Multi-asset allocation views

Read this article to understand:

• Why reflation has been the single largest explainer of market activity in 2024
• The impact of reflation on real assets, particularly gold
• The emerging risks that are now challenging bond and equity markets

In the year to date, the two biggest themes from a market perspective have been the rise in yields across bond markets, meaning falling bond prices, and the persistent strength of broad equity markets.

That combination generally suggests an improving growth outlook, and indeed that fits the key macroeconomic news of recent months. In the autumn of 2023, investors debated whether higher interest rates would cause a “soft” or “hard landing” for the global economy. However, if you had asked people then what a “no landing” scenario would look like, it would look remarkably close to the data seen in 2024.

There has been little sign that supposedly restrictive interest-rate policy has slowed the US economy. Employment and house prices have all shown strength, while sentiment is improving in the lagging manufacturing sector. Core consumer price index (CPI) inflation in the first quarter tracked at a rate which would annualise above four per cent. There were continued signs investors viewed the US as an economic leader, with both the biggest rise in government bond yields among major economies and US dollar outperformance. From its lows at the end of 2023 to its mid-April highs, the US dollar rose by 4.5 per cent.¹ Ten-year US Treasury yields have risen by about 80 basis points year to date.²

The story was not one of US exceptionalism, though. Instead of recessionary conditions in the US rippling out, as some gloomier economists had feared, US economic strength actually began to feed into other markets, even to those where the fourth quarter of 2023 had seen weaker growth. The euro area, the UK and even China, where growth has consistently disappointed investors over recent years, have shown signs of GDP stabilisation. Therefore, even those areas with weaker economic prospects have seen yields rise since the low point at the start of 2024.³

Reflation and the bond-equity relationship

The relationship between bonds and equities is complex and often confusing. Most of the last 20-30 years has seen a negative relationship, where greater confidence on the economy tends to be associated with falling bond prices and rising equity prices, as profits drive stock-market gains. The last two or three years, however, saw inflation take centre stage and drive both asset classes to gains (when prices appeared to be under control) or losses (when inflation seemed to be accelerating). Last year ended with strong gains in both asset classes, suggesting the inflation-dominant pattern remained in place.⁴ Central banks fuelled the narrative by expressing strong confidence in future disinflation and priming investors for a rate-cutting cycle.⁵

Would this continue in 2024? In the event, rising bond yields did not drive a reversal in the equity market, and the gains continued. Global equities rallied by 8.5 per cent in the first quarter, increasing by nearly 26 per cent from the October lows. No drawdown exceeded two per cent. In terms of volatility, the VIX index peaked in late October at over 21, dropped by the end of the year to about 12.5, and stayed in a 12 to 15 range through the first quarter. In other words, not only were stock markets rising, but they were doing so in a very calm and consistent manner (see Figure 1).⁶

So, while the economic case for reflation was clear, the market reaction was more surprising when compared with the experience of recent quarters. In hindsight, perhaps investors were more concerned about growth than the October-to-December equity rally implied, and so reflation provided more relief on profits than concern on central bank rates. We may now be in a regime which is more growth-dominant, or at least less inflation-dominant.

Reflation and real assets

Another face of reflation, both as an indicator and driver, is the recent strength in commodity prices – from energy to base and precious metals, and agricultural commodities. In many cases we can directly map this strength back to the improved economic outlook, especially on a broad regional basis. Energy markets are more strongly driven by US industry, and industrial metals by China, but both saw demand revive in the first three months of 2024.

But to see the connection between investor preference and reflation, a look at gold is instructive, since demand for it is not driven by the economic cycle. In fact, the first-quarter currency and interest-rate movements driven by real-economy reflation were more of a headwind than a tailwind for gold. Generally, a strong US dollar or increasing real bond yields increase the opportunity-cost of holding gold and drive its price down. However, both of these factors pertained in the first quarter of 2024 and neither held the gold price back (see Ask the fund manager: As good as gold).⁷

Investors are still looking for ways to protect themselves against an extended reflation scenario that again turns out to be a problem for equities and bonds at the same time. A context of continued high global debt issuance also raises the question of debt sustainability and whether there will be enough demand for all this supply.⁸

Private sector opinions are not the only ones that matter. In the last 12 months, central bank reserve managers bought more gold to diversify their holdings. Geopolitical considerations may play a part, in creating a desire to move assets out of reach of Western authorities. But probably just as important has been a reaction to declining bond values and local currency weakness (most currencies have underperformed the dollar but gold has outpaced it). And as official sector institutions tend to be long-term holders of gold, their acquisitions remove supply almost permanently from the market, even if prices rise.

