Financial markets eye the 3-D Reset
Asset managers have adopted the phrase ‘3D Reset’ to refer to the three dominant themes that will affect asset allocations and investment decision making into the New Year; they expect decarbonisation, deglobalisation and demographics to drive financial market returns through 2024 and beyond. This was among the messages shared during the Schroders Crystal Ball 2024 Investment Outlook webinar, held late-November 2023.
A four-phase cyclical model
“Over the last couple of years, we have been talking about being in the middle of a shift in the investment regime,” said Johanna Kyrklund, Chief Investment Officer at Schroders. “We have called it the ‘3D Reset’ in recognition of the number of trends that lead into a deterioration in the trade-off between growth and inflation”. She observed that developed market central banks had hiked interest rates “more than most people would have expected” over the past 12-18 months, before offering valuable insights into the four-phase cyclical model that the asset manager’s multi-asset teams rely on to get their longer-term allocation to cash, bonds and equities ‘spot on’.
The four phases include recovery; expansion; slowdown; and recession, and Schroders reckons the United States (US) moved into the slowdown phase mid-year 2023. The slowdown phase is characterised by a peak in growth, inflation and interest rates … all of which favour global bonds and create tactical opportunities in global equities. What about the case for a US-led global recession, this writer mused. After all, entering 2023, he had sat through countless presentations during which analysts said a US recession was imminent. “All the macroeconomic factors point to a recession,” they cried, with the only uncertainty being its extent and duration.
Rethinking US recession
Kyrklund cleared up the confusion by explaining the US recession would likely be delayed until the end of next year. “We think that recession will be delayed until the end of 2024 because consumer balance sheets are still very strong after the fiscal expansion we saw during the pandemic,” she said. US consumers are still ‘running down’ the excess savings that accrued to them during that period, as well as benefitting from improvements in real wages through 2023. Her thoughts on when the US Federal Reserve (Fed) will start cutting interest rates will be difficult for local consumers to digest because the South African Reserve Bank (SARB) is unlikely to cut before the Fed.
According to Kyrklund, stability of rates is typical during the slowdown phase of the cycle, meaning investors should not over-egg expectations of a Fed pivot. In the light of strong US employment numbers, the Fed will probably delay making interest rate cuts until after the second quarter of 2024. “It makes more sense for the Fed to sit back and see the cumulative impact of the tightening it has put in place so far, and actually keep things where they are given the fact that the labour market is still quite tight,” she said. As far as global bond market prospects, the asset manager warned of continued monetary policy divergences between China, Europe, Japan, the United Kingdom and the US.
The CIO said that US equities seemed a bit expensive compared to “less stretched” equity valuations in offshore markets, before welcoming Alex Tedder, Head of Global and Thematic Equities at Schroders, to expand on the opportunity set in this asset class. Tedder kicked-off his presentation by noting that the asset manager held a “reasonably constructive” view on global equities despite the challenging macroeconomic backdrop. “The past 12-18 months saw an extraordinary reversion in bond yields and a lot of turbulence in the bond market,” he said. “And equities have done a lot better in this environment than you might have expected”.
Lower-for-longer is now part of history
Over the decade to end-2021, US equity investors generated excellent returns by ignoring excessive company valuations and taking advantage of leverage thanks to the then lower-for-longer interest rate environment. However, this scenario is about to unwind. “Looking ahead there is a strong case to be made for doing the opposite of what you did in that decade,” Tedder said, with the caveat that technology could still have an outsized influence on index performances. As evidence, he noted the bifurcated performance of the so-called Magnificent Seven and the rest of the US listed market.
For readers who are not familiar with the term, the Magnificent Seven is a basket of US-listed technology shares including Apple, Amazon, Alphabet, Nvidia, Meta, Microsoft and Tesla. For a South African equivalent, you might think of the Magnificent One-or-so, being Naspers | Prosus. According to Tedder, the three key takeaways for equity investors entering 2024 are that US equity valuations no longer look particularly compelling; that the returns generated by US-equites over the past decade are unlikely to repeat over the next decade; and that the polarisations exhibiting in global equity markets presently will have to unwind at some point.
Although there are still some tech-related opportunities in US equities, asset managers will be eyeing undervalued, unloved companies in emerging markets as well as China, Japan, Europe and the UK. And of course, they will select their equity exposures to benefit from the three themes mentioned in the opening paragraph of today’s newsletter. “You cannot lose sight of these structural changes that are already incredibly powerful and are only going to become more meaningful for corporates, individuals and society in the coming years,” said Tedder. He then offered some thoughts on how to incorporate these themes in share selection strategies.
Deglobalisation exhibits as re-shoring
Under the deglobalisation theme, he noted the emerging obsession of ensuring that the US achieved semiconductor security. “The US has recognised that it needs to change its policy, and is re-shoring semiconductor manufacturing [as] part of a major deglobalisation initiative that is ongoing,” Tedder said. “We are not saying that the globalisation theme is finished; but that deglobalisation or re-shoring will be very powerful forces over the next few years”.
Turning to climate change and the ongoing push for decarbonisation, Schroders singled out alternative or renewable energy as a sector to keep an eye on over the coming few years. “The sector has been out of favour this year with the alternative energy index down 45% year-to-date 30 November 2023; but now is a great time to get involved in a trend that has not gone away, offering [good entry points] at valuations that are much lower,” Tedder said. The equity opportunities under the demographic theme centre around how private sector firms respond to the impact of ageing, obesity and other emerging health issues.
AI and automation, individually or in combination
But wait, there was more, courtesy a fourth bonus theme shared during the webinar. Tedder singled out automation and artificial intelligence (AI), individually or in combination, as key responses to higher labour costs and labour shortages. “We expect the automation trend to continue and to accelerate very sharply over the next few years with AI being an important part of the story,” he said. Yes, AI may be over-hyped; but the acceleration of the AI trend through new technology is going to have an incremental impact over the coming years. In fact, PwC recently published a study that “shows that the incremental impact of AI implementations could be around USD17 trillion annually” compared to a global economy totalling around USD110 trillion!
As an aside, the four themes highlighted during this short-and-sweet global equity discussion make an excellent argument in favour of local investors diversifying their equity exposure offshore; they have limited (if any) opportunities to get JSE exposure to same. “By focusing on these structural trends over the next few years, and perhaps reinforcing your exposure to them, you can do very well over the next one-, two- and three-years and beyond,” Tedder concluded.
Writer’s thoughts:
Clients who save for their retirement in Regulation 28 compliant funds are forced to hold at least 55% of their assets onshore, despite South Africa being less than 1% of the global economy. Do you believe your clients have enough offshore diversification to benefit from the Schroders 3D Reset theme? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].
