13 December 2023
Happy Holidays! Another challenging year is coming to a close. Yes, the US (and global) economy defied expectations of recession. True, the S&P 500 has recorded a 20% gain. However, the rally was narrow: only technology outperformed the market. Indeed, of the 8 market sub-sectors, only tech, industrials, and financials posted positive returns (the other six actually declined in value).
To many, it almost seems as if we have been in a two-year bear market. Since the beginning of 2022, the S&P is down 4%. And, aside from energy, only tech and industrial shares have registered small positive returns. The other six sub-segments underperformed the overall index, and posted negative results.
In 2023, market sentiment has swung between two narratives. Early on, investors fully embraced the “soft landing” scenario. Eventually, the US Federal Reserve warned us that achieving this outcome would require interest rates remaining “higher for longer” than generally anticipated. As the year ends, hopes for the soft landing have returned.
What does 2024 have in store? At present, there’s a strong consensus the US economy (and global) will slow further, but again dodge recession, e.g. American GDP advancing a meagre 1%. As a result, inflation will decline, and the Fed (along with other major central banks) will begin cutting interest rates by the middle of the year.
To be honest, I don’t have a major argument with this view. Therefore, I will focus on what surprises — both positive and negative — may emerge, which may drive exceptional returns. In particular, what does a “soft landing” actually entail, and what are the market implications? (This Outlook will present highlights using lots of favourite Charts. Many of the themes are detailed in earlier blogs available in the archive).
Overall, I expect financial market returns to be modest in 2024 (explicit equity, bond, and FX forecasts can be found at the end of the blog). My current preference for bonds will give way to stocks as the year progresses: equity returns should become increasingly attractive over a 24-month period. During the next 12-24 months I expect non-US markets to outperform the USA.
2024 will be a busy political year, with key elections taking place in the USA, UK, Russia, Mexico, India, Taiwan, Indonesia, South Africa, etc. (representing over half the world’s population). This packed calender will add to geo-political risks worldwide, but will also likely delay key decisions on fiscal belt-tightening and climate change mitigation.
Soft Landing: What Does It Look Like?
One of the surprises of 2023 has been the US economy’s resilience against higher interest rates; leading to superior GDP results compared to other G7 nations. The Chart above illustrates the outperformance resulted primarily from more robust consumer and government spending (and exports). However, each of these sectors are likely to be weaker next year. Fiscal policy is expected to be less expansive. And, the resilient American consumer will feel the pinch of a low savings rate and weaker income growth (the post-Covid windfall has run its course). Further, the US dollar’s appreciation should curb sales abroad in 2024.
As a result of the durability of US activity, little “slack” has emerged in the economy, e.g. unemployment remains low and capacity utilisation rates are still elevated. To be sure, employment and wage gains have cooled. Nevertheless, the closely-watched unemployment/openings ratio (a reliable indicator of both labour supply and demand) remains near historic lows (Chart above). Labour market conditions remain tight.
The Federal Reserve, therefore, confronts a tricky balancing act. Reducing inflation to its 2% target will likely require GDP growth below 1.5-2% (the economy’s long-term potential) in 2024, and perhaps 2025 as well. Achieving this result — the “soft landing” — will not be easy, and inadvertently tipping the economy into recession remains a meaningful risk. 2024 Surprise #1: US and global growth risks are to the downside.
Sticky Inflation: Central Banks Will Err Towards Caution
In my March blog “Soft Landing: What Could Go Wrong” , I indicated that US core inflation would be “stickier” than expected: underlying inflation would remain above 3% until the end of the year, and only to 2-2.5% in H2 2024. Consequently, interest rates would remain “higher for longer”. While the Fed has now signaled rate cuts in 2024, the pace may ultimately disappoint the market’s bullish expectations.
Sticky inflation results from high wage growth, which tends to keep service sector price increases stubbornly high (Chart above). Fortunately, hourly earnings hikes are now slowing, as are price rises in the tertiary sector — paving the way for inflation to decline towards the Fed’s target (2-2.5%) by the end of next year.
With the US labour market still tight, the Federal Reserve will err on the side of caution in the near term. Surprise #2: I expect three rate cuts in 2024, while the market is pricing 4 or more. Over the medium term, I am more optimistic. I share the consensus view the Fed funds rate will decline to 3.5% by the end of 2025.
