Real Return: our 2024 outlook

The four most dangerous words in investing are: ‘This time it’s different.‘

John Templeton

Key points

• Our forecast is that the lagged impact of the steepest and fastest interest-rate increase in recent history will start to be felt more acutely in the real economy as we enter 2024.
• There are specific pockets of equity markets where we see value, while we believe thematic support remains for select alternatives.
• There is likely to be a cyclical opportunity in bonds, although the window of opportunity may prove to be short-lived.
• Once a market reset has occurred, we should feel confident to remove direct hedges in the portfolio and shift the strategy’s posture towards a focus on return generation.

Few would dispute the fact that 2023 has been a year of ‘Waiting for Godot’. Our expectations were that a US recession would have materialised by now; however, a combination of pent-up savings, a robust labour market, the tailwind of fiscal support, and corporate balance sheets eschewing distressed territory, has meant that the much-heralded recession has proved elusive.

Looking ahead, our forecast is that the lagged impact of the steepest and fastest interest-rate increase in recent history will start to be felt more acutely in the real economy. Periods of rapidly rising real rates are normally followed by a deleveraging cycle and recession, and today real rates have risen in an environment of significantly higher debt loads. We believe the pain will initially come through the small and medium-sized enterprises which are more dependent on bank-based financing, and where stress is already beginning to emerge. Moreover, the correction may manifest itself through idiosyncratic weakness rather than via a more disorderly systemic sell-off. Its severity, to a large extent, is likely to depend on the reaction of central banks, which historically do not have a good record of containing crises.

While the fundamentals of large companies have been strong, and businesses have been successful in extending the terms of their debt, we anticipate that margins will increasingly come under pressure in the face of weakening demand. The larger-capitalisation companies that underpin the US economy are unlikely to be immune from contagion, and the mood music could change.

Europe is arguably already in the throes of recession, with both the consumer and many housing markets struggling. The industrial side of the economy has been adversely affected by links to China which, unlike during the global financial crisis of 2008, is no longer willing or able to bail out the global economy and is more focused on its domestic agenda.

Equities – a defensive skew

On the equity front, the impetus around artificial intelligence (AI) has propelled equity markets higher, with the ‘magnificent seven’ big tech monopolies defying the customary playbook of long-duration asset sensitivity to rising bond yields. While we have identified some exciting opportunities in relation to genuine growth in the AI area, we are mindful that, in some cases, both valuations, and expectations as to how rapidly this technology can be deployed, appear to be inflated. We also contend that the technology sector will prove to be more cyclical than envisaged by many investors.

Our bias remains defensively skewed and, given the likelihood that bond yields have peaked in the near term, we have begun to build positions in more bond-sensitive areas of the market such as utilities and consumer staples. There are also specific pockets of the market where we do see value and where a very adverse scenario already looks to be priced in. A good example of this is the UK-listed real-estate sector, which has unsurprisingly come under significant pressure against the backdrop of rising government bond yields and a UK market that remains out of favour with international investors. We anticipate that there will be further opportunities of this nature as the global economy falters in the first half of 2024 and are ready to deploy cash to this effect.

Bonds – pockets of opportunity

We have previously commented that bonds are likely to be a less reliable hedge for the strategy than in the past owing to structural headwinds, including increased issuance, a deteriorating demand picture for US Treasuries, and higher government deficits. While there is likely to be a cyclical opportunity in bonds, this window of opportunity may prove to be short-lived as inflation expectations are likely to rise once the US Federal Reserve changes its tone to become more accommodative. Moreover, we note that inflationary cycles typically come in two waves, with the second adjustment being the most painful. We would therefore look to lighten exposure to government bonds in favour of other hedging assets should structural forces reassert themselves later on in 2024.

Elsewhere in the fixed-income complex, investment-grade bond spreads could widen significantly in the event of a major market correction, while high-yield bonds are likely to be more treacherous, with the need to be discerning as default rates rise. Emerging-market debt, on the other hand, provides an attractive yield, with scope for many economies to cut interest rates, having previously been held back by the rising rate trajectory in the US. Given the robust and less inflationary nature of many domestic emerging markets, monetary easing would appear to be a fitting path which should be beneficial for the asset class.

