Monday Digest

Posted 18 December 2023

Policy and politics set to play a pivotal role in 2024

Heading into 2024, capital markets are in a somewhat contradictory position. Global growth has been slow (and in some places negative) for some time, while central banks have raised interest rates at the fastest pace in a generation. But despite all those challenges, equities have had a good year overall. With inflation finally falling, central banks are now loosening their vice grips, and bond markets are predicting a slew of rate cuts from the major players starting as early as March. That has pushed risk valuations in favour of equities and, perhaps more importantly over the long term, has even bolstered growth expectations. How these expectations play out will be crucial for markets next year.

And yet, anxiety lingers. The rise in equity valuations has left stocks looking a little expensive, particularly in light of damp growth expectations in some regions. And despite the fact that no one seems to believe them, central bankers beyond the US are still toeing the official line that rates will have to stay higher for longer pretty much everywhere.

The consistent theme of this year has been that whenever markets look overexcited, monetary policymakers pour cold water over rate cut expectations. The policy outlook has become the dominant driver of markets, and ignoring what policymakers tell us has made for a volatile ride in investments all year. We expect this to continue for at least the early part of 2024. Ever since the financial crash of 2008, investors have been extremely sensitive to expected monetary policy, and 2023 was no different. This is historically unusual, but it could just be because – for most of that period – rates have been historically low. Rates staying lower for longer increases the sensitivity to rate changes because longer-duration assets gain in relative value and thus make up a larger share of the market (the so-called duration effect). Now that real interests (inflation-adjusted, i.e. what is left after inflation is subtracted) have moved higher, it is possible we will see fewer valuation effects and more focus on earnings stability and growth.

Growth prospects for the UK and Europe greatly deteriorated this year, while the US powered ahead thanks to the incredible resilience of the American consumer and considerable fiscal stimulus. Now, with inflation plummeting, interest rates will surely follow here and in Europe. Across the Atlantic, however, and regardless of the latest Fed acknowledgment that rates have peaked, market expectation remains that looser policy there might take some time. As we go through 2024, that could mean underperformance in the world’s largest economy – a reversal of what we have seen for years. If that happens, bond and equity dispersion will be joined by currency volatility. Such volatility makes firm predictions difficult. Looser monetary policy and (in the latter half of the year) an economic recovery in Europe are likely. Beyond that, unfortunately, we can only predict unpredictability.

Outlook for regions
US: The US was indisputably the standout performer this year, with US equities once again outperforming other markets. But the US economy might not be as strong as its global peers in 2024. Partly, this is about starting points; the US has grown more quickly than the rest but that growth did not spread outwards in 2023. Next year could see US demand providing more external support. That past strength is also likely to keep the Fed relatively less accommodative than other central banks (despite investors perceiving a dovish shift in the Fed’s policy following its December 2023 meeting). This could mean underperformance in US markets relative to Europe or even Emerging Markets. Currency volatility may result, perhaps continuing the recent trend of dollar weakness, which is again generally a growth positive for the global economy. There is also the small matter of a presidential election next year, which is likely to bring further spending promises and plenty of political instability. That being said, energy – especially natural gas and electricity – is much cheaper than in Europe and nowhere looks ready to match the depth and dynamism of the US economy.

The US might well become the victim of its own success in 2024. The liquidity from the pandemic period still is yet to be worked off. Meanwhile the lagged impacts from the pandemic-inspired loose fiscal stance are likely to keep the Fed from cutting rates as early as the European Central Bank (ECB) in Europe, even though growth is weakening. Markets seem to have a rosy view of Fed policy at the moment and so could end up disappointed. In our view, interest rates are likely to come down in Europe (and possibly even in the UK) before the US. These factors could bite in the second half of the year. At that point, Fed policy will have sucked up most of the excess liquidity while real disposable income growth may be slowing (possibly as wages growth slows and goods deflation lessens). We may even see the US flirt with recession. If so, currency volatility and, hence, wider market volatility, is likely.

