After last year’s rally, markets have looked wobblier in January. Should investors be more cautious?
- The MSCI World index rallied around 15% in the final two months of 2023.
- Much of the recent rally is premised on the assumption that interest rates will fall in the coming months.
- There are still a range of factors that could push up inflation in the near-term.
Financial markets delivered some much-needed optimism at the end of 2023. The MSCI World index rallied around 15% in the final two months of the year. Just as importantly, markets finally looked beyond the narrow handful of AI stocks that had driven performance all year. It appeared to augur better times for the year ahead.
However, increasingly, there are a number of factors that could derail investor optimism. Much of the recent enthusiasm is premised on the assumption that interest rates will fall in the coming months. The immediate catalyst for the rally was the Federal Reserve releasing estimates showing three rate cuts in the year ahead.
This is not assured. Inflation has come down sustainably for much of 2023, but the December inflation report showed prices rising again. Jobs data shows little sign of significant weakness, and high employment continues to support high consumer spending. Equally, it is an election year, which makes any attempt to tackle mounting government deficits unlikely.
High government deficits are a risk in themselves. The US national debt is currently sitting at nearly $33 trillion dollars, up almost 90% since the start of the pandemic. The annualised interest bill has hit $1 trillion, or 20% of tax income. This is a long-term risk to the stability of the US economy.
There are also leftfield factors. The geopolitical environment remains febrile. The Houthi attacks in the Red Sea threaten to disrupt trading routes, bringing delays and additional costs for companies shipping across the world. If this disruption is reflected in goods prices, it will start to push up inflation once again. This makes interest rate cuts less certain.
The mounting crisis in the Middle East is also a threat. So far, commodity prices have remained unmoved by the Israel/Gaza conflict, but if it spreads to the surrounding countries, it could disrupt supply. Equally, there is a worldwide scramble for commodities to support the energy transition. This could also be inflationary.
Equally, while all the signals are pointing to a ‘soft’ landing for the US economy, neither is that a certainty. It is even less likely in the UK and Europe, where employment and consumer data are already wobbling, and economic growth increasingly scarce.
These risks may not come to pass and most economists still have a more benign scenario as their central case. However, after the market’s recent rally, bad news is barely reflected in market prices. As such, it is worth ensuring some balance in a portfolio, a fund that can zig when the rest of your portfolio zags.
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