Q1 2024 Update
2023 was a good year for markets, despite a challenging journey. Global growth was resilient driven primarily by a tight jobs market and declining inflation which support consumption across the Western world. The rapidly improving inflation picture finally forced a decisive shift from central banks towards a rate-cutting cycle, to the delight of investors in the final months of the year.
Inflation across the core Western economies fell on average by c.60% in 2023, and the weighted average headline rate across the UK, US, and EU hit 3.3% by the end of the year, a normal level if we look back over years of historical data. The downtrend in global inflation continues but we should still expect periods where inflation rises due to less favorable base effects and sporadic bouts of geopolitical pressure points, such as the attacks we are currently seeing in the Red Sea. The significant contributors to inflation today are services and these are related to rents, wages and the jobs markets, where leading indicators all suggest a continued gradual decline in inflation over 2024.
Politics and geopolitical affairs will dominate the airwaves, alongside inflation and central banks. In 2024, there will be 40 national elections covering 40% of the world’s population and world’s GDP. The European Union parliamentary elections will take place over the summer, ahead of the US presidential election that will take place in November. In the UK, an election must be called by 17 December 2024 at the latest, with Labour set to win by a landslide.
The 3 core economic regions – China, Europe and the US – are desynchronized relative to historical norms, primarily due to significant variation in fiscal policy and the differing measures taken to contain the covid pandemic. In the US, financial support for businesses and households was swift, China it was limited and in Europe it is incredibly still being dispersed. Only 35% of the €2 trillion EU Recovery Fund, a covid relief package, has been distributed to date. This variation in policy is leading to a multi-speed world which limits the downside to growth and reduces the threat of a more severe recession from higher interest rates.
Economic Outlook – Key Points
- Global manufacturing cycle is tentatively improving. This current manufacturing downcycle is long in the tooth, with US and European manufacturing sectors having been in contraction for 14 and 18 months respectively. PMI activity indicators remain below 50.0 but have troughed and are improving. Inventory levels remain low and need to be replenished as highlighted by rising new orders to inventory measures, and Asian exports are accelerating, all indicating a revival in headline manufacturing PMIs globally in the coming quarters.
- Consumer, business and investor confidence has improved supporting growth in the short-term. The closely followed ZEW Economic Sentiment Index for Europe jumped firmly into expansion in the last 4 months of 2023. The Conference Board Consumer Confidence Index in the US, rose in December by the most since early 2021 as Americans grew more upbeat about the inflation outlook. And finally, investor confidence as measured by the bulls versus bears index, is now in bullish territory. Improving confidence levels supports future economic activity.
- Inflation has normalised rapidly and will support consumer spending. Inflation has returned to more normal levels and whilst the threat of a second wave cannot be ignored, the pressure remains to the downside in our view. In the US, the sticky shelter component of inflation, will start to ease in 2024, and food, wages and services-based inflation will ease in the UK and Europe, further supporting consumer spending. In the UK for example, the average household has experienced 8 consecutive months of rising disposable income due to falling inflation and wage gains.
- Interest rates set to be cut, supporting investor confidence and credit demand in economy. The threat of ever rising interest rates was a significant headwind for markets over the last 2 years. However Central Banks, have made a firm statement to cut rates in 2024 removing this overhang. There is an 93% chance the Fed will cut rates in May and will cut rates by a total of 1.25-1.5% over the course of 2024. This will create a more supportive backdrop of markets, and credit demand in the economy, as mortgage rates fall and bank lending standards ease.
- Chinese stimulus increasing, improving prospects for 2024. Prices of new homes in China’s 70 largest cities fell 0.4% annually in December which, whilst not great, is not suggesting a collapse by any means. The Chinese Caixin PMI indices jumped into expansion in later part of 2023, and the PBoC injected c.$600bn into the banking system in the second half of the year to support lending to the property sector, small medium sized business and consumer credit. We expect more meaningful stimulus to be announced to spur the Chinese consumer and draw international investors back into Chinese equities.
- Central Bank firepower has been restored in event of recession. We believe any recession will be mild due to the multi speed global economy mentioned above and the potential stimulus that can now be provided via rate cuts in the event of a recession is now sizeable, given interest rates are at c.5% across the developed world.
Market Outlook – Key Points
Bond and equity investors had a rollercoaster ride in 2023, but were ultimately rewarded for their patience, with good returns achieved. The rally in equity markets broadened out to other regions, sectors and market capitalisations. A revival in the global manufacturing sector and Chinese growth will support non-US equity markets in 2024 which are more cyclically exposed through sector composition. Corporate profitability is more sensitive to industrial and manufacturing demand.