UK: Monetary policy is perhaps the most important part of Britain’s outlook for 2024. Despite the perceived hawkishness of the Bank of England’s Monetary Policy Committee (MPC), we expect interest rates to come down, thanks to inflation finally falling back to target, and rate cuts should be underway by the summer. This will mean falling bond yields and a pick-up in equity valuations. UK equities are notably cheaper than global counterparts on a price-to-earnings basis, reflecting years of neglect by foreign investors. Valuations have plenty of room to climb and – since we expect positive bond market movements – Britain looks good value.

Next year will almost certainly see another General Election (though the latest possible date is January 2025, which is unlikely but cannot be fully ruled out) which, barring an historic turnaround, is likely to deliver a Labour government. Given Keir Starmer’s cautious approach, though, we do not expect this will dramatically change medium-term growth prospects or financial conditions. There are some hopes that trade negotiations with Europe might be improved by a structurally less antagonistic government, but any effect from this will likely be long in the future. Overall, it will likely be slow and steady for UK investors, but starting from a low base will help.

Eurozone: Economic weakness should mean supportive European monetary policy early in 2024. With any luck, and with the global economic tide potentially turning, this could translate into stronger growth in the second half of the year. These cyclical factors, combined with the relative cheapness of European equity versus the US, should mean market outperformance as of late, but risks remain. There is a risk that the European Central Bank (ECB) has overtightened already, throwing the fragile economy into deeper recession than needed. On the other hand, the continent is still recovering from its energy price shock and the fiscal deterioration it brought. We do not think these factors will disrupt what is ultimately a positive story, but we must stay wary.

We expect tight fiscal policy to be a feature of most major regions in 2024, but probably more so in Europe. That only increases the urgency of the ECB’s rate cuts, which are now a matter of when not if. Headline Eurozone inflation has been on a downward path for months. Markets have subsequently brought forward their rate cut expectations to as early as March. And even then, many commentators are suggesting the ECB is once again ‘behind the curve’ on inflation – only this time in reverse. With so much gloom around the Eurozone economy, growth optimism may seem strange. But looser monetary conditions and a recovery in global growth are sure to benefit the Eurozone. European equities are some of the most cyclical there are; the start of a new cycle should serve them well.

Emerging Markets: If our central scenario of a global cyclical recovery and weaker dollar plays out, Emerging Markets (EMs) stand to benefit in 2024. This would be helped by a Chinese economic recovery, particularly if consumers there felt confident again. With the inherent economic and financial risks surrounding the world’s second largest economy, EMs would do well to focus on securing their own prospects. Fortunately, this is already underway, particularly for regions like Brazil that sorted their inflation problems early.

For China, the main question is now not whether Beijing is willing to soften its deleveraging stance and promote growth, but whether it can. Private sector business confidence appears to have plummeted when one looks at market-based indicators. While government borrowing is now rising, private sector borrowing continues to decline.  The recent spike in consumer default numbers, and the weak pricing power for goods exporters, suggests it might not be so easy. Even with central government support, we expect China to radiate disinflation for at least the early parts of 2024.

The green shoots of a global recovery, if and when they show, should boost sentiment around EM assets. But with the global economy in such a precarious position, 2024 will likely be another year where differentiating between EMs is key.

Outlook for asset classes
In line with our expectations for government and central bank policies, we expect bond market dispersion in 2024. Despite ECB President Christine Lagarde indicating a continued bias towards tightening, a mild tightening in fiscal policy, softening wage rises, energy price falls and generally lower inflation should allow interest rates to fall sooner in Europe than in the US. That is likely to mean a widening of the gap between US and European yields in the early part of the year.

Shifts in the long-term risk premia – how long-term bonds are valued against short rates – have become more prominent in 2023. These have fallen sharply since October, dropping below historic averages. With inflation still lingering, we expect them to move higher in 2024 – primarily in the US. Relative risk valuations will impact credit spreads too, but these have thankfully been resilient. Even though growth is weak (and in some cases negative) investors do not seem to fear widespread bankruptcies or financial instability. That is good, since it will likely mean a ‘buy the dip’ mentality in corporate bond markets.