Similarly, other G7 central banks will proceed with care. The impact of the Ukraine war on food and energy quotes has hit Europe hard, and both headline and core inflation have been higher than in the USA. However, the worst appears over, and I expect Eurozone inflation will decline towards 2% next year (Chart above). Nevertheless, with wage growth still above 4%, the ECB will mirror the Fed’s caution — waiting until H2 2024 before easing monetary conditions. Meanwhile, as compensation awards are still running above 7%, UK inflation will take longer to control. Another Bank of England rate hike is still possible.
Stocks Versus Bonds: Priced for Perfection?
A “soft landing” sounds bullish, right? However, the US market is priced for near-perfection: equity valuations are one standard deviation higher than the historical experience, and are expensive relative to other regions (Chart above).
Likewise, equity risk premia are at the lowest level in two decades (Chart above provided by Ed Yardeni). Consequently, my year-end 2024 S&P projection is 4,900. And, I have a slight preference for bonds over stocks. However, I recognise we are approaching a stage in the investment cycle — economic upturn and falling interest rates — that’s typically bullish for equities. But, that may be a 2025 story, or am I too timid?!
Real Bond Yields: End of an Era?
Until the Federal Reserve began tightening monetary conditions, real interest rates had been declining for decades (Chart above). Does the recent rise in inflation-adjusted yields mark the end of an era? The IMF suggested recently the “natural” interest rate — the level consistent with full employment and stable price growth — would revert to pre-pandemic levels after central banks win the inflation battle, e.g. back to 0-1%.
I’m not so sure. There are several plausible explanations for recently rising real yields, beyond tighter monetary policy. US bond market supply/demand dynamics are unfavourable, as a result of large budget deficits and quantitative tightening. Of course, the US is not alone, as government debt has ballooned world-wide during the Covid pandemic (Chart above).
High is bad, unstable is worse. The economists’ rule of thumb is that stabilising debt ratios requires the non-interest deficit (as a percent of GDP) be no larger than the gap between real yields and GDP growth. In the US, for example, stabilising the debt ratio will require a tighening of fiscal policy by 4% of GDP over the medium term. The scale of the problem differs, but all nations face similar challenges (Chart above).
Fiscal tightening will pose a medium-term economic headwind. However, with elections in the US and elsewhere in 2024, there’s little prospect of belt-tightening in the near term. And, future demands for climate, infrastructure, and other supply-side public investments are enormous. Market Surprise: Under normal circumstances, I believe the new “natural” real bond yield is around 1.5% (trend productivity growth plus a fiscal premium), which is lower than current levels. But, if markets believe rising debt will remain unstable, inflation-adjusted yields could rise to 2.5-3%.
Europe: Energy Transition Progressing
After many years of underperformance, European equity markets have produced higher returns than the S&P 500 over the past three years. However, the region has struggled to keep pace in 2023, as its stagnant economy has lagged well behind the USA. In part, this reflects the significant headwind posed by the need to end its reliance on Russian energy.
Fortunately, however, the region has made great progress in finding new energy sources. For instance, Europe no longer imports any Russian coal; compared to 52% in 2021. Likewise, Russia represents only 3% of EU petroleum imports versus 26% prior to the Ukraine war (Chart above). Similarly, Russia’s share of EU natural gas imports has declined from 52% to 18%. More work will be required to eliminate NG imports (both LNG and gaseous). Recent indicators suggest NG dependence will also cease by the end of next year.
Market Surprise: With the headwind of the energy transition easing somewhat, I expect European GDP growth to match (or exceed) the USA in 2024 — of course, both will grow a meagre 1%-1.5% next year. In adition, as indicated earlier, I expect European inflation will be lower than the USA in the next 12 months — unlike this year. And, while Europe has its own budget deficit issues (and the situation varies widely by country), the region’s overall imbalances are arguably more manageable than in the USA. Finally, the earlier valuation Chart indicates European markets are cheap historically, as well as relative to the USA. All considered, I expect European markets to resume their outperformance over the next 12-24 months.
China: Slow Reform = Slow Growth
I have been bearish on China’s growth prospects for the past five years (see my numerous previous blogs). I believe most observers now share my view China is undergoing a secular GDP growth slowdown, reflecting poor demographics, weaker productivity, high debt levels, and over-investment in non-productive activities.
