Soft or hard? We’re not talking eggs, but whether the US will enter a recession or not.
Download PDF VersionBack in September, we spoke about a divided Wall Street and City. There was concern whether, after a strong first half of the year, gains would continue, or the rally would be set to fizzle out in the second half of 2023. The last two months of the year put paid to that!
According to a report from UBS in Q3, there were three narratives an investor would need to believe in for equities to rally further:
1. The Fed will not increase rates
2. The widely predicted US recession is no more
3. The AI rally was justified
In the three months since writing this, the Fed did not increase rates, the US avoided a recession, and remarkably the market rallied across the board - and not just in the tech sectors, as the S&P 500 closed out 2023 with a gain of more than 24% and the Dow finished near a record high.
Another cause of this optimistic end of year rally was the prospect that the Fed could finally pull off the so called “soft landing” and start decreasing interest rates early in 2024. The year really was a game of two halves, as we predicted back in January, and so 2023 would prove to be indeed a year of inflections.
Our view now is that 2024 could bring about the “soft landing” which will mean slower economic growth, but no recession, leading to rate cuts. In this environment, most analysts now predict improved earnings for S&P 500 companies. What this means in terms of equity performance, varies widely, especially in a US election year (5 November 2024), but the consensus seems to fall in the range of 8% to 9% gains. If we end up here in December, I think most investors would be “happy” given the rollercoaster ride since the pandemic.
“Soft landing”: The Economist asks, “Could 2024 be a year unlike any in America’s post-war economic history?” Continuing, “never since 1945 has annual inflation, measured by the consumer price index, fallen from above 5% to below 3% without a recession at the time of the fall, or within the subsequent 18 months. Yet professional forecasters surveyed by the Federal Reserve Bank of Philadelphia say that at the end of 2024 headline annual inflation will be 2.5%, whereas real GDP will grow by 1.7% over the course of the year—roughly in line with its long-term trend. Financial markets are rejoicing at the prospect of such a “soft landing”.”
• Corporate earnings: US corporate earnings should improve in 2024 to an expected 11.1% (as opposed to a modest 3.1% last year) as cooling inflation is a strong positive for companies.
• Central banks are close to the end of their rate hike cycles: The table is set for multiple cuts in 2024 and beyond. Markets are currently pricing six Fed rate cuts of 0.25% each in 2024, starting in March.
• Inflation falling: In its long-term economic projections from December, the Federal Open Market Committee (FOMC) forecasts core that the inflation, captured by the personal consumption expenditures (PCE) index, will drop from 3.2% in 2023 to 2.4% in 2024 and then to 2.2% in 2025. The final phase of the war on inflation will be focused on the “sticky” elements such as core services. Meanwhile, price inflation, which changes gradually over time, could be slow to respond to monetary policy adjustments.
• Economic downturn: The number one risk for the global economy will be geopolitics, from the war in Ukraine and an escalation of trouble in the Middle East to elections in the US, Europe, and the UK. There is also the not-insignificant risk of what could happen in Taiwan. These political uncertainties could stop businesses and households from spending as they wait and see, leading to a year without momentum.
• European recession: The Eurozone is expected to grow by 0.3% to 0.8% in 2024 so there is not much room for error, especially with France and Germany not firing on all cylinders. The services Purchasing Managers’ Index (PMI) was 47.1 points, and the Manufacturing PMI has remained below 50 points for eight straight months at 44.3 points (a reading under 50 points suggests a contraction in business activity).
• Oil prices: The global market is largely bearish, but increased demand, especially from Asia, could lead to higher prices. Goldman Sachs for example revised its forecast to $70 - $90p per barrel (down from $80 - $100) and Citigroup predicts an average of $75, factoring in slower demand growth and higher US output.
• Artificial Intelligence (AI): Technology will outstrip AI governance in 2024 as regulatory efforts falter, tech companies remain largely unconstrained, and far more powerful AI models and tools spread beyond the control of governments. I would recommend reading “The Coming Wave” by Mustafa Suleyman for a guide to the coming technological revolution.
• US ‘shutdown’: A partial government shutdown could begin on 19 January without interference to avert it, a growing sign of political unrest in the US.
Overall, the global stock market is poised for growth in 2024, with positive earnings projections and the potential for new market highs. According to Finveo MN, “investors should carefully consider the impact of interest rates on different sectors and explore opportunities in dividend-paying stocks and other high-yielding assets.”
According to CBS “investors in the US came into 2023 expecting inflation to ease further as the Federal Reserve pushed interest rates higher. The trade-off would be a weaker economy and possibly a recession. But while inflation has come down to around 3%, the economy has chugged along thanks to solid consumer spending and a healthy job market.
The stock market is now betting the Fed can achieve a “soft landing,” where the economy slows just enough to snuff out high inflation, but not so much that it falls into a recession. As a result, investors now expect the Fed to begin cutting rates as early as March.” The Fed’s next meeting is 30-31 January.
CBS continues, “The Fed has signalled three quarter-point cuts to the benchmark rate this year. That rate is currently sitting at its highest level, between 5.25% and 5.50%, in two decades.”
Still, according to CNN “the Fed hasn’t declared victory just yet, but it has indicated a subtle shift. The central bank’s latest policy statement, released last month, said it would consider a range of data and other factors to determine if “any” additional policy firming would be appropriate.
Officials also look at economic activity broadly, since strong growth could make the Fed’s job of taming inflation difficult. Officials acknowledged that gross domestic product, the broadest measure of economic output, “had slowed” since the summer.
