What diversified portfolio for 2024?

In search of a "new" normal

The arrival of the pandemic in 2020 changed the minds of investors. The successive shocks of Covid and the energy crisis introduced extreme points into economic and financial data. This noise is beginning to fade, as in all wave phenomena. The year 2023 was marked by uneven economic performance and mixed corporate results. As the year draws to a close on a positive note for bonds and equities, but affected by a high degree of performance dispersion and significant idiosyncratic risk, what portfolio should we build for 2024?

2024 should bring greater visibility for investors

Better visibility, or better readability? Probably both. Some economic data are finally returning to "familiar" territory. Inflation gave way and is set to fall rapidly below 3% in both the US and the Eurozone[1], no longer a primary concern for investors. Similarly, according to IMF forecasts, the wide range in economic growth rates among countries should narrow considerably by 2024/2025, after the shocks have been absorbed. The same is true of monetary policy: We are at the end of the monetary tightening cycle, with central banks having succeeded in their mission and having restored their room for manoeuvre. The central question for investors has shifted from whether there will be rate cuts, to when they will take place.

Investor sentiment and positioning have become much more positive than they were at the beginning of 2023, and this is where the question for 2024 lies: To what extent has this seemingly more predictable and legible environment now been integrated?

Structural changes in interest rates modify portfolio balance

The pivot of the US and European central banks is likely to take place during 2024, but we do not anticipate any major rate cuts in our central scenario. Today, we are very close to our US and German rate targets for 2024. Inflation has decelerated rapidly, but medium-term inflation expectations (5-10 years) are anchored at 3% in the United States, a level in line with the average seen over the 1998-2008 period[2]. The persistence of a higher-rate environment alters the balance of a diversified portfolio, as investors have a wider range of assets offering positive real returns.

As the year draws to a close, given the expected returns on equities and bonds, investors seem to have little incentive to increase the level of risk in their portfolios. In our view, the expected returns on equity markets are insufficient to cover the risk of disappointing economic growth and geopolitical risks. After all, half the world's population will be going to the polls in 2024! On the bond side, the carry provides a return for investors.

Our target portfolio for 2024 therefore favours bonds over equities, with a longer duration, as the US and European central banks declared their pivot at the last meetings of December. In bonds, we seek to invest in government debt (including dollar-denominated debt, with currency hedging). We also favour corporate credit (investment grade) in euros and dollars. Finally, emerging debt offers attractive yields in both dollars and local currencies, and should perform well in a world of slower but positive growth and a weaker dollar.

Selective investment in equities

As 2023 draws to a close, equity markets are once again integrating a "Goldilocks"[3] scenario, which is favourable to them. Based on the current level of the main indices, we expect a single-digit return, underpinned by low but positive earnings growth and dividend yields (see December 7 article on equities). As a result, we expect equity markets to be range bound, i.e. without any major trend, with limited upside and downside potential. Indeed, in the event of economic disappointment or an exogenous shock, central banks should find it much easier to intervene than they did last year.

While the market as a whole seems to us to lack a catalyst, we nevertheless believe that there are some attractive opportunities in certain themes. For example, we look towards high-quality defensive companies in the healthcare and consumer staples sectors. These sectors largely underperformed in 2023, penalized in part by rising interest rates and by much stronger-than-expected growth in the United States in 2023. In 2024, these companies offer the dual advantage of lower sensitivity to changes in the economic cycle and relatively attractive valuations. We also remain positive on companies in the technology sector, and beneficiaries of the AI theme. Their stock market performance is underpinned by superior earnings growth, which should continue into next year, while the interest-rate environment should not be an obstacle to their valuations. Finally, we see opportunities in stocks that have suffered from sometimes forced and undifferentiated selling. This includes some of the smallest-cap companies in Europe, as well as in the United States. However, a sustained rebound will depend on business activity holding up well.

"It’s Difficult to Make Predictions, Especially About the Future”. What if... we were wrong?

Is our allocation scenario-proof? Should fears of recession re-emerge, we expect government bonds should perform well, providing a partial hedge for the riskier part of the portfolio (notably equities). The correlation between the two asset classes, bonds and equities, is likely to become negative again in an environment where inflation has normalized. Other assets can help cushion the fall in equities: For example, gold, the yen and alternative strategies should perform well in this context.

We think rising inflation would be the worst-case scenario for a diversified portfolio, putting both bonds and equities at risk of a 2022-style downturn. In this case, liquidity and exposure to certain commodities such as gold or energy (oil) should be favoured to limit the decline.

The last type of risk is an exogenous risk (geopolitical risk, risk to financial stability). This type of shock causes a sharp rise in volatility, and would need to be assessed in terms of its impact on activity, which returns us to the first scenario: Government bonds, gold, the yen as well as alternative strategies can partially protect a diversified portfolio.

We therefore favour a balanced and selective approach for 2024: On the bond side, we are looking for longer duration carry, exposure to investment-grade credit and emerging debt; and on the equity side, more specific exposure to certain themes that have greater upside potential than the indices: Consumer staples, the technology sector, and smaller caps.