Investing involves risk that your capital goes down as well as up; you may get back less than you invested. The commentary below is not intended as a recommendation for you to personally buy or sell any of the investments mentioned nor to take any investment action whatsoever.

Markets had a very strong finish to 2023 with both bonds and stocks rising >10% over November and December. This was driven primarily by inflation figures that continued to soften and corresponding signals from the US Federal Reserve that it would reduce interest rates in 2024. Cue the ‘everything rally’.
​
The question, as ever, is what happens next.

​Our ‘Base Case’

The most probable scenario is precisely what is seemingly priced into markets: a slowing economy but one that doesn’t slow too much and one where inflation settles into a broadly acceptable range of 2-3%. This is widely referred to as the ‘Goldilocks scenario’, i.e. not too hold nor too cold. As we saw in November and December, most asset prices rise in this scenario. If this pans out over 2024, I expect there will be more asset price increases but not at the pace that we saw at end of last year. I would instead expect stocks to earn 5-10% and a ‘balanced’ portfolio to earn a little more than 5% over the course of 2024.

The rub is that I would be very surprised if the path to this decent outcome is smooth.

​The Inflation Risk

It is not at all clear to me that the inflation genie is back in the bottle and, indeed, the most recent US and UK inflation figures are consistent with this fear. It is somewhat likely that inflation stays high enough this year that central banks are barely able to cut interest rates.

Related to the above risk is the immense amount of debt that the US government, in particular, is going to be issuing this year. In short, persistently high inflation and increasing supply would be bad for government bonds (in both the US and UK, to be clear). The risk, therefore, is that we get another version of 2022 where stocks and bonds selloff simultaneously.

The Recession or ‘Shock’ Risk

On the other side of the coin is the possibility of a dramatic decline in economic activity and/or a ‘shock’ akin to the Silicon Valley Bank collapse and associated banking panic of Q1 2023. Related to this risk is that there is a significant number of companies and investment strategies that rely on inexpensive debt / low interest rates to earn their required returns; in other words, these companies or investment strategies could be the source and/or suffer materially from another shock.

One of the keys to asset allocation in the coming years is going to be avoiding the areas of the market that have these unresolved risks lurking under the surface or, at least, buying into them selectively and opportunistically.

By contrast, government bonds would likely go up in value in these scenarios thus offering investors some cushion to a likely decline in stock prices. This is why we own no corporate bonds or other ‘credit’ investments but we do own a reasonable proportion of government bonds.

What are we doing?

​Our non-equity holdings are split roughly 50/50 between government bonds and the absolute return funds that we have favoured for years. This is implicitly saying that we are giving a roughly 50/50 probability weighting to the two risks outlined above which, I think, is giving far more weight to the ‘inflation risk’ than consensus.

There is a fascinating question within equities: to own the megacap US stocks that drove 2023’s returns (at least until November when the market broadened out) or to ‘underweight’ these shares on the basis that they are overvalued and therefore will underperform the market going forward? We have been consistently underweight these companies to our detriment. Nevertheless we remain underweight and of the firm belief that future returns will be driven by a broader cohort than the so-called ‘Magnificient Seven’.