China’s long-term GDP potential is now 4% (or less). Market surprise: Chinese GDP will struggle to grow 3% in 2024, as the government fails to aggressively implement needed reforms. For example, government support of State-owned Enterprises has prevented necessary deleveraging (Chart above). Likewise, failure to support households has slowed the the rebalancing of the economy from investment towards consumption (next Chart).
Stimulative monetary and fiscal policies will be maintained to battle deflationary pressures. However, rising public sector debt and large deficits will limit their options compared to the past (including the stimulus that boosted 2023 GDP). Of course, China has enormous economic strengths, and will eventually deal with these issues. But, I remain wary until the government shifts its priorities towards supporting households, shifting investment towards the private sector, and addressing flagging productivity (next Chart).
Emerging Markets: Has the Time Finally Arrived?
Is it time to reconsider Emerging Markets, as the underperformance has reached extreme levels (Chart above)? By the way, it’s worth noting that much of EM’s underperformance in the past three years reflects the divergence between the US and Chinese markets. Excluding these nations (granted, they’re huge), EM have tracked developed markets quite closely.
What’s the case for EM? First of all, Emerging Markets fare best when global interest rates are declining and the US dollar is falling: both of which I expect. In addition, EM performs best when the GDP growth differential is widest — observe the 2005-2014 decade (next Chart). EM’s 2024 growth premium will the largest in years. Above-trend GDP growth is expected in India, Indonesia, Vietnam, Philippines, Mexico, and Brazil. Laggards include China, Emerging Europe, South Africa, Colombia, Chile, and Argentina. Nevertheless, weak global and Chinese growth will be a major headwind.
Domestically, inflation has peaked in all nations, and monetary conditions are being eased already in many countries (next Chart). I expect 2024 inflation targets to be achieved in virtually all countries, and several will enjoy substantial interest rate reductions. The earlier valuation Chart illustrates EM are not expensive. Many markets are very cheap, e.g. China, but many are expensive, e.g. India. Market surprise: EM should outperform during the next 12-24 months…at last!
FX: Opportunities?
I expect the overvalued US dollar to weaken as growth slows, fiscal problems remain unaddressed, interest rates decline, and political uncertainties mount (Chart above). INR, TWD, PHP, PLN, HUF, GBP, CHF, and CNY are also likely to depreciate. I favour undervalued BRL, C$, JPY, MYR, as well as MXN (see Forecasts at the end of the report).
Productivity: In the Long Run, It’s Just About Everything
If you believe financial markets and TV pundits, artifical intelligence (and technology more broadly) are about to transform the world. As productivity-guru Robert Gordon famously said, signs of technology are everywhere except in the productivity data. Indeed, efficiency gains have slumped worldwide, especially after the Global Financial Crisis (Chart above).
To be sure, stronger productivity growth changes everthing: GDP and living standards rise, inflation declines, budget deficits and government debt ratios fall. It’s been done before. US output per hour accelerated in the Naughties following widespread adoption of the internet and information technology (Chart above). Market surprise: Watch for positive productivity shocks….likely to favour USA and China! Would be a hugely bullish outcome.
Climate Change: Urgent Action Still Needed
I can’t end without at least a word on climate change — the most important issue of the next decade. Yes, there has been some progress. Countries accounting for 90% of global GDP have made net-zero commitments. The usage of renewable energy (especially solar) is growing strongly, EV adoption is accelerating, electricity grids are expanding capacity. Nevertheless, despite lower emissions from advanced nations, global GHG levels are still rising, not declining.
And, despite net-zero commitments, actually policies adopted so far will not lead to Net-Zero this century, let alone by 2050 (Chart above). Climate models suggest current policies will lift temperatures about 2.5% above pre-industrial levels. Investors should focus on opportunities in renewable energy expansion, the EV ecosystem (including batteries), and methane-reduction efforts. Affordable (and effective) carbon capture tech, hydrogen, and heat pumps are critical, but may require more time and government support to become economically viable. Market Surprise: Soft landing? Without urgent action, more like Crash landing! Unfortunately, this year’s busy political calendar doesn’t point to assertive policy shifts in 2024.
Forecast
