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US Multi-Cap Income Q4 Review 2023


Key Points

- Both bonds and stocks posted strong results in the fourth quarter, delivering very healthy full-year returns

- Lower inflation, lower interest rates, and a positive turn in economic momentum are encouraging signs for risk assets

- Those upbeat changes have been met with higher stock prices. Expectations and security valuations are both high, increasing risk in portfolios

Fourth Quarter Results and Full Year Results

Defying many forecasters’ downbeat outlooks, capital markets delivered very healthy results for both stocks and bonds in 2023. With a strong finish in Q4, a balanced portfolio of 60% in global equities and 40% in domestic fixed income delivered 16% returns for the calendar year (see chart below). Despite the strong numbers, the year was not without turmoil. In the spring, multiple large U.S. banks collapsed. The panic was contained with the help of policymakers, but the episode highlighted some of the risks associated with the significant rise in interest rates over the past two years. Domestic politics also supplied a fair share of drama with political brinksmanship over the U.S. debt ceiling and the ousting of the speaker of the House of Representatives. Outside our borders, the ongoing war in Ukraine and the devastating attacks in Israel are just two examples of the tumultuous state of geopolitics. Despite all that, the inflation outlook has continued to improve, and U.S. economic growth has even accelerated over the final two quarters. Moderating inflation has encouraged the U.S. Federal Reserve to halt interest rate increases and even suggest that interest rate cuts are likely coming in 2024. In response to the Fed’s messaging, both bonds and stocks surged in the final two months of the year, and the S&P 500 returned 12% during the fourth quarter.

What do we know

Forecasting markets is a tricky business. The only constant is surprise. With this outlook, we choose to focus on what we know, namely:

• Inflation continues to fall, and monetary policy appears set to ease in 2024

• U.S. economic fundamentals are showing signs of improvement

• 2024 is packed with political activity

• U.S. stock valuations carry elevated expectations

We will address each point.

Inflation is moving down the priority list

The policy responses to the Covid shutdown provided significant stimulus to consumers. With nowhere to go, demand for consumer goods was strong. Coupled with pandemic-induced supply chain disruptions, goods prices rose at the fastest pace in nearly four decades. War breaking out in Ukraine exacerbated this, sending several key commodity prices higher (namely oil). Inflation peaked in June of 2022 at over 9%, becoming the key concern for the Federal Reserve and financial markets.

Fast forward to today, and reported inflation rates have fallen sequentially nearly every month since (see below). We expect this trend to continue. We see additional measures of real-time price changes, including market rents and used car pricing declining and leading the official price indices lower. With official measures of inflation already nearing levels deemed appropriate to Federal Reserve policy setters (~2%), public comments from Fed Chairman Powell imply rates will be reduced in 2024. We expect investor focus to move more acutely to the health of the economy and its associated impact on corporate profits.

Economic Fundamentals

With investor focus shifting, fortunately fundamentals have gotten more constructive. Despite signs that suggest the economic cycle is in the latter stages of expansion (inverted yield curve, a slowdown in housing and manufacturing, tight labor market, etc.), the U.S. economy continues to grow. A healthy labor market has surprised many with its resiliency, delivering 23 straight months of unemployment below 4%. Although job growth has slowed (another late cycle phenomenon), there have been scant signs of businesses cutting labor. Initial unemployment claims have been declining and still hover near the lowest levels of the last 40 years (see following chart). As labor goes, so generally goes the broad economy.

There have been other recent developments making things better for consumers. Gasoline prices have fallen 20% since September, nearing three dollars a gallon. Interest rates have fallen in recent months, providing some relief on financing costs for items such as mortgages, car loans, and credit cards. Rates remain high relative to recent history, but the trend is encouraging. A recent acceleration in new housing starts suggests falling rates are already making a difference. Although survey results can be fickle, measures of consumer confidence have moved higher as a result (see below). This bodes well for the near-term health of consumer spending.

Expect politics to grab headlines

According to the Washington Post, “More than 60 countries, with some 4 billion people, are set to stage national elections in 2024. That means roughly half the planet could go to the polls in what could be the greatest rolling spectacle of democracy in human history.” The U.S. election takes center stage and will have a substantial impact on domestic policy and international relations. This comes at a time when geopolitical pressures have become more intense than in many years.

In addition to the election, the polarization in Congress is setting up several policy debates early in 2024 that will most certainly be contentious. Another budget fight looms with threats of a potential government shutdown. Same problems, new year. Together with the Republican primary season getting underway and legal challenges facing former President Trump, the first quarter is set to face a fair share of volatility-inducing news flow.

