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Citation - Fourth Quarter 2023



George Herman
Chief Investment Officer
Estimated reading time: 6 minutes 44 seconds

The geopolitical instability from last year has escalated in 2024, expanding its reach and impact. The conflict in the Middle East is slowly but surely metastasising and the Russia-Ukraine war is far from over. Leadership changes in Taiwan that don’t suit China are escalating that region’s tension. Adding to all of this, the global geo-political pressure cooker is going to be further fuelled as around half the world’s population will be voting for leadership this year. If recent outcomes are anything to go by, populism is gaining support as people want change. If change is what you want, change is what you’ll get, should we get Trump 2.0 in November!

However, before we get there, we need to reflect on the final quarter of 2023, where the United States (US) Federal Reserve (Fed) hinted for the first time that we might have reached the peak of interest rate hikes for this cycle. The markets didn’t waste a minute and started pricing in the positive effects of these anticipated lower interest rates. All asset classes rallied as equities, bonds and real estate all celebrated the relief of rate cuts to come. Asset revaluation was rapid and large and by the time we reached year-end, the markets had already priced in six interest rate reductions of 25 basis points each, starting in March, for 2024! Such an outcome is highly unlikely in our opinion, as the Fed has clearly stated that inflation hasn’t been fully vanquished and because the US economy hasn’t, and isn’t, expected to fall into a sharp recession soon. The feeling is thus that the market front-loaded or borrowed some returns from 2024 into 2023, leaving it ripe for some disappointment early this year. Following stellar returns in 2023 the risk premia on most asset classes are too low and warrant caution as some retracement is imminent.

The big conundrum of 2023 ended up being the recession that never arrived. At the beginning of the year history was made when a recession in the US was the consensus outlook for the year. Never before had a recession been forecast. With inflation at 40-year highs, sharp interest rate increases were a foregone conclusion and indeed they were delivered. Economic theory elegantly postulates that higher interest rates constrain consumption expenditure as higher debt servicing costs absorb discretionary and/or capital spending. This leads to lower economic growth, higher unemployment and clearly lower property values. However, the US in 2023 made a mockery of this expectation as economic growth hardly slowed, unemployment remained historically low, and wages increased more than inflation. The final blow to ‘normal’ economic theory was that house prices in the US increased, despite a record pace of interest rate increases. “Impossible” I hear you say. Yep, that’s what happened. As they say in the classics: “Truth is stranger than fiction!”. In hindsight, we find plausible explanations for these highly unlikely outcomes, but that doesn’t make understanding the future any better or easier.

These incongruities to both theory and history left the financial markets in a state of paralysed perplexity. As uncertainty regarding economic macro fundamentals increased, financial market volatility decreased to near record lows. Clearly, fast money withdrew from the game as all macro-sense left the building. Herein lies an important marker for us going into 2024 though. It’s clear that many market participants and investors threw in the towel and are just sitting on their hands, waiting for normalcy to return. We doubt that time alone is what resolves this dichotomy between macro volatility and market volatility. With half the world’s population voting this year, geopolitics will likely deliver the fibrillatory impulse to market volatility, and in so doing, will restore the correlation between the world and the street.

At Citadel, our second pillar of the Citadel investment philosophy is that valuation matters. It is a well-known statistic that returns, following periods of high valuation, are generally lower than returns following periods of undervaluation. With markets having dragged future returns into 2023, valuations are frothy and would require exceptional fundamental drivers to generate further gains. With geopolitical uncertainties and economic slowdown, risks are still prevalent, and our solutions remain extremely cautious and very widely diversified. We expect the global macro situation to start improving at the back end of this year and into 2025, which will be an opportunity to engage more return-enhancing opportunities.

Enjoy this first edition of CITATION for the year!