Q4 2023 Update
Global economic growth has proven to be more resilient than many expected, driven by a tight jobs market, rising wages and declining inflation supporting consumption growth. The global service sector is now slowing, but leading indicators suggest the global manufacturing cycle will return to expansion in the coming months. Markets, however, remain challenging and investor sentiment fragile, driven by continued bouts of extreme market volatility and a fear of ever-increasing interest rates. Central Bank actions strongly suggest a peak in interest rates is near, if not already achieved. The US Federal Reserve has paused rates twice in the last 4 months, and the Bank of England opted to pause rates going against market expectations for a rate rise. A firm pause by leading Central Banks would remove the primary source of market volatility and improve investor confidence.
The downtrend in global inflation continues. US inflation has normalised quickly over the last year, while UK and European headline inflation looks set to fall further in the coming quarters. Labour markets have cooled from red hot levels, and wage inflation has come down thanks to lower job openings, but promisingly without a sharp rise in unemployment. China’s recovery from lockdown has underwhelmed, however, the active stimulus programme from the Chinese authorities gives us confidence that the widespread bearishness surrounding Chinese growth is unwarranted. The current lack of economic synchronisation between core sectors and economic regions is favourable. The service sector is slowing as the manufacturing sector picks up, Chinese growth is improving whilst European growth is weak. We are currently in a multi-speed world which limits the downside to growth and reduces the threat of a more severe recession.
Economic Outlook – Key Points
- Global manufacturing cycle is tentatively improving and is set to move into expansion in the coming months, after a year in contraction. Small manufacturing hubs in Europe and Asia are showing tentative signs of improvement when we consider demand measures such as new orders and exports in Taiwan, Korea and Sweden. In the US, new orders-to-inventories have increased suggesting the US manufacturing sector is also starting to accelerate.
- Inflation is normalising, boosting real wages and supporting consumer spending. The headline inflation rates are 59.3%, 59.5% and 39.6% below peak levels across the US, Europe and UK respectively. There will be volatility around the inflation prints particularly in the US, now it is registering normal readings of 3-4%. The trend is still firmly to the downside. In the US, the sticky shelter component, will start to ease in 2024, and food, wages and services-based inflation will ease in the UK and Europe, supporting consumer spending.
- Interest rates set to peak, supporting investor confidence. The uncertainty surrounding interest rates has plagued markets and has greatly reduced investor risk appetite causing some inertia. However, with inflation falling, Central Banks have now held rates steady on multiple occasions, suggesting they have moved off cruise control and are getting closer to the beginning of a rate cutting cycle. The FED typically cuts rates within 8 months of the last hike.
- Chinese economy set to improve on greater stimulus. The Chinese property market has seen prices stabilise and retail sales rose 5.5% year-on-year, suggesting consumer confidence is improving. We expect more meaningful stimulus to be announced to ensure growth targets are achieved and draw international investors back into Chinese equities. China has huge firepower with $3.2 trillion in FX reserves and household savings rates between 30-40%.
- A recession is still likely; however, it is likely to be mild, and Central Bank firepower has been restored. We believe any recession will be mild due to multiple offsetting macro factors. Critically, the potential stimulus – e.g., rate cuts – that can now be provided in the event of a recession is now sizeable given interest rates are at c.5% across the developed world.
Market Outlook – Key Points
Equity markets are positively correlated to the global manufacturing cycle. Corporate profit growth is more sensitive to industrial and manufacturing demand. The mega cap US technology and AI stocks have driven the bulk of the rally in 2023, however, an improving global manufacturing sector and stronger Chinese growth should draw money out of US equities and allow the rally to broaden into other regions, sectors and market capitalisations.
UK, European and Emerging Markets (EM) equities are attractively valued and trade below their long-term average valuation levels and are currently trading at a 20-40% discount to the US equity market. In the UK, many FTSE companies are returning significant cash back to shareholders in the form of dividends and share buybacks, in some cases over 10% of total market cap. The UK Chancellor’s Autumn Statement in November could be a catalyst for a rally in UK equities, notably small and midcap stocks. The S&P 500 is trading at elevated levels, however, there are pockets of opportunity in the US including small-caps and income stocks. Across most regions, smaller companies are trading near lowest relative valuations when compared to their large-cap peers, and value stocks remain over 2 standard deviations cheaper relative to growth stocks. In EM, Chinese equities look attractive, with very cheap valuations combined with an improving backdrop of growth and further stimulus. Market pricing suggests recession risk is relatively well priced in certain markets.
Bonds are well supported in this environment of continued normalisation in inflation and peaking interest rates. We are confident we are at peak government bond yields. UK Gilt yields have been range bound for months, and Fed governors have indicated they want the 10-year US Treasury yield to be sub 5%. The return asymmetry in bonds is very appealing. For example, if we consider the 10-year US government bond, a 1.5% drop in the yield would generate a 16.4% total return, and a 1.5% rise in the yield would generate a loss of only 5.8%. The downside to government bonds is capped given the offsetting income return offset and bond convexity. The risk reward is very favourable.
Long-term return prospects for equities and bonds have improved due to cheaper asset values and higher yields, and patient investors will be rewarded. Data from BlackRock confirms there is now a staggering c.$8 trillion sitting in money market funds, and when investor sentiment finally turns bullish, most of that cash will find a home in bonds and equities, pushing values higher as it does so. Short-term prospects have improved. Historically, market conditions are typically supportive for risk assets once interest rates plateau, and this environment tends to last 9-12 months on average. Also, market seasonality is typically strong in the November to April window, when professional investors are most active. Probabilities, history and valuations remain on our side, and we are confident we can finish the year on a positive note and enter 2024 in a strong position.
Top-3 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 and there is a risk that Central Banks have gone too far, too fast. Interest rate rises do eventually slow down an economy, however, the effect on economic activity is occurring more slowly than in previous cycles and will therefore likely be less damaging. We remain on alert for issues emerging, notably in the housing market.
- Recession Risk – the recession is now well anticipated which gives us confidence that it will be mild, a so-called soft landing. Some growth weakness, notably in the global manufacturing and certain European countries, has now passed without any major issues. The multi-speed world does provide some downside protection to global growth. However, 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.
- Geopolitical Risk – the Israel Palestine conflict is now an additional geopolitical risk; however, it is likely to be contained with limited economic impact. 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. Warfare will be challenging in the harsh winter months, and the Israel Palestine conflict will now take precedence in the media. The China-Taiwan issue will be an ever-present risk for markets. The Taiwanese elections are scheduled for the 13 January 2024, and there is a chance a pro-China party is elected, reducing the risk of conflict. As we approach the US Presidential election in 2024, we may start to see some de-escalation in these geopolitical tensions if a resolution is beneficial to Democrats and/ or Republicans in their pursuit of the White House. The US holds significant sway in global geopolitical affairs.
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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.