Fund selectors reveal biggest portfolio risks for 2024

Higher-for-longer interest rates and a spike in inflation, investors assess their biggest risks to markets in 2024

Theo Andrew

Bear market

'Careful what you wish for’ could be one of the most important mottos for professional investors rebalancing their portfolios for 2024.

The equity and bond market rally that encapsulated the final two months of last year has left markets wondering if there could be a reckoning on the cards.

Last December, Wall Street analysts were forecasting no less than six interest rate reductions throughout 2024 – a potentially 150 basis point cut from 5.50% to 4% – as investors banked on the Federal Reserve successfully engineering a soft, or no, landing.

While markets have rowed back somewhat on this bullish outlook, investors have been left assessing the market dynamics of such aggressive rate cuts as they look to hedge against the risks of overexuberance at the end of last year.

“I would say be careful what you wish for,” Stephen Kemper, chief investment strategist,team advisory desk at BNP Paribas Wealth Management, told ETF Stream. “If we see six rate cuts in Europe and the US in 2024,it is because we have a recession.

“I am not sure the market would enjoy such as scenario so that for me is one of the biggest risks.”

An equally worrying prospect for investors is the idea that central banks will keep rates higher for longer – as inflationary pressures linger – which risks tipping major economies into recession.

In addition, heightened geopolitical tensions and several key elections means there are plenty for fund selectors to be wary of in 2024.

No landing vs recession

Despite sounding like the ideal scenario for portfolios, the prospect of a ‘no landing’ in the US poses risks for investors.

Dimas Cuevas Izaguirre, portfolio manager at Sabadell Urquijo, believes this would result in “transitory disinflation”, the idea inflation could rise sharply again on the back of an economic rebound.

“If this scenario comes to fruition, the consequences could be an unexpected surge in inflation, delayed rate cuts, and increased volatility in both equity and bond markets,” he said.

“The Fed is delicately balancing its responsibility to maintain price stability and promote full employment, suggesting that we cannot signal the all clear just yet.”

Historically, the last mile of disinflation –from 4% to 2% – has been the most challenging and many believe it will not be achievable without a recession across major economies.

“A significant slowdown or a recession in the US this year is not currently priced into equity markets,” Jack Byerley, collective portfolio service manager at Verso Investment Management, said.

"A lot of people are now expecting the US to avoid a recession, of which there is little historical precedent following a rate hiking cycle such as the one we have just had. A US recession could have a big hit on earnings and that is the biggest risk to equity markets currently.”

Despite this, US economic data continues to be strong, following a sizable gain inretail sales in December 2023, a bounce in consumer confidence in January and a fall in jobless claims to an 18-month low.

Meanwhile, the S&P 500 hit an all-time high in January as it broke above its previous January 2022 peak, driven by hopes for substantial rate cuts, exacerbating fears the Fed could leave rates higher for longer.

Investors have been wary of this overconcentration, however, with equally-weighted ETFs proving to be one of the most popular allocations in the second half of last year.

Peter McLean, director of investment strategy research at Stonehage Fleming, said his base case is the Fed will achieve a ‘soft landing’ but noted how the central bank is still walking a tightrope with monetary policy.

“The challenge for the Fed is to recalibrate their policy cleverly to land the plane smoothly,” he said. “There could be a situation where interest rates are cut too slowly and policy remains too restrictive for too long, tipping the economy into recession. Or, they could cut too quickly and reignite inflation domestically.”

In a bid to hedge against a recession, McLean said the group had been upping its US Treasuries exposure with 10 years re-turning around 4%.

“If we do have a recession, yields are very likely to push lower and that means you have the lift in capital value as well as the ongoing income.”

Geopolitical risks

Alongside the risk of a recession keeping interest rates higher for longer, the prospect of rising geopolitical tensions could cause inflation to edge upwards.

The Russia-Ukraine war has already re-shaped global commodity markets and increased uncertainty in the Middle East,impacting oil prices and influencing market sentiment further. “The biggest geopolitical risk is that we get a spike in inflation as more countries get dragged into the Israel-Palestine conflict,” Byerley warned. “The Middle East is increasingly fluid and volatile and that is where the biggest geopolitical risk is.”

Kemper added the attacks on global trade by Houthi rebels in the Red Sea could create a supply chain bottleneck and a subsequent rise in inflation.

“We saw during COVID-19 how quickly things can get nasty. It is not my high conviction, but central banks may have to go from cutting rates to hiking again and it is certainly an area investors need to keep an eye on,” Kemper said.

As a result, he has been shortening duration risk in case rates stay higher-for-longer and added Treasury Inflation-Protected Securities (TIPS) could be another option for investors concerned about rising inflation.

“We felt the moves down in the yields at the long end of the curve were a bit over-done so we are reasonably short duration,” he said.

Echoing his views, McLean said rising tensions in the Middle East “could have a meaningful impact on global inflation".

"If we do have a scenario where inflation rises very suddenly or unexpectedly, the Fed may need to raise interest rates further,” McLean continued.

“The scenario really is the worst one because markets will behave like 2022 with bonds and equities going down.”

He said the group has been balancing its portfolios with alternatives, physical gold and insurance-linked bonds to defend against the prospect of rising inflation.

Trump volatility

How much of these geopolitical risks will play out in 2024 and beyond will largely be down to who is in power. With over half of the world’s population set to hit the polls throughout the year, all eyes will be firmly focused on the US presidential election, most likely between Donald Trump and Joe Biden.

McLean argued the election cycle colliding with geopolitical risks is likely to lead to heightened volatility in markets as the year progresses.

“With Trump and Biden offering very different visions for America, the election could have meaningful consequences for the global economy, particularly given what is happening in the Middle East and Ukraine where there is a risk of escalation,” he said.

Despite this, Byerley argued much of the volatility this year will be a result of monetary policy and other geopolitical tensions rather than uncertainties around the election.

"While there will no doubt be noise, most election-linked volatility, if it does occur, would likely be post-election once the market has digested the result.”

Instead of posing a risk to markets, Izaguirre views the US election as an opportunity to increase the group’s equity allocation.

“Our strategy is dynamic, and as the year progresses, a carefully planned shift towards a more risk-on position in equities could be implemented if the opportunity arises,” he said.

“Historical data indicating favourable market conditions in US election years provides a strategic rationale for this anticipated shift.

“Most often, the best hedge against market uncertainties is to ‘keep a cool head’ and hold a diversified portfolio of assets, adding to it as opportunities arise. Recent experiences in 2022 and 2023 confirm the effectiveness of this approach.

This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To read the full edition, click here.


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