Thematic support for select alternatives

Alternatives have typically provided effective diversification within the core part of the Real Return portfolio. However, in 2023 many alternative investments faced challenges, in part because they were adversely affected by the disastrous UK mini-budget the previous year. Looking ahead, falling bond yields should initially represent a tailwind for many alternatives, in view of their interest-rate sensitivity. However, there will be a need to be disciplined about exposure, given the potential for bond yields to resume their upward path later in the year, coupled with liquidity considerations. In our view, some of the more traditional alternative areas within the portfolio, such as renewable energy and infrastructure, remain attractive, in drawing upon secular trends such as those identified by our natural capital investment theme, which considers how careful management of natural assets and solutions that address the stresses we have placed upon them will be necessary for economic, social and planetary stability.

Finally, we will need to calibrate both the size and composition of the portfolio’s stabilising layer based on the evolution of the backdrop. We anticipate that our current, more tactically constructive stance as we head into the end of 2023 will be followed by a more cautious phase, consisting of a reduction in upside exposure, combined with a bolstering of the level of protection. Once a market reset has occurred, we should feel confident to remove direct hedges and shift the strategy’s posture towards a focus on return generation.

Nimbleness is key

In summary, it is hard to determine the exact timing of a sell-off, but it remains our base case that the increasingly stretched rubber band of a global economy still wedded to multiple decades of easy money will eventually snap. This, we believe, will present a myriad of exciting opportunities across the capital structure, and we will seek to capitalise on these. Within equities, growth compounders and quality cyclicals, where a combination of elevated valuations and concerns about underlying demand have kept us on the sidelines, could prove highly attractive, while widening spreads in credit could also lead to opportunities in this area of the market. Flexibility and nimbleness remain key, and have been a vital part of the Real Return strategy’s DNA throughout the period since its launch in 2004.

Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.

Analysis of themes may vary depending on the type of security, investment rationale and investment strategy. Newton will make investment decisions that are not based on themes and may conclude that other attributes of an investment outweigh the thematic structure the security has been assigned to.

Newton Real Return strategy – key investment risks

• Performance aim risk: The performance aim is not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for returns to vary significantly.
• Currency risk: This strategy invests in international markets which means it is exposed to changes in currency rates which could affect the value of the strategy.
• Derivatives risk: Derivatives are highly sensitive to changes in the value of the asset from which their value is derived. A small movement in the value of the underlying asset can cause a large movement in the value of the derivative. This can increase the sizes of losses and gains, causing the value of your investment to fluctuate. When using derivatives, the strategy can lose significantly more than the amount it has invested in derivatives.
• Changes in interest rates & inflation risk: Investments in bonds/money market securities are affected by interest rates and inflation trends which may negatively affect the value of the strategy.
• Credit ratings and unrated securities risk: Bonds with a low credit rating or unrated bonds have a greater risk of default. These investments may negatively affect the value of the strategy.
• Credit risk: The issuer of a security held by the strategy may not pay income or repay capital to the strategy when due.
• Emerging markets risk: Emerging markets have additional risks due to less-developed market practices.
• Liquidity risk: The strategy may not always find another party willing to purchase an asset that the strategy wants to sell which could impact the strategy’s ability to sell the asset or to sell the asset at its current value.
• Shanghai-Hong Kong Stock Connect and/or the Shenzhen-Hong Kong Stock Connect (‘Stock Connect’) risk: The strategy may invest in China A shares through Stock Connect programmes. These may be subject to regulatory changes and quota limitations. An operational constraint such as a suspension in trading could negatively affect the strategy’s ability to achieve its investment objective.
• China interbank bond market and Bond Connect risk: The strategy may invest in the China interbank bond market through connection between the related Mainland and Hong Kong financial infrastructure institutions. These maybe subject to regulatory changes, settlement risk and quota limitations. An operational constraint such as a suspension in trading could negatively affect the strategy’s ability to achieve its investment objective.
• CoCos risk: Contingent convertible securities (CoCos) convert from debt to equity when the issuer’s capital drops below a pre-defined level. This may result in the security converting into equities at a discounted share price, the value of the security being written down, temporarily or permanently, and/or coupon payments ceasing or being deferred.
• Counterparty risk: The insolvency of any institutions providing services such as custody of assets or acting as a counterparty to derivatives or other contractual arrangements, may expose the strategy to financial loss.
• Investment in infrastructure companies risk: The value of investments in Infrastructure Companies may be negatively impacted by changes in the regulatory, economic or political environment in which they operate.