Global 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 materialized by now; however, a combination of pent-up savings, a robust labor 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-capitalization 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 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 favor 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 favor 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. In our view, 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 diversification within the core part of the Global 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 stabilizing 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 capitalize 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 Global Real Return strategy’s DNA throughout the period since its launch in 2009.

Past performance is not a guide to future performance. 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.

This strategy is managed by Newton Investment Management Ltd (“NIM”). NIM, along with its affiliates, Newton Investment Management North America LLC (“NIMNA”) and Newton Investment Management Japan Limited (“NIMJ”), form the Newton Investment Management Group (“Newton”).

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 Global Real Return Strategy – Key Investment Risks

• 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 the returns to be significantly different than expected.
• This strategy invests in global markets which means it is exposed to changes in currency rates which could affect the value of the Strategy.
• The strategy may use derivatives to generate returns as well as to reduce costs and/or the overall risk of the strategy. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
• Investments in bonds are affected by interest rates and inflation trends which may affect the value of the strategy.
• The strategy holds bonds with a low credit rating that have a greater risk of default. These investments may affect the value of the Strategy.
• The strategy may invest in emerging markets. These markets have additional risks due to less developed market practices.
• The strategy may invest in investments that are not traded regularly and are therefore subject to greater fluctuations in price.
• The strategy may invest in small companies which may be riskier and less liquid (i.e. harder to sell) than large companies. This means that their share prices may have greater fluctuations.