the US market still trades on a premium. However, this is concentrated in a small handful of very large names.
The so-called ‘Magnificent Seven’ tech stocks were boosted by both a recovery from 2022’s de-rating as well as impressive relative earnings growth, but they now account for almost a third of the US index and collectively trade on a forward price-earnings ratio of 27 times, so they may not be so dominant in 2024.
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This erratic backdrop continues to favour a quality strategy. Companies with high returns on capital and robust profit margins are best placed to deal with slowing demand and lingering inflationary pressures. A properly capitalised balance sheet that avoids excessive leverage is also important as higher interest rates steadily feed through into corporate borrowing costs.
Furthermore, a slower growth environment favours businesses that do not rely simply on the economic cycle to drive earnings, so businesses with a structural growth driver behind them should benefit.
For this reason, one of the sectors we favour is healthcare. An ageing population in the West and China means greater demand for healthcare, while innovation in areas such as genetics, robotics and biotechnology is providing better treatment outcomes. Alongside this is the need to provide better value for money as healthcare systems and governments plan for strong future demand.
In the US, for example, care providers such as Humana and United Health have improved the efficiency of a fragmented healthcare system. They achieve this through their scale, but also by facilitating ‘value based care’ versus the traditional ‘fee for service’ model which tends to incentivise procedure volume yet prompt little interaction between providers.
Last year was tough for some life-science tools companies, where profits were hit by post-pandemic destocking and slower biotech spending. We expect this to flatten out in 2024 and current valuations are attractive.
The explosion in demand for data – the need to store it, analyse it and use it more effectively – supports investments from cloud to AI companies. We continue to favour providers of proprietary data, particularly companies like credit bureaus or rating agencies hit by higher interest rates and therefore lower credit demand. This should favour holdings such as Experian and S&P Global.
This should also benefit semi-conductor companies. While Nvidia has had an extraordinary year, other players have had more difficulty with slowing demand for PCs, phones and autos following the pandemic. This year should be supportive for companies like TSMC, Broadcom and NXP.
We remain cautious on stocks that we have low returns, are highly cyclical or facing structural headwinds. We have very little exposure to banks for instance, because rates have peaked, net interest margins are under pressure and credit conditions are tightening. This all indicates the possibility of higher provisioning requirements.
Commodity sectors have had a difficult 2023 and with record oil supply from the US, a slowing Chinese economy and the long-term shift away from hydrocarbons, it is an area we continue to avoid.
We are also very selective in consumer stocks. Cost-of-living pressures are still a real issue for low income consumers, so luxury and travel companies are likely to slow down after the pandemic-induced spending spree.
