By Dewi John, head of research at LSEG Lipper
This time last year, I finished my review of 2022 with a quote from quantum mechanics pioneer, Niels Bohr: “Prediction is very difficult, especially about the future.”
The caution (if nothing else) was prescient: while inflation has trended down since last November, it has remained high relative to developed market peers. A year ago, consensus for peak rates was somewhere between 4% and 5%. The Bank of England base rate is currently at 5.25%, so we can chalk that down as a near miss – or “close enough” – for consensus. How has this impacted the UK fund market?
The direction of flow
I’m hitting the keyboard before December is out, so flows figures are only for the first 11 months of the year.
In total, more than £69bn was redeemed from UK mutual funds and ETFs. However, almost £49bn of this is from money market funds, drip feeding back into the market after the post-mini-budget dash to cash. That seems to have netted out at the start of the fourth quarter.
Despite the world skirting recession over the year, and equities keeping their head above water, it’s not been a great year for the asset class, with £4.9bn of redemptions. That’s not been a uniform trend, with global equities seeing positive flows of £7.1bn, summing global, ex UK and income categories.
Despite the standout performance of the Magnificent Seven, US equity funds have suffered outflows of more than £1.4bn, although the trend turned positive in the second half of the year. It’s also been another year of misery for UK equity funds, whether large or small, vanilla or income, with total outflows of nearly £2.4bn.
It’s been a different story for bonds, which have seen inflows of £10.7bn year to date, rebounding from a dire year in performance terms in 2022. Unsurprisingly, because of narrow spreads, high grade and government bonds have attracted much of this cash, plus longer duration flows picked up from Q4, as the expectation that rates have peaked became engrained.
What unites equity and bond funds, however, is the ongoing rotation from active to passive, with the trend driven by cost and transparency.
Performance: Seven v the rest
The FTSE 100 was up 3.9% to 30 November on a total return basis, compared to 19% for the S&P 500. The returns of the latter have been driven by the Magnificent Seven mega caps. Excluding these, the S&P 500 has returned just 4.5%. Regarding US and European equities, unless you’ve had significant exposure to these seven, you’ve probably been lucky to keep pace with inflation. In terms of style effects, it’s unsurprising that large-cap growth has been the only game in town. But, longer term there have been significant style rotations from one year to the next: over three years, value dominates, as in 2022 these tech titans tanked.
So much for the past year. Here’s my stab at a couple of 2024 themes.
The US had a surprisingly strong year, and that’s doubtless been supportive of the rest of the world. Much of that economic support has been from the US consumer. However, the excess savings from Covid are now gone.
Another negative factor is the lag – typically 12 to 18 months – between monetary policy changes and impact. That implies that next year will be the difficult one. Does that necessarily mean that the US has run into empty space, like Wile E Coyote off the cliff edge? Maybe; maybe not. The spend from President Biden’s Inflation Reduction Act may well pump prime the economy to keep moving forward.
What’s more, election years in the US tend to be positive in economic terms as the White House incumbent tries to ensure his residency for the next four years. So there may well be more in the tank for US equities, and more even for the Magnificent Seven, as analysis suggests that these stocks may have further to run.
A stable but higher rate floor is likely good for bond returns, though the important caveat here is that it will inevitably see higher defaults in lower quality credit. Defaults have been heading northwards, and more companies are due to return to the market for finance in 2024 than in 2023. But the higher yields are not to be sneezed at. This could also lead to a lower buying pressure for equities, as investors can get greater income from bonds, with the November yield for the 10-year gilt only about 30 basis points lower than the yield on the FTSE 100. This will be supportive for fixed income.
There is one positive for UK equities. Higher rates could work in their favour, the UK being more of a value market, and therefore one that should do better in such an environment. However, the catalyst for this return to favour could well be the underperformance of US or global equities, causing equity investors to shift their allegiances, which is a moot point.
And finally, a codicil on sustainable funds. Despite the pessimism around ESG investing, the UK reality seems more positive. For instance, the largest sustainable fund inflows for the first three quarters of 2023 were into equity funds, which took £9.62bn (with £16.43bn of conventional outflows). While the rest of the market was muted, it’s still net positive overall. When I crunch the full-year figures in January, I’ve little reason to think that the dial will shift greatly.
Performance depends on what part of the sustainable market you’ve been invested in. Overweight large-cap tech, and this will have worked. On the other hand, renewables have been hammered over the past year; hit by rising costs, coupled with a limited ability to pass them on.
Many renewable energy businesses are locked into long-term contracts on fixed prices, plus are carrying significant debt. Both elements have proven toxic in this rising rate environment, despite the increased funding for renewable projects coming from Europe and the US.
The new year brings with it the SDR, which at long last will provide the UK market with a set of comprehensive sustainable fund guidelines.
The situation is finely balanced: coward that I am, I’m loath to make any big calls. But overall, it seems that 2023’s consensus that “bonds are back” was premature, although they’ve certainly been favoured by flows. With decent yields locked in, this may be the year they deliver.
All that said, it’s worth remembering the adage that the best way to make the gods laugh is to tell them about your plans for the future. The transition from glossy investment outlook to chip paper can be rapid, especially in an environment riven with so many risks.