Despite some optimism among market participants, the macroeconomic environment remains rather weak and growth is set to slow in 2024. The big question is whether this will be a soft landing or a harder one. Caution therefore seems to be the order of the day in the first half of the year, even if price falls will provide opportunities to add to positions.
Beware of complacency!
As the VIX index currently stands at 13-14, volatility remains very low, which seems to indicate a degree of complacency in the market. Indeed, there are fears that inflation could persist longer than expected, due in particular to wage increases, which could also lead to a temporary rise in rates in the short term, contrary to the perhaps over-optimistic consensus expectations.
In addition, small and medium-sized businesses are having to cope with rising financing costs, generating liquidity problems that could trigger forced sales of real estate assets, or even bankruptcies.
What’s more, while consumption remained strong in 2023, this could change in 2024. Moreover, given the economic panorama, it is surprising that distribution was the best sector in 2023. Households could change their attitude in 2024, consuming less in order to increase their savings and reduce their debt.
Finally, given the rise in yields, asset allocation is likely to change. After the famous „TINA“, which concentrated all investment on equities, we have now moved into a period of „TARA“ (There are reasonable alternatives), with reasonable alternatives to the stock market, particularly as regards bond investments. We should therefore see more balanced portfolios in the future, with a more moderate equity component.
We remain relatively cautious after the end-of-year rally, as we can expect downward revisions to earnings forecasts when the 4th quarter results are published in February. In this respect, the downside risks are highest in the USA, where earnings growth forecasts of 11% for the S&P 500 in 2024 seem (over) optimistic. Expectations for Europe look more realistic, with a growth forecast of +6.7% for the Stoxx Europe 600.
Given these potential unpleasant surprises, the US presidential election and worsening geopolitical tensions around the world, we can expect volatility to rise in 2024. However, this environment may offer attractive buying opportunities, which is why we are maintaining a high cash position (currently around 10%).
A more cautious stance
In a less than enthusiastic environment, we are adopting a balanced positioning, which should enable us to respond to the various possible scenarios. We are also focusing on secular trends, which are less sensitive to the economic cycle. In terms of companies, we favour quality, with a preference for solid balance sheets, resilient business models and proven management.
In practice, this means underweighting consumer cyclicals, while remaining ready to increase our positions in cyclicals if the hoped-for soft landing materialises and inventories start to build up again. In the event of a market downturn, we will also benefit from the decline in growth stocks. To guard against geopolitical risks, we are adding exposure to energy. We are taking advantage of the fund’s manageable size to remain agile and take advantage of opportunities as they arise.
A largely undervalued asset class
Despite this conservative stance, we remain very positive on small and mid caps for a number of reasons:
- Valuation. Small and mid caps are cheap compared with large caps. While they usually trade at a PE premium of between 10% and 20%, they are now trading at a discount. Such a situation is highly unusual and generally short-lived.
- High yield. The earnings yield and dividend yield of the Stoxx Europe 600 are 8% and 3.4% respectively, compared with a German government bond yield of 2.2%. The same is true of the S&P 500, with yields of 4.9% and 1.5% respectively, compared with 4.1% for a 10-year Treasury bond.
- Outflows. Outflows from this asset class have been going on for more than 2 years, an exceptionally long period (even longer than that seen after the 2008-2009 financial crisis).
- Timing. Small and mid caps tend to outperform large caps during the slowdown and recovery phases of the economic cycle. It seems unlikely that small and mid caps will underperform large caps for a 3rd consecutive year, and the time seems right to increase the weighting of this asset class in portfolios.