Volatility and active investing will define 2024
Sebastian Mullins, Head of Multi-Asset
The last two years have been a rollercoaster
ride for investors. The recent rate hike cycle
has been the hardest and fastest in decades,
upending the relative tranquillity of markets in
the post-GFC era. Bond holders have seen one
of the largest and longest drawdowns in history,
and global equity investors had to stomach
+/-20% swings only to underperform cash.
It’s fair to say that investors are looking for some good
news in 2024. Inflation has peaked and is rolling over,
providing a pathway for central banks to ease monetary
policy next year. It is therefore no surprise that
investors are celebrating and the market is now pricing
in a soft landing.
“ We predict that
fiscal policy will be
looser, governments
will be increasingly
protectionist, and
input costs will
be higher.”
Outside of a recession, interest rates could remain
higher than the market is anticipating. The remarkable
insensitivity of the US to rising rates is due to both
households and corporates locking in low fixed rate
loans in 2021. In Australia, the overwhelming majority
of home loans are floating rate, where as in the US it
is less than 10%. US households managed to lock in
30-year mortgages near the lows and have therefore
mostly been insulated from rate rises.
Corporates are no different. Less than 15% of non-
financial companies have debt maturing over the
next two years. Higher quality companies issued
longer dated debt in 2021 at rates below what they’re
currently earning on their hefty cash piles, with some
even seeing a decrease in debt servicing costs in 2023.
Outside of a crack in the labour market, pre-emptive
easing is premature.
Looking beyond 2024, fiscal imperatives will likely
continue to drive looser fiscal policy, keeping upward
pressure on inflation, while central banks remain
more hawkish to try and keep inflation under control.
There are many different factors at play but we think
they can be grouped into three categories, namely
deglobalisation due to rising geopolitical tensions
and the need for greater supply chain resilience;
decarbonisation or energy security as economies
transition to a new energy mix; and demographic
constraints, where income inequality clashes with a
continued reduction in workforce supply. Together,
they form what we’ve called the 3D Reset. We predict
that fiscal policy will be looser, governments will be
increasingly protectionist, and input costs will be
higher. The cost of money, the cost of labour and the
cost of energy will create winners and losers, both at
the corporate and state level, depending on their ability
to access these resources.
Stay nimble, stay active
In this environment, investors must stay nimble and
active. Higher inflation leads to higher rates which leads
to higher volatility. Higher inflation causes the negative
corelation between equities and bonds to breakdown,
further exacerbating volatility in portfolio returns.
However, more volatility offers more opportunity
to active asset allocators as they can capitalise on
dispersion of returns.
Investment regime shift
High rates leads to more volative bond/equity correlation

Chart 1: US 10-year treasury yields Chart 2: Rolling 5-year US equity vs bond correlation

Source: Schroders, Refinitiv as at October month end 2023. RHS shows rolling 5-year correlation between US Bonds and US Equities.

Investors should also look to be active in security

selection in both equities and credit. When money
was free, loss-making companies could survive on
the promise of future earnings. Yet with today’s much
higher cost of capital, companies will be forced to pay
off their debts sooner rather than simply roll over their
paper. This means identifying companies that can
defend their moat and make adjustments to defend
their margins. On the fixed income side, managing
duration will require a more hands-on approach.
Country and curve selection will be important as each
economy walks the tightrope of reigning in inflation
but not pushing their economies into recession.
“ With today’s much
Will the equity laggards catch up or will the generals higher cost of
roll over?
The extraordinary rally in equities in 2023 was driven capital, companies
by a mere seven stocks. The “magnificent-7” are
up over 100% year to date, whereas the S&P rallied
almost 20%, but the equally weighted S&P 500 is up will be forced to
less than 5% over the same period. Laggards such as
Australia have delivered over 5% and emerging markets
delivered a paltry 3% in local terms. This has caused
pay off their debts
the US equity market to look expensive relative to
others. US exceptionalism has always led to a valuation
premium to other markets, but even this valuation
sooner rather than
gap between the US and other markets is becoming
stretched. The question for 2024 is whether the US simply roll over
equity market will continue its dominance or whether
the laggards will catch up.
While US equities are expensive on most valuation
their paper.”
metrics, forward looking earnings expectations are
strong. Analysts expect earnings to grow just shy of
12% over next year and another 8.5% the year after,
which would bring forward looking P/E ratios down
to a far more attractive 17x and 16x respectively.
While these earnings numbers do look optimistic, our
macro driven earnings model suggests they may be
achievable outside of a recession.
US remains expensive, but rest of the world cheapening
US is supported by company earnings beating expectations
Chart 3: P/E Ratio vs historical range
Source: Schroders, MSCI, Refinitiv as at October month end 2023.
If policy makers are able to achieve a soft landing,
there is scope for laggards to catch up. Earnings
outside of the US have lagged, but recent earnings
revisions have picked up markedly in places like the
EU and UK. Valuations and structural change make
Japan attractive despite the recent rally. Even within
the US, the average stock looks attractive on a valuation
basis at only 15x, falling to less than 14x next year,
when using the equal weight S&P as a proxy. Therefore
2024 could see a bull market under the surface as the
rally extends its breadth and the other 493 stocks catch
up in the US and ex-US countries climb the wall of worry.
Australia looks attractive given its relatively cheap
valuation and very low expectations for earnings next
year. In the world of the 3D reset, corporates with
inflation linked earnings are likely to prosper. Australia
also benefits from its commodity linkage, particularly in
“Australia looks attractive given its relatively
cheap valuation and very low expectations
for earnings next year.”
Chart 4: US earnings per share growth model
commodities that will be required in the tech space
and energy transition. With increasingly volatile
geopolitics, countries like Australia stand to benefit
as investors and customers from the developed world
look to secure supply from friendly nations.
The multi-asset portfolio is positioned for continued
equity strength over the short-term as markets climb
the wall of worry into the new year. In 2024 we believe
there is a risk for the market to shift back to a higher
for longer narrative, potentially putting pressure on
equity multiples again. We will likely be reducing our
overall equity positioning in early 2024. Once we see
more evidence that growth is holding up, we would
look re-enter via ex-US markets to capture the laggards.
Conversely, if the economy continues to weaken, it will
be time to finally extend duration risk, particularly in
the front end.
Australian equities look cheap, expectations are low
Analysts expect 0% earnings growth in 2024, our model suggests an upside surprise

