2023 will soon be history. It has been another turbulent year, with several major crises, high inflation and a sharp rise in interest rates. Most people have become less well-off. Despite this, returns have been good. The equity portfolio is up more than 20 per cent, and a balanced portfolio of equities and fixed income has risen more than half of this.
Strong returns caused by weaker macro figures
The main drivers behind this year's returns are the development in interest rates and inflation, as well as optimism about artificial intelligence. Central banks have raised key interest rates to levels not seen since before the financial crisis in an attempt to bring inflation under control. Market interest rates rose significantly, resulting in price losses in bonds with longer maturities/durations.
Macro statistics in November provided further indications that inflation is under control and on the way down. Market interest rates fell, reversing much of the earlier rise this year. Returns on bond funds so far this year have turned from negative to positive.
The best fixed income investments this year have been in credit, also known as high-yield bonds. High credit margins and few defaults have provided good returns in this asset class this year.
The Norwegian krone is having another bad year. The US dollar and the euro have both strengthened 12 per cent against the NOK. As the equity portfolio is not currency hedged, this contributes significantly to the year's return on international equities for a Norwegian investor.
The return on global equities measured by MSCI All Countries World is 17 per cent measured in local currency. The return on an equally weighted index of the same equity universe is 6 per cent. In other words, it is the largest companies that have risen, while the average share is more or less unchanged in value. Most of the year's return can actually be attributed to just 10 large US companies, 'The Magnificent 10', which together have risen by more than 80 per cent.
This year's price increase in the broad equity market has not been driven by growth in earnings per share, but almost exclusively by multiple expansion - higher Price to Earnings multiple. Shares in the MSCI World Index are now trading at 17 times expected earnings per share next year. The average over the past 20 years is a multiple of 15 times.
If we turn this on its head, expected earnings divided by current share prices, we get a "share yield" of 6 per cent. This is low compared to the historical average, and especially if we compare it to fixed income investments. The real interest rate, nominal interest rate minus inflation expectations, on 10-year US government bonds is now 2 per cent. If we subtract the real interest rate from the equity rate, we get a risk premium in equities of 4 per cent. Historically, this has been 6 per cent. Equities therefore do not look cheap after this year's price rise.
Soft landing in 2024
We make no changes to our market view in December. We have a moderate overweight in investment grade and high yield bonds and a moderate underweight in equities. The risk-adjusted return potential in fixed income investments looks somewhat better than for equities in 2024.
Consensus forecasts for next year show that economists expect weaker global growth in 2024, caused by lower growth in the US and China. Growth in the Eurozone is expected to be unchanged from this year, which was a weak year. The good news is that this will result in the inflation rate normalising and interest rates can be reduced. The market is pricing in a reduction in key interest rates of more than one percentage point in the US, the Eurozone and Norway. The opposite is a moderate increase in unemployment. If this happens, it will be a so-called soft landing, and the central banks will have succeeded in taming inflation without causing a major recession.
In the alternative scenario, growth is more likely to disappoint than to surprise positively. In this case, wage and price inflation is still too high and central banks remain at current interest rates. The normal outcome in periods when monetary policy and bank credit have been tightened so much is that the economy slows down considerably more.
Next year is also a year with an unusually high number of elections globally, including in the USA. On "Super Tuesday" on 5 March, the most likely outcome is that Trump will be the Republican presidential candidate. It is reasonable to assume that geopolitical risk will remain high next year, causing volatility in the markets.
Given this uncertainty, it makes sense to keep a well-diversified portfolio in equities and fixed income. Although the equity market currently seems somewhat expensive, it is unlikely to be very weak if we see many interest rate cuts next year. There are also parts of the market that have performed poorly this year that could rebound next year, such as Renewable Energy.
If a soft landing is the outcome, we believe that high-yield bonds will be the best fixed income investment and the asset class with the best risk-adjusted return in 2024. The effective interest rate on the loans in our credit portfolio is now around 10 per cent, and defaults are expected to be moderate.
Investment grade bonds, fixed income investments with low credit risk, now yield an effective interest rate of around 5 per cent. The interest rate duration in this part of our portfolio is around five years. This means that a change in the market interest rate of 1 per cent up or down will have a price effect of +/- 5 per cent, in addition to the underweighting of interest payments. Given the uncertainty surrounding growth next year, this appears to be the cheapest insurance we can own against a major fall in the stock market.