Ringing in a new investment reality in the new year

Below is a commentary I wrote that was published by The Straits Times here.

This has been another year of profound change across financial markets.

Interest rates and bond yields have soared to multi-decade highs, the geopolitical sphere has been reshaped by war and strategic competition and the first ever trillion-dollar AI-related company was crowned – and all as US exceptionalism continues to defy expectations.

Amid?this new normal – of economic uncertainty, geopolitical volatility and technological progress – healthy returns can still be had. Indeed,?with global stocks powered by the artificial intelligence (AI) rally and bonds cushioned by high yields, the 60/40 portfolio has managed to return 8.5 per cent in US dollar terms in 2023, comfortably outperforming cash.

Looking to 2024, three forces will likely ring in a new investment reality: A slowing US economy, China’s transition and a geopolitical super-cycle.

But while these create an uncertain backdrop to start the new year, conditions should gradually fall into place for both equities and bonds to deliver positive returns in 2024, even if the room for error is small.

Slow-motion slowdown in the US

First, we think the US economy will slow but avoid a recession. Though that would be a historically rare occurrence after an intense period of rate hikes, the job market is robust, household and corporate balance sheets are healthy, and investments in the energy transition and AI revolution should continue.

But the excess savings that drove economic activity in 2023 will soon start to run low. With US consumer strength fading and disinflation in place, we think the Federal Reserve’s tightening is over and see around 50 basis point rate cuts on average in the second half of 2024.?

Slowing US growth, falling inflation and lower interest rate expectations all point to a step down in yields as well. In our base case, the 10-year Treasury yield should fall to 3.5 per cent by the end of 2024, supporting both bond and equity valuations.

The benefits extend to Asia, where central banks should broadly track the Fed’s course. Easing across the region will likely also start around mid-2024, a catalyst that could lift Asia ex-Japan and China growth to near 5 per cent each in 2024, alongside a moderate trade rebound and more stimulus in China.

China 3.0

Second, China is entering a new phase of lower growth as it sheds old structural drivers for new ones. In the 2000s, China’s growth was driven by manufacturing and foreign direct investment. In the 2010s, China 2.0 saw a digital boom and debt-fuelled expansions in real estate and infrastructure.

Now, Beijing is engineering version 3.0, driven by consumer spending, the green transition and tech innovation. But this structural transition will take time, and old drivers may need to be demolished before new ones gain economic heft.

Because of this, growth variability will likely be high in the next five to 10 years. Still, an average annual expansion of 4 per cent to 4.5 per cent is attainable with China’s gross domestic product per capita at only one-sixth the US and ample headroom for productivity to catch up.

To smooth the growing pains, Beijing could increase policy support or slow the transition; if so, both would support the market in the near term. Over the next six months, we see about 10 per cent upside for Chinese equities as stimulus steps up.

Geopolitical known unknowns

Finally, 2024 will kick-start a political super-cycle featuring elections in the US, Britain and nearly half of the world’s top 20 economies.

Though a year is a lifetime in US politics, recent polls suggest former president Donald Trump is gaining ground. A divided Congress is likely, which could limit major domestic policy changes.

But while history shows US presidential elections do not have a sustained market impact, it is important to note that foreign policies – like China relations, trade tariffs and wars – will sit with the next president.

In Asia, we are closely watching leadership votes in Taiwan in January, Indonesia in February and India in the second quarter. The first could signal how US-China ties might evolve; the latter two should not derail the domestic pro-growth policy agendas in place.

This packed election calendar will unfold against a backdrop of elevated geopolitical risk. Conflicts, competition between superpowers and industrial policies are rearranging and regionalising supply chains and capital flows.

Here, South and South-east Asia are key beneficiaries: China’s foreign direct investment in the region is now four times the size it was 10 years ago as it seeks to sidestep trade curbs from the West.

Investing in this new reality

As global growth could still surprise either way in 2024, our tactical asset allocation is focused on quality heading into the new year.

Notably, quality bonds should deliver both yield and capital appreciation, while stocks with stable balance sheets, sustainable profit margins and higher returns on invested capital are best positioned to generate earnings in a weaker growth environment, in our view.

In Asia, we also tilt our exposure?to quality large-cap stocks. We expect regional earnings to bounce 18 per cent in the next 12 months, led by cyclical sectors such as IT, consumer discretionary, materials and industrials.

For more strategic holdings, we recommend investing in an equal-weighted basket of the largest index stocks in each of the 10 Asia ex-Japan market indices.

The next decade should also give rise to the AI economy in Asia, which favours industry leaders with deep pockets and a first-mover advantage.

Meanwhile, geopolitically induced supply chain shifts mean a focus on investment alternatives outside mainland China, or “China+1” strategies. In China, investors should focus on new growth drivers like leaders in the consumer, high-tech and green industries, while managing the size of their longer-term exposure.

To hedge geopolitical market risks, investors can look to capital preservation strategies, alternatives (while being mindful of illiquidity risk), or positions in oil and gold.

The decade ahead

Looking beyond 2024, the mix of higher inflation and interest rates, together with defiantly low unemployment, begs the question of whether we have entered a new macroeconomic regime. The answer will be defined by developments in the “Five Ds”: deglobalisation, demographics, digitalisation, decarbonisation and debt.

These megatrends are measured over decades but are playing out today, creating openings and challenges along the way. We expect some of the highest equity returns in the decade ahead from companies that harness new technologies to grow markets, dislodge incumbents or slash costs.

Successfully identifying these “leaders from disruption” is critical to boosting long-term portfolio potential.

In this new era, investors must learn to embrace change. Just as many managed to adapt to a post-pandemic world of supply disruptions, soaring inflation and geopolitical uncertainty, further adjustments now need to be made in a new reality – one of greater macro volatility, geopolitical instability and technological advancements than before.

Please visit?ubs.com/cio-disclaimer?#shareUBS