There is still also the possibility that inflation’s slowdown could stall.”
Slowing economic activity at the end of 2023 suggests, according to Vanguard “that the rate-hiking cycles of the European Central Bank and the Bank of England are taking hold. We expect both central banks to keep policy restrictive until they are confident the fight against inflation has been won.”
Economic growth flirted with a recession last year, so the trend is still a little subdued with market sentiment predicting GDP to be between 0.5% - 1.0% for 2024 with the trend eventually boosted as inflation comes down to the 2% target as set by the ECB by the year end.
With growth stabilising and inflation coming down, the expectation is that interest rates, currently at 4%, would be cut, possibly from the middle of the year.
The UK is entering an election year with a struggling economy as borrowing costs, higher taxes and elevated living expenses bite into business and household budgets.
Inflation, currently at 3.9% (November), is set to remain above target until the end of 2025, which may mean rates will need to be cut from the middle of the year.
However, the Bank of England has warned that there is a 50-50 chance of recession, beginning around the spring. The OBR has pencilled in growth of just 0.7% for the year, still less than half the annual average growth rate between 1998 and the 2008 financial crisis.
Asia is expected to account for 60% of global GDP in 2024, higher than the pre-pandemic average. The IMF is predicting growth of 4.2% from the region, compared to 2.9% globally.
Geopolitical developments will also be closely watched. Elections in Taiwan, India, and the U.S. are poised to bring about “dramatic changes in the economic and diplomatic dimensions of the Asia-Pacific region. The heightened uncertainty and anxiety, unavoidably fueled by the swiftly evolving international landscape and the critical point in the China-US relations, will not make it easy for global investors to find their solace,” Hebe Chen, market analyst at IG International said.
We have selected key indices as a representation of the markets rather than a substitute for the whole market as they are the most recognisable for our clients.
Market sentiment has improved strongly since the end of October as softer macroeconomic data releases and the Federal Reserve supported market expectations of interest rate cuts in 2024. Markets now expect as many as six rate cuts in 2024, starting in March, against three in the Fed’s latest “dot plot” of interest rate expectations.
After peaking at a 16-year high just above 5.0% in October 10-year US Treasury yields have consequently fallen sharply to 3.9%. Similarly, German 10-year Bund yields have fallen from a 12-year high of 3.0% in October to below 2.0% in the space of two months.
Credit spreads have continued to tighten amid strong demand and solid credit fundamentals. Default rates are lower than the historical average at this late stage of the economic cycle and are only expected to rise marginally from current levels.
Equity markets have surged higher, with performance broadening across sectors, while the Chicago Board Options Exchange's CBOE Volatility Index (VIX) has fallen to its lowest level since before the pandemic in 2020.
The USD has weakened against most major currencies.
All the major central banks now have a mandate to ensure that interest rates rise and fall within what are considered stable inflationary limits.
In most instances, this is 2% per annum, the ‘goldilocks’ scenario whereby the underlying economy is neither ‘too hot nor too cold’.
The Federal Reserve signalled its highly anticipated “pivot” toward a more accommodative monetary policy and interest rate cuts in 2024 at the 13th December FOMC meeting.
The central bank left the Fed funds rate unchanged between 5.25% and 5.5%, as expected, and updated its “Dot Plot” of interest rate expectations. In the September “Dot Plot”, ten Federal Reserve members still thought the Fed funds rate would remain above 5% at the end of 2024. In December, only three did. The median projection is for three rate cuts in 2024.
Chair Powell’s subsequent press conference confirmed the shift in monetary policy: he mentioned that monetary policy was “well into restrictive territory” despite the recent loosening in financial conditions. He also said explicitly that the Federal Reserve would need to start cutting interest rates “way before” inflation reached its 2% target and that policymakers had discussed when they should start cutting. Finally, he declared that the central bank was “very much focused” on the economic risks of maintaining interest rates too high for too long.
Treasury yields subsequently moved sharply lower and equity markets surged as investors priced in as much as six rate cuts in 2024.
Market sentiment improved into the year-end, with the S&P 500 up over 24% in 2023 and US 10-year yields back to near 4%, down from 5% just a few weeks ago. While the positive market moves were a welcome festive gift for investors, UBS thinks we are entering “a new world” in 2024.
Mark Haefele, Chief Investment Officer at UBS, states that “against this backdrop we maintain our overall preference for bonds over equities, though we recommend investors buy quality in both asset classes. Quality bonds offer attractive yields today and we expect capital appreciation as growth slows and yields fall.”
“With interest rates set to fall next year amid slowing growth, the return on cash will be diminished, while reinvestment risks will grow. We recommend that investors actively manage liquidity and prioritize minimizing cash balances and optimizing yields.”
“Lastly, 2024 will be a challenging year for investors with the backdrop of war and geopolitical uncertainty. That means investors need to consider ways to hedge market risks. Aside from diversification, we see value in capital preservation strategies, alternative investments, or positions in oil and gold.”
On casting back to our thoughts for 2023 it was indeed a year of inflections, although we had to wait until the last two months of the year to be proved correct.
We expect the good news to continue to flow in 2024, but investors might need to broaden their perspective to grasp the broader context and move beyond the present distractions and market fluctuations. We expect there will be a turning point in central bank policy rates and earnings growth, but they may not be possible to see in real-time.
Investors will need to be vigilant and patient as 2024 promises to be action-packed, especially geo-politically, and it will be hard to ignore the short-term headlines. Our theme in 2024 is all about widening the lens and being able to take a longer-term approach, even if the shorter term is chaotic.
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