Equities: We expect global equities to be a tale of two halves, especially in the US. The heavily anticipated global recession – if it comes – will mean stagnant or falling corporate earnings, lowering the base attractiveness of stocks. On the other hand, a lot of that negativity is already priced into current equity values, after global stock markets saw heavy losses in 2022. Investors are tempted to look forward to the cycle after this one – when central banks will loosen policy and growth can start again. Optimists are hopeful about the next cycle, pessimists are still worried about this one, and everyone else is caught in the middle. Markets will likely go back and forth between these two modes until the underlying economic data makes it clear who is right.

The strength of the US equity market, much like its domestic economy, has been unparalleled in recent years. In particular, the outperformance of the US mega caps was stunning in 2023. Share prices for the so-called ‘Magnificent Seven’ – the most highly valued companies in the S&P 500 – increased by more than 70% in response to the generative AI investment craze, while the remaining stocks in the S&P gained just 10%. Whatever the justification for this outperformance, it means the US continues to be more expensive (on a price-to-earnings basis) than anywhere else.

Comparatively, British and European stocks are trading at cheap valuations. This is certainly true for the UK, whose attractiveness as an investment destination has been in decline since before Brexit. These, historically relatively cheap valuations are still a little pricey in absolute terms, at least for where interest rates are. But Europe’s rate cuts are effectively confirmed at this point, while we have argued elsewhere that the UK must follow suit. If global growth is stronger than expected, British and European equities stand to benefit.

The rest of the global equity picture is mixed for 2024. In Japan, improvements in corporate structures have gone under the radar in recent years, but it is clear that companies and shareholders are seeing the fruits of structural change. Margins are improving (from admittedly low levels) and Japanese workers are among the cheapest in the world for their skill levels. Any pick-up in exports (which can only come from a global cyclical rebound) will likely have second-round effects on wages and domestic demand, making Japanese stocks a worthwhile bet.

Currencies: Assuming our policy and economic outlook holds up, the US dollar should decline in 2024, but with bouts of volatility in currency markets. The dollar has become undeniably expensive over the last few years – thanks to impressive capital flows into the US – and this process has to stop at some point. There is every reason to think that point will come next year. Even a mild outperformance from outside of the US would likely cause some capital outflow, lowering the dollar’s value. The Japanese yen could be a particular beneficiary – considering its current cheapness on a purchasing power basis.

Commodities: Commodity prices – oil and gas in particular – will probably stay weak into the start of 2024. As the year goes on, though, global growth expectations should shift. Global growth usually means stronger commodity demand, so prices should be supported. But the amount of support depends on many factors, like where growth is expected to come from and in what form. Outside of oil and gas, metals have slowly lost ground – with the exception of iron and steel. This will not turn around until growth recovers, which is unlikely before the middle of 2024.

The biggest demand swing could come from China, whose government has made clear it prioritises consumer demand and building activity. If Beijing keeps revving the economy, prices for commodities in general will be well-supported. In this sense, we should keep an eye on commodity prices, as these could signal a wider recovery.

Property: There is potential for a property rebound in 2024, but whether it happens will depend on policy. The past year has been difficult for residential property, but activity has picked up across the world – even in China’s ailing building sector. This happened after the fall back in long-term bond yields, which suggests current rates are cheap enough to spark building activity.

Commercial real estate, on the other hand, is still in a clearing phase. The stable, post-pandemic level of demand for retail and office space is not yet clear, while input costs (including insurance) are also in flux. The end of 2023 has seen European real estate investment vehicles come under pressure – a trend that will likely be repeated across the world.

The biggest hope for property prices is government building policy. Next year will see nearly half the world’s population go through elections, and building is an easy sell for most politicians. In multiple regions, we have already seen suggestions of looser planning regulation. This has the potential to unlock substantial amount of growth for the wider economy. Prospective governments might see this as an easy win, considering that many building projects are at least partially funded by private groups, lowering the spending that appears on their balance sheets.

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