KYLE WALES: Optimistic market views could prove misguided in 2024

As Wall Street hits consecutive record highs in the waning weeks of January, the reality is that in 2024 the long-delayed recession could well land. The likely market declines, potentially led by the “Magnificent Seven” tech stocks, could then equate to a reasonably hawkish outlook. So where can investors seek refuge during what looks to be another highly unpredictable year? 

Forecasts have proved notoriously unreliable, with 2023 a good example. Whereas the prevailing view was that recession would set in, US growth materially outperformed expectations.  The Bloomberg Median 2023 GDP forecast for the US at the end of 2022 was a mere 0.3%. However, the latest data released this week shows the US economy grew 3.3% in the fourth quarter versus expectations of 2%.  

GDP was not the only macroeconomic data point that outperformed expectations in 2023. In addition to GDP, the US labour market was stronger than expected, and inflation declined despite the strong economy. In other words, the ultimate Goldilocks scenario unfolded.  

Perhaps even more startling than the performance of the economy was that of the stock market. The S&P 500 closed the year up 24% and the Nasdaq added a blistering 54% for the year. After this run, market valuations are definitely sitting at elevated levels. The blended forward price:earnings (PE) ratio for the S&P 500 is 20 times, versus a long-run average of 16.7. For those of us who believe in mean reversion, a market correction seems long overdue.

Looking more granularly, another noteworthy observation of 2023 is how lopsided market returns were. The Magnificent Seven (Apple, Microsoft, Google, Nvidia, Meta, Tesla and Amazon) accounted for 76% of the S&P’s total return in 2023 on artificial intelligence(AI)-led exuberance.  

While there is no question that AI is a game-changer, market expectations around similar game-changing technologies have been hopelessly optimistic in the past. The internet bubble of the late 1990s/early 2000s comes to mind. While the internet was unquestionably a game-changer, it took many years for most dot.com companies to grow into their valuations, and many never did as they failed along the way.  

We believe selective fast-moving consumer goods (FMCG) stocks offer value. These are stocks that should perform well in the event of a recession. I choose to emphasise the word “selective” because many FMCG stocks trade on high multiples relative to their growth prospects and are not attractive. We are looking for those stocks that trade on a wide valuation gap relative to their own histories and can grow in line with their peers. In this case, a stock like Heineken springs to mind.    

Secondly, European defence is a sector that appears interesting and doesn’t often attract attention. European countries have long underspent their Nato budgets and their attention has been drawn to their lack of military preparedness as a result of the war in Ukraine, which is now entering its third year. This is especially true for Europe’s largest economy, Germany. Among European defence companies that appear worthy of consideration are Hensoldt and Thales.  

These companies are trading on mid- to high-teen multiples but are expected to grow their revenues and earnings in the low teens. This translates into a very reasonable PE to growth ratio of just over one times. In addition, this growth is reasonably secure because their clients are governments and their order books are full.   

It would be remiss not to discuss China, where stocks performed abysmally in 2023, in contrast to the excellent year experienced by peer countries. The share price of a stock such as Alibaba (a Chinese bellwether) has essentially moved sideways since its initial public offering (adjusting for the number of shares in issue), even though its revenues are 42 times larger.   

The question then becomes: is 2024 the year to have a relook at China shares? While we believe it is good to have some Chinese exposure as valuations are so compelling, investors should exercise restraint rather than diving in. Chinese valuations are low for a reason. The regulatory environment is unpredictable, and legal recourse against irrational regulations is nonexistent. This is also playing out against a background of geopolitical tension between China and the US.   

While economists’ predictions are for a smooth ride in 2024, many factors give us pause for thought. We believe it pays to be cautiously positioned, despite what the bulls may say, and concentrate on the less beloved areas of the equity market that did not participate in the bull market in 2023. However, whatever happens in 2024 there are sufficient unknowns and potential downside risks to make it likely that we will be taken by surprise. 

• Wales is a portfolio manager at Flagship Asset Management.