Rational investment strategies will win out in 2024, argues Luke Hickmore, investment director, abrdn.
Much research has been done into how humans assess risk and the answer remains – not particularly well.
Although we have a perfectly analytic neocortex, capable of carrying out rational reasoning and logical thinking, we also have an ancient amygdala, which reacts instinctively to threats and lessons learned from experience.
This means emotional reactions and old assumptions are hard to challenge, which makes assessing risks from new environments and new threats particularly difficult. Is AI a risk? We can’t judge. Is flying safer than driving? We know statistically yes, but we’re more likely to feel frightened on a plane.
Assessing the risks around a particular investment can be difficult – and that’s why we often rely on experts to guide our decisions. One of the biggest investment stories of late 2022 through 2023 was how ‘boring’, ‘safe’ government bonds went from being a low-risk, low-yield investment to become instruments risky enough to bring down several banks and one UK Prime Minister. If 2023 was the year of the bond, then look out, as with interest rates expected to make moves again next year, 2024 may be another year of the bond.
Before late 2022, central bank interest rates in developed markets had been low for so long that investors searched everywhere else for returns. There was talk of the traditional 60% equity and 40% bond portfolio being dead.
Memories in investing are not long and investors could hardly remember interest rates above 2%, far less envisage a ‘norm’ of 5%. More importantly, they appeared to have forgotten that rapid changes to interest rates can have dramatic effects on the value of bonds.
When rates fell quickly in 2008, post Global Financial Crisis, the value of bonds with long locked-in higher interest rates rose sharply. Even Warren Buffet, to his surprise, found himself trading in government bonds and making substantial profits.
The flip side – when interest rates rise quickly, the value of bonds with long locked-in lower interest rates falls hard and fast – was barely considered during the years when government interest rates stayed way below the norm. So, when rate rises began in 2022 and carried on unabated through 2023, investors, plus many financial institutions, were caught unawares.
Their ‘low-risk’ holdings in government debt were suddenly worth a great deal less and for institutions such as pension funds and banks – take Silicon Valley Bank as an example – this meant capitalisation was far below the required levels, sparking a crisis.
The bond story in 2023 was anything but boring and it transformed perceptions of what is ‘low’ or ‘high’ risk. Holding government bonds suddenly became risky, as rates rose but values plunged.
As 2024 promises further interest rate movements – further upwards if developed market governments don’t see inflation continue to lower, or rate cuts if economic growth stagnates and recessions loom.
The question now is how to navigate the potential risks when investing in bonds next year? Among those risks is the fact that the world’s largest economies are facing much greater fiscal and structural debt mountains than ever before. The UK, the US, China, countries in Europe and elsewhere, have all seen their national debts spiral upwards since the global pandemic.
Different bonds perform in a variety of ways in different environments, so they shouldn’t be banded together. But, if we are at the point of ‘peak rates’ and there are cuts to come in the year ahead, then this is usually an attractive entry point.
Currently, investment grade bonds – debt in highly credit worthy companies – appear to be offering more value than high yield bonds – debt in less credit worthy companies. Also, emerging market debt, usually seen as riskier, is currently lower risk than usual. What are the reasons behind this skewing of the risks?
Investment grade is currently looking like a better choice if there is volatility and recession ahead. The case for high yield is unlikely to improve over 2024, as, should we go into economic downturn, these are the riskier companies, more likely to default, and currently their yields are below long-term averages.
Where to find the best investment grade exposure? Currently, banks are looking like a strong pick. Those that have robust capital buffers, high liquid balance sheets, quality assets and strong profitability. Despite the cost-of-living crisis, loan delinquencies have been low, with the only uptick in credit cards, but still well below 2008 levels. Investment grade real estate, which has been an unloved sector, also appears to be valued attractively.
Emerging market debt currently appears to offer more value and less risk in the year ahead because these economies raised interest rates ahead of developed markets and are now already into their cutting cycle.
The caveat with investing in any of these bonds is that valuations must be considered very carefully. Unlike with equities, buying at the wrong price will not usually come good in the longer term.
After the tumultuous events of recent years, we may live in times that feel ‘riskier’ but the best way to control investment risk is to take a deliberately blended approach and allocate between ratings, sectors and different companies.
In other words, to listen to the rational, well considered advice from the neocortex, instead of allowing the amygdala to rush us into going with what ‘feels’ right or even running for the hills in a panic.