At a headline level global equities are not cheap and are in-line with long-term averages of c.17x; however, this is skewed by the dominant US equity market, and once we decompose the global index into regions there is significant disparity and opportunity. For example, the FTSE 100 has a dividend yield of 4.5% and PE of 11x, whereas the S&P 500 trades on 1.5% and 20x respectively. UK, European and Emerging Markets (EM) equities are attractively valued and trade below their long-term average valuation levels, currently trading at a 35-45% discount to the US equity market. China, the dominant market within EM, is trading at a c.60% discount to the US and there is a $38 trillion market cap gap between US and Chinese equities. This is a monumental gap between the 2 largest economies in the world and we expect this to narrow.
Across most regions, smaller companies are trading near their lowest relative valuations when compared to their large-cap peers, and value stocks remain over 2 standard deviations cheaper relative to growth stocks. This is due to the potential threat of a severe recession and ever rising interest rates, and therefore the opportunity is plentiful in these areas once investors become comfortable that a severe recession is unlikely, and rates will be cut definitively. We have seen a glimmer of this recently in market moves through Q4. Over the long term, smallcaps and value stocks have proven to outperform due to superior growth and lower valuations respectively.
Bonds remain well supported in this environment of continued normalisation in inflation towards target and falling interest rates, combined with attractive starting yields of c.4-8% across government, investment grade and high yield bonds. On a relative basis bonds are also attractive. For example, the difference between the earnings yield on equities and corporate bond yields is the lowest it has been in over 10 years suggest bonds are relatively more attractive once you take into consideration risk and volatility. Refinancing requirements start to pick-up for corporates in 2024, with c.21% of the global investment grade market and 15% for the global high yield market set to come due in 2024/25, therefore active bond management will be increasingly more important.
We are confident of another positive year for markets and portfolios in 2024. There is significant dry powder waiting in the wings with global money market funds hitting c.$8.8 trillion in cash assets that could seek a home in bonds and equities in 2024, particularly given investor confidence has improved, and cash rates are set to fall. Historically, market conditions are supportive for risk assets once interest rates peak and begin to be cut, as long as a meaningful recession is avoided, which we believe is likely.
Key Risks to Outlook
- Interest Rate Risk and Policy Error – the full impact of higher interest rates has still to be fully absorbed by the global economy. However, many key areas of the economy have experienced significant weakness such as manufacturing and housing but are recovering, therefore this rate hiking cycle has had an impact but is less broad based and more gradual relative to previous cycles.
- Interest Rate Pricing Risk – the recent market euphoria was driven by investors pricing in more rate cuts as Central Banks made a clear pivot in November and December to a rate cutting stance for 2024. A big risk therefore is that the expected rate cuts by the Fed get priced back out, i.e. investors reverse their rate expectations, or the Central Banks do not deliver them. One scenario where markets will be comfortable if the Central Banks do not cut rates in 2024, is if the economy grows strongly and inflation continues to fall. All other scenarios are likely to be negative.
- Recession Risk – we believe recession is still likely given interest rates rapidly increased from 0% to 5.25% in 18 months. Indicators that have a high predictive power of forecasting recessions, such as the shape of the government bond yield curve and bank lending standards, also suggest recession is likely. The jobs market is the key factor to follow. However, the multi-speed economy provides a floor to any growth weakness, and any recession is likely to be mild.
- Geopolitical Risk – the Israel Palestine conflict has broadened out to include other countries and groups, but the primary aggressor remains Iran – they fund Hezbollah, the Houthis and Hamas. The oil price is the biggest concern but any disruption to Iranian oil can be substituted by Saudi oil. The Ukraine war remains an economic risk via commodity markets. The war sadly seems to be grinding on but without any major escalation. The China-Taiwan issue will be an ever-present risk for markets. The recent Taiwanese elections provided some clear wins for Beijing reducing the risk of war. The incumbent pro-independence DPP lost the parliamentary majority and failed to secure over 50% of the popular vote, indicating the majority of the Taiwanese population don’t want independence at any cost. The US holds significant sway in all global geopolitical affairs and the upcoming US election will be pivotal to the future direction of these conflicts.
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Information was obtained from proprietary and non-proprietary sources deemed reliable by Chase de Vere.
Where the qualified Investment Manager has expressed views and opinions, they are based on current market conditions and their professional judgement and are subject to change.
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Prices were correct at the time of writing.