We do not profess to have much of an advantage in predicting the outcomes of the many potential political scenarios. Our focus is instead on incentives. No matter which side of the aisle a politician sits on, it is clear that in an election year, officials will focus on what they need to do to get re-elected. Election success has proved elusive to sitting presidents who preside over economic contractions. As a result, we would expect the president to push as many levers as he can to stimulate the economy. This pattern is likely part of the recipe that has seen the S&P 500 deliver positive returns in the last 13 presidential re-election years.

Earnings estimates appear optimistic

The economy picking up, inflation and interest rates falling, and increasing fiscal stimulus all bode well for the outlook. The challenge is distinguishing between that positive outlook and what is already embedded in current valuations. The key to successful investing is stacking the odds in our favor when the likelihood of revisions in those expectations is positive. Today, we see risk in achieving the current consensus forecast in corporate profitability. Since stock prices ultimately follow earnings per share, our optimism for stocks is tempered.

The consensus opinion of Wall Street analysts is that S&P 500 companies will grow earnings 11% in 2024. Included in this forecast are expectations for 5% sales growth and an improvement in profit margins. A review of the last thirty years suggests 5% growth is about average.

However, the 3-year compound growth rate implied is 26%, only topped by the 34% result achieved in 2023 (lapping Covid, low comparison), and 31% in 2006 (see figure below). At a minimum, this leaves little room for error to meet current expectations. Similarly optimistic are current estimates for profit margin improvement of over 1.4% next year¹.This would mark the largest year-over-year margin improvement of the last three decades, excluding years exiting a crisis.

Following the recent rally in stocks, the S&P 500 trades at a multiple of those earnings estimates of nearly 20 times. This measure of valuation has only been eclipsed twice, in late 2021 and the late 1990s/early 2000s. Neither of those periods offered strong prospective returns to investors. With expectations this high, downside risk is elevated.

Putting it all together

Forecasting markets is an incredibly humbling undertaking. Positioning portfolios against an unknowable future requires intellectual honesty and flexibility to deal with an ever-changing world. It is not hard to see the positive changes impacting the economy today, but we are forced to prepare for the endless possibilities of tomorrow. We are encouraged by the constructive changes we are seeing in the economic outlook, but the recent run-up in stocks has matched that positive fundamental change. This increases the expectation hurdle and risk facing financial markets. As a result, we continue to position portfolios somewhat conservatively. Consistent with our latest guidance, we maintain lower equity exposure relative to long-term investment plan targets and higher exposure to lower-risk asset classes, including bonds. Within equity portfolios, we continue to follow the same approach we always have. We seek companies that are “all-weather” with the ability to withstand the ultimate pressures tougher economic environments foist on businesses broadly. These types of companies require less prediction of the future. High quality companies of this nature can be identified by their high profitability, low leverage, and durable growth in cash flow and dividends. These companies are prepared to handle adversity and manage through it. Portfolios constructed with these types of companies and managed for risk through a cycle have the best ability to compound investor returns over time.

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Risk Warnings

Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds. Our funds invest for the long-term and may not be appropriate for investors who plan to take money out within five years. The fund will be exposed to stock markets and market conditions can change rapidly. Prices can move irrationally and be affected unpredictably by diverse factors, including political and economic events. The fund invests in other currencies. Changes in exchange rates will therefore affect the value of your investment. The fund invests mainly in North America therefore investments will be vulnerable to sentiment in that market which may strongly affect the value of the fund. In certain market conditions some assets may be less predictable than usual. This may make it harder to sell at a desired price and/or in a timely manner. In extreme market conditions redemptions In the underlying funds or the Fund itself may be deferred or suspended. All or part of the fees and expenses may be charged to the capital of the fund rather than being deducted from income. Future capital growth may be constrained as a result of this. Dividends paid by companies are not guaranteed and can be cancelled, which may impact the fund’s ability to deliver an income to investors.

Regulatory Information

This material is for distribution to professional clients only and should not be distributed to or relied upon by any other persons. It’s provided for general information purposes only and is not personal advice to anyone to invest in any fund or product. Information taken from trade and other sources is believed to be reliable, although we don’t represent this as accurate or complete and it shouldn’t be relied upon as such. Calls will be recorded for training and monitoring purposes. Issued by Marlborough Investment Management Limited, authorised and regulated by the Financial Conduct Authority (FRN115231). Registered in England No. 01947598. Investment Fund Services Limited (IFSL) is the Authorised Fund Manager of the Fund. IFSL is registered in England No. 06110770 (FRN 464193). Both firms are authorised and regulated by the Financial Conduct Authority in the UK. Registered Office: Marlborough House, 59 Chorley New Road, Bolton, BL1 4QP. Copies of the Prospectus and Key Investor Information Documents are available from or can be requested as a paper copy by calling 0808 178 9321 or writing to IFSL at the registered office above.