Making predictions is hard, they say, especially when they are about the future. One of the many truisms attributed to baseball player and popular philosopher Yogi Berra, this pearl is front of mind for those of us on the hook for our market forecasts for the year ahead.
Guesswork about what the next 12 months holds is fun but it bears little relation to what investors actually do. As my old friend Jim Slater once said about the importance of acting on your convictions: ‘the difference is that I did it.’ Anyone can have an opinion about the future direction of markets, but whenever you make an investment, you have to do so without the benefit of hindsight.
That’s the context for the decision by my investment colleagues at Fidelity to dispense with the usual Outlook circus this year and instead indulge in some scenario analysis. Without the benefit of a crystal ball, thinking through possible outcomes and assigning probabilities to them is all an investor can do. Anything else is just putting your finger in the air.
This year feels like a particularly difficult time to make predictions. But, in reality, it always has been. Yes, there is uncertainty about the future path of inflation, about when and how quickly interest rates will start to fall again, how things will evolve in Ukraine and Gaza, or who will emerge victorious from the many elections that 2024 will bring. But we are always looking through fog at the start of a year, just as we are at every other point in the calendar.
Let’s start with what we know. We have lived through a couple of years in which central banks have raised the cost of borrowing at an unprecedented rate. The rapid tightening of monetary policy since the start of 2022 has been an experiment, the outcome of which will only become clear in the months ahead.
The first signs of the impact of rising interest rates are starting to show. Inflation has rolled over and, while it is higher than we would like it to be, it is heading back towards target. Related to that, economic growth is slowing, even if economies have been more resilient to the rising cost of borrowing than many people expected.
So, three of the likely scenarios for the year ahead are variations on a theme: a continued fall in inflation, a deceleration in economic growth and consequently lower interest rates. For completeness, there is a fourth possibility: that the economy just keeps growing, inflation stays high and so too does the cost of borrowing.
The scenario that the market is currently pricing as most likely is the ‘soft landing’. Achieving this would be a rare triumph for policy-makers - overcoming inflation without simultaneously pushing the economy into a recession. It doesn’t often happen this way, so investors are betting on those four most dangerous words: this time is different.
Navigating a path to a soft landing would be good news for investors but we only attach a 20pc probability to this. It would give a boost to the majority of shares which have not bounced back much since the market low in October 2022 and can still be bought on reasonable valuations. Government bonds would also look attractive because victory over inflation would allow central banks to start to reverse the last two years’ monetary tightening. At the same time riskier corporate bonds would benefit from an improving business outlook. Parts of the property sector, such as the logistics warehouses that support online shopping, could do well.
Even less likely, we think, but nonetheless possible, are the two extreme outcomes: a deep and painful ‘balance sheet recession’ that triggers widespread cutbacks in spending by both companies and households; and a so-called ‘no landing’ in which growth continues, inflation remains sticky and central banks push interest rates even higher for even longer. We think there’s just a one in ten chance of each of these.
The hard landing of a deep recession would be bad for most risk assets like shares and corporate bonds. Investors would need to seek out safe havens like the US dollar, gold and government bonds. Within the stock market, defensive sectors like utilities and healthcare would do relatively better but probably not well in absolute terms. The winners in a no-landing scenario would be mid-cap companies that would benefit from increased demand and which haven’t yet seen a recovery in valuations. Commodities could do well too.
Add up the percentages so far and you can see that the remaining outcome, a mild recession, comes with a 60pc probability. A cyclical recession is our base case. It would involve inflation remaining higher for longer before being dragged down by a moderate economic contraction followed by recovery at the end of next year or early in 2025.
Because the market is currently pricing a softer landing than this, earnings forecasts are probably a bit too high which means that investors should look at cheaper markets where more bad news is already expected. Europe and Japan fit the bill on this front. It’s probably not the best scenario for the UK, which has a weighting towards cyclical sectors like energy and mining and financials. As with the no-landing scenario, a mild recession might favour mid-cap stocks that have so far missed out on 2023’s ‘priced for perfection’ rally but are big enough to have some resilience during a downturn.
Setting out four probability-weighted scenarios runs the risk of sitting on the fence - on the one hand X, on the other Y. But it does have the merit of honesty. No-one knows what the future holds, and investors need to approach their task with an open mind and a willingness to alter long-held beliefs as the facts change. As Yogi Berra also said: when you come to a fork in the road, take it.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
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