We believe the outlook for gold is strongest when uncertainty about financial policies (monetary, fiscal and regulatory) are at their greatest. Today, we think the strategic case for gold remains intact.⁹ The likeliest challenge could come from a further weakening in bonds, which would increase the opportunity-cost of an asset without an income.

Other “real” assets are affected by owners’ typical use of leverage; for these investments, reflation means both more demand for diversification, but also higher financing costs. The UK property market faced headwinds in 2022 and 2023, and because property valuations operate with a lag, the next six months could still see lower asset values. However, pricing appears to be stabilising, some sectors still offer attractive yields and interest rates are expected to fall later in 2024.¹⁰

Although the past is never a guarantee of future returns, long-term growth prospects in UK property have historically been strong after sharp falls in valuations. Looking beyond the next few months, if the key driver of interest rates remaining higher is stronger economic growth, that could be good news for property markets in the medium term.

Reflation and risks

After the first quarter’s strong rises in equities and bond yields, investors have been in a more reflective mood of late.

Firstly, the rates market has moved to a much more neutral stance on the policy outlook. From anticipating consistent cuts through 2024, it is now expecting most central banks to keep rates on hold until at least the third quarter, and then deliver only a cut or two before the end of the year (see Figure 3). That has validated the rise in bond yields, but the outlook now depends on whether policy expectations continue to tighten. Could rate hikes be on the table?

Turning to the corporate world, in 2022 and early 2023 investors had worried rising yields might affect the valuation of future earnings. Similarly, investors today are having to reevaluate the point where rising yields become a headwind for risky assets, whether credit or equities. It’s therefore not surprising that April saw a return of volatility in equity markets at the same time as the pick-up in rates.

Secondly, expectations for strong earnings performance had become concentrated in a handful of market leaders like the “Magnificent Seven” US tech companies. Outside those, whether for the rest of the S&P 500 or Europe, for instance, earnings expectations were generally in decline during the first quarter. This narrowing of corporate optimism naturally drove caution as investors positioned for first-quarter reporting. The market reaction to Meta’s first-quarter results – a 16 per cent drop in the share price because of weak revenue expectations, despite strong quarterly earnings – fuelled this worry early in the reporting period.¹¹ Even for the earnings leaders, the question was whether expectations had become insatiable.

The third challenge is the return of geopolitics as a source of risk. The number of elections in 2024 in geopolitically important countries will have a broad range of potential political outcomes and knock-on effects. Low asset-price volatility at the start of the year may not have done justice to these possibilities. Uncertainty around policy focus and direction after the US presidential election in November, for instance, could have implications for Ukraine or the Middle East, which investors have to take into consideration.

These concerns will not quickly disappear from the investor debate. Our proprietary indicators for volatility and risk appetite suggest that both are relatively unstable at present, and greater volatility could be a feature of the summer. 

On balance, we do not expect the risks to derail the underlying trends. Although inflation may not allow central banks to cut rates soon, policymakers are set against causing an economic slowdown through rate tightening. Combined with the stronger economic activity that was starting to play out in the first quarter, that creates a decent longer-term backdrop for corporate profits, where upgrades are now broadening beyond the tech mega-caps. Even among these titans, a period of price consolidation would improve valuations given the pace of earnings growth. Perhaps it is hardest to claim political risks are fully priced in, but it seems likely that investors are more alert to the risks now than they were at the start of the year.

Investment implications

Overall, while volatility is likely to emerge periodically for some time, our medium-term view is relatively constructive on equities. We also continue to like bonds to diversify and protect portfolios against a growth shock in equities, but we are selective and currently favour gilts.

Although commentary from the Monetary Policy Committee has been divided on the path for cuts, economic activity in the UK could be more disinflationary as 2024 progresses (see Aviva Investors House View Q2 2024).¹² There is stickiness in areas like service inflation or wages, but we regard those as mostly lagged effects rather than pointing to additional tightness in the job market.

From a portfolio perspective, we have tactically managed our position sizes in equities, but retain broad-based preferences across the US, Europe and Japan. In some portfolios, we also hold gold as a hedge against the reflation theme.