Aus earnings per share growth model Expected earnings growth 2024

Source: Schroders, MSCI, Refinitiv as at October month end 2023.

For now, the income is back in fixed income

The volatility in sovereign bond yields was extreme in
2023. Looking at the MOVE index (the bond equivalent
of the equity volatility index or VIX), 2023 saw the
highest reading since 1989, excluding the GFC. While it
is understandable that investors have been burnt and
may have given up on the asset class, both nominal
and real yields on offer are now at the highest level
in 15 years. Higher inflation in the age of the 3D reset “ We believe
will likely limit the diversification benefit of sovereign
bonds, but this higher yield improves their return
contribution relative to equities, flattening the efficient investors should
frontier.
We believe investors should look to reallocate to look to reallocate
duration. Nominal yields between 4.5-5% are attractive,
as are real yields on offer from inflation linked bonds
of 2-2.5%. Based on our models, sovereign bonds in
to duration.”
the US and Australia are at fair value. With inflation and
growth slowing and central banks towards the end of
their hiking cycle, the headwinds should soon turn to
tailwinds for bond investors, at least in the short-term.
Over the medium-term investors will have to be more
active in their duration management in the age of the
3D reset.
Sovereign bonds are at fair value
But will volatility keep investors guessing at where yields settle?

Current and Fair Value Sovereign Bond Yields

Source: Schroders, Refinitiv as at October month end 2023

All in yields for credit have also improved, both from
a rise in the sovereign bond yield but also from the
widening of credit spreads. Investment grade credit
now offers around 6% and high yield almost 9% (AUD
hedged) which is significantly higher than what was
on offer two years ago. These higher yields can offer
protection to investors. All in yields will have to rise
more than 1.7% to wipe out the yield earned over the
next 12 months. This can provide a margin of safety.
Australian investment grade credit also looks attractive
on a rock bottom spread basis, which essentially shows
that current spreads are compensating investors
for a recessionary level of corporate defaults.
Indeed, our current allocation favours credit as one
of our preferred assets for a soft landing, potentially
allowing us to collect carry as we wait for more concrete
evidence of where the economy is heading. While
higher yielding credit offers attractive all in yields,
we believe this is a shorter-term trade. The risks
of a potential slowdown and rise in defaults leads us
to prefer higher quality investment grade credit over
high yield more structurally.

Higher yields now provide a larger cushion

Limiting likelihood and magnitude of losses

‘Margin of safety’ = how much would yields have to rise to wipe out the current yield to maturity?(1)
Percent

Australian IG bond yields need to rise by 1.7% over 1 year for capital loss to be larger than yearly income

Source: Schroders, Bloomberg as at October month end 2023. (1) Charts show local currency yield to maturity divided by modified duration.
Investors can also look to alternative sources of credit.
Fixed rate Australian commercial loans are currently
offering around 10% yield, but with less than 1-year
duration, and floating rate Australian private debt
offers AUD cash +5-6% (currently yielding over 9%)
but with no interest rate sensitivity. That’s higher
than the long run return from equities. In the age of
3D reset, having floating rate credit or short duration
credit should benefit for now.

For now, the income is back in fixed income

There are alternatives to equities

Yield by asset classification (AUD)

Source: Schroders, Aladdin, ICE BofA as at 31 October 2023. All yields are hedged to AUD. Insurance linked securities yield is net of expected loss.
Australian equities yield is the dividend yield of the ASX 200.

When sovereign bonds are no longer providing
diversification, other assets should be considered.
Using breadth of investment opportunities will be
essential. For example, insurance linked securities may
pay high yields but can lose money during catastrophic
weather events, such as hurricanes. These assets have
next to zero correlation to equities or bonds as they
are unrelated to the economic cycle and instead driven
by the weather or seismic events. They are currently
yielding over 15% in USD terms or 10% in AUD terms
once expected loss is removed.
For more information about investing in Multi-Asset with Schroders, please contact us.

Schroder Investment Management Australia Limited

Level 20, 123 Pitt Street, Sydney, NSW 2000
T +612 9210 9200

schroders.com.au

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