Expectations of recession in developed markets were high in January 2023. We’d just come through the fastest series of rate increases in four decades, so an economic fallout that would depress both corporate earnings and equity valuations felt inevitable.
However, with expectations at rock bottom and cautious positioning the order of the day, it was actually easier for macro data to surprise on the upside.
The same held true for fixed interest over summer and early autumn. Central bankers reiterating that rates would remain higher for longer led to more short positions in medium-to-long duration government bonds.
When lower-than-expected inflation was revealed in October and November, a wave of short covering and the unravelling of these crowded positions followed.
But the trend is not always your friend.
Going against consensus is never easy. It often feels uncomfortable. But when it’s underpinned by compelling valuations and applied as part of a diversified and disciplined structure, it can be rewarding over the long term.
Our asset allocation committee recently reviewed our current positioning, and identified a few anti consensus stances that we are quietly confident about.
Small-caps
Following a torrid period of underperformance, investor exposure is light, valuations are at or near to record lows, and expectations depressed. Even if there is a mild recession, which we’re not ruling out, small caps already appear priced for this. That means if a soft landing is achieved, there is scope for considerable upside surprise.
History suggests that small-caps outperform following the peak in interest rates, as investors look forward to a pick-up in activity as interest rates decline.
The chart below illustrates the valuations on various indices in terms of forward price-to-earnings (P/E) ratios and the blue dots show that small-caps are at the bottom end of their historical range across most markets.
Source: JP Morgan Asset Management
UK equities
This deeply unloved, under-owned and cheap asset class offers value that is expected to be realised at some point, thanks to the prospect of an improvement in domestic growth as real incomes turn positive, the declining cost of living for households as inflation normalises and mortgage rates moderate, solid recurring cashflows underpinning attractive earnings yield and an easing of (or end to) selling pressure following 32 consecutive months of investor outflows.
With UK institutional pension fund UK weightings now down to around 5-6% on average from approximately 40% in the 1990s, who is left to sell?
Emerging Markets
Having underperformed for three consecutive years, emerging markets are cheap and a consensus underweight. GDP growth forecasts of 4-4.5% for 2024 and 2025 look achievable as stimulative monetary and fiscal policies are rolled out, with inflation already close to/below central bank targets.
The relative stability in emerging market currencies during a period of material Fed tightening shows just how far the macro has changed from the past. We believe the risk reward trade-off has notably shifted in emerging markets’ favour.
A time for selective opportunism
There can be long and variable lags before the full impact of monetary tightening takes effect. That’s why, despite the market euphoria in the last quarter of 2023, we retain a cautious tilt within our portfolios.
Our continued commitment to a disciplined investment process of seeking long term opportunities helps us identify selective opportunities that can deliver compelling returns for investors over time. 2024 may be the year when they start to show their worth.
Peter Dalgliesh is chief investment officer at Parmenion. The views expressed above should not be taken as investment advice.