Why politics will drive markets in 2024

Last year gave investors a relatively calm investment environment, something to be welcomed after the roller-coaster ride and travails of 2022. While stagflation and interest rates fears abated somewhat, inflation continued to dominate headlines along with interest rate hikes made by central banks around the world in their ongoing battle to tame inflationary pressures.

Although there was initial optimism in the early part of the year of a tempering of rate hikes and perhaps even rate cuts looming on the horizon as inflation appeared to have peaked, this faded quickly as it became apparent that central banks were predicting a “higher for longer” interest rate environment. 

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After a torrid 2022, global equities closed 2023 up 15% with developed markets leading the charge, in particular being led by the US and Japanese markets[1]. Despite typically being more interest-rate sensitive, technology-related stocks trumped the market in 2023, specifically the “Magnificent Seven” (Apple Inc (NASDAQ:AAPL), Microsoft Corp (NASDAQ:MSFT), Alphabet Inc Class A (NASDAQ:GOOGL), Amazon.com Inc (NASDAQ:AMZN), NVIDIA Corp (NASDAQ:NVDA), Meta Platforms Inc Class A (NASDAQ:META) and Tesla Inc (NASDAQ:TSLA)) all of which are involved in artificial intelligence (AI) or high-end semiconductor chips, which are needed to power AI.

The S&P 500 index rose 19% in sterling terms in 2023 with the best-performing sectors being Technology (48.5%) and Communications (47%). Outside these sectors performance was more modest. Last year saw the resurgence of Japanese equities, which rallied 28%, hitting a 33-year high as the economy saw a welcome return of inflation driven by the weak yen, coming on the back of decades of deflation or low inflation.

This move caught many asset allocators off guard. Another long-term structural change came from the Tokyo Stock Exchange (TSE), which started actively pushing corporate governance reforms focused on enhancing corporate value and sustainable growth for shareholders. In contrast emerging markets, and most notably China, lagged as its economic growth slowed dramatically after a short-lived post pandemic economic bounce. Chinese equities fell 16% as the boost from the reopening of its economy fell short due to geopolitical tensions with the US, regulatory crackdowns on certain sectors and a flagging real estate sector threatening to cause negative issues in the financial system. Emerging markets in aggregate rose modestly gaining 3.6% for the year.

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Fixed-income markets posted modest but positive returns over the year as fears of inflation abated with central bank interest rate hikes having the desired effect of dampening inflation expectations. This positive sentiment accelerated into the final quarter of the year, with bonds posting near double-digit returns as sentiment on monetary policy began to shift towards an anticipation of rate cuts being on the near-term agenda. Globally, corporate bonds outperformed government bonds with the higher-risk segments doing best, most notably High Yield bonds. In the final quarter of the year, gilts and inflation-linked bonds rose circa 8% as the Bank of England opted to hold rates at 5.25% from August, with expectations of future falls being quickly priced in.

The outlook for 2024 is complex to say the least. The economic situation at present is looking fairly benign with central bankers seeming to be more confident that inflationary pressures are on the wane, which is encouraging investors. Alongside this, economic growth is proving to be very resilient, albeit low in Europe, and valuations across asset classes, except for technology, are looking reasonable. This is naturally leading to rising investment optimism in many markets in the early part of the year. However, this year is also presenting us with some major, albeit known, unknowns.

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Politics will dominate throughout 2024 as there are some major elections which could impact the outlook significantly. The most obvious and uncertain event is the US election in November, with a Trump second presidency looking more likely, if recent polling trends are sustained. This would potentially have dramatic ramifications from a geopolitical perspective, introducing huge uncertainty around major global fault lines with a consequent increase in risk premia potentially being asked by investors. This is hard to plan for but will be a focus for investors throughout the year and will inevitably lead to greater volatility towards the back end of the year. The UK election will no doubt capture lots of attention for a domestic audience, but the impact on UK asset prices will arguably be much more muted compared to the outcome of the US election. 

It is a reasonable assumption that the direction of inflation and interest rates will trend downwards over the year - but how fast remains difficult to predict. There are lots of areas of the market that should offer investors an attractive return throughout 2024. With yields on bonds looking optically high, and certain equity markets looking attractive, most notably European, UK, and emerging market equities, the attraction of holding high levels of cash may be short-lived.

Gavin Corr is head of due diligence and manager selection at Morningstar Investment Management Europe.

[1]Morningstar Direct