Much progress has been made. Inflation risks have eased, with core measures annualising nearer central bank targets. There are clearer signs global growth will be slower in 2024, led by a less buoyant consumer confronted by a less favourable jobs market. For most central banks, the peak in rates is in. Yet, more time is needed to ensure residual inflation risks, mainly in services, can be abated through 2024. Global (and US) growth now appears less likely to collapse, making the task of returning to a low inflation environment a little more challenging, particularly given the less disinflationary medium-term backdrop.
Interest rates should be lower by end-2024, as central banks commence trimming rates from mid-year. Slowing growth, and rising real rates as inflation falls, are the probable calls to action. The US is likely to lead the shift, followed by the UK and Europe. Australia may well lag, given a stronger macro backdrop, helped by a stabilising China. Meanwhile, policy in Japan will likely remain stimulative. The consumer, as was the case in 2023 given excess cash balances, remains key to whether rates are trimmed earlier or later than mid-2024.
Thus, 2024 holds the prospect of being more supportive for markets as a path toward lower rates comes into view. This should support fixed income returns (where we retain our strong overweight) relative to equity returns (where we remain constructive but neutral). A more favourable equity environment may emerge during 2024. Yet, 2024 also has the potential for renewed volatility, as twin wars in Europe are joined by elections in the US and Taiwan and the evolving structural forces of artificial intelligence (AI) and the energy transition.
The UK’s Monetary Policy Committee tweaked its forward guidance, adding that "policy was likely to need to be restrictive for an extended period of time", reinforcing its commitment to keep policy "sufficiently restrictive for sufficiently long to return inflation to the 2% target".
When we first flagged a ‘higher-for-longer’ theme in mid-2023, it was less of a consensus view than it is now. In 2023, the combination of structurally tight jobs markets and excess post-pandemic cash has helped to mute the impact of 2022’s rapid hikes in interest rates. Together with structural ‘re-inflation’ forces (including ageing, elevated geo-political volatility, and shifting global supply chains), central banks are likely to need to hold policy tighter for longer to avoid the mistakes of the 1970-80s. This is likely to see policy rates in the US, Australia, the UK, and Europe being held in restrictive territory until mid-2024.
But in positioning portfolios for 2024—and regarding what we believe to be the main game—we need to look beyond the ‘higher-for-longer’ theme, which is likely to dominate in early 2024. The final months of 2023 have furnished clearer evidence that the global economy is slowing, and inflation is moving gradually lower. As the chart below shows, the Organization for Economic Cooperation and Development (OECD) expects growth to slow further from 3.0% in 2023 to 2.7% in 2024. UBS, who similarly forecasts 2.6% for 2024, views recent data as flagging a meaningful further slowing of growth into mid-2024 from around 3% to 2%, ahead of a patchy recovery through 2025.
“The euro area’s prospects would be stronger if the world were peaceful, but the outlook is complicated by two conflicts near its borders.”
The US economy has proved supremely resilient through 2023, benefitting from markedly higher levels of fiscal stimulus and policy activism to support growth. However, after accelerating through Q3 2023, data more clearly reveals a slower pace of growth into year-end, with most forecasters predicting either a moderate or sharp slowing in growth into mid-2024. A stalled housing sector, the run-off of pandemic stimulus, and some modest weakness in the jobs market (with unemployment already rising from 3.4% to 3.9%) are seen as the key drivers of some softer US growth in H1 2024, even if recession is avoided.
Outside the US, as Longview Economics notes, “growth in the rest of the West (where stimulus levels have been much lower) is poor. The UK, Germany and the Eurozone economies are stagnating, while the Chinese economy is suffering from a housing bust”. The run-off of pandemic stimulus and higher interest rates are also likely to contribute to slower growth in Australia in 2024, with recent consumer spending data slowing significantly. However, as discussed in the November edition of Core Offerings, we expect Australia to be a macro-outperformer during 2024.
We expect central banks to trim rates by 0.5-1.0% during H2 2024, relatively modest in an historic context, albeit consistent with an outlook where inflation is likely to settle higher than in the recent past.
For central banks, the near-term challenge is finding comfort that policy has already been tightened sufficiently to ensure inflation returns, over time, to its respective targets, mostly around 2% (or 2-3% in Australia). Thereafter, the focus will turn to how long restrictive settings should be maintained to avoid unnecessarily damaging the growth outlook.
We believe the recent progress on inflation is key to the former. As the chart below shows, inflation has clearly passed its peak globally. While still above targets, it is now clearly annualising materially lower than a year ago. In the US, the Federal Reserve’s (Fed) preferred core inflation measure (the personal consumption expenditure price index) has moderated from an annual pace of around 4.5% in H1 2023 to a little less than 2.5% in the most recent three months. Similarly, after Australia’s higher-than-expected rise in inflation in Q3, monthly data showed some improvement to 4.9% in October (having unexpectedly risen to 5.6% in September), down from 8.4% at the end of 2022.
Of course, holding rates restrictive as inflation continues to moderate ultimately increases the ‘real’ policy tightening. The recent moderation in inflation has already led to greater real effective policy tightness. We expect that likely weaker growth through H1 2024 that supports further inflation moderation will ultimately lead central banks to start trimming policy rates around mid-2024. This will serve to avoid policy getting unnecessarily tight, even if inflation is not yet cemented in the inflation target. We expect central banks to trim rates by 0.5-1.0% during H2 2024, relatively modest in an historic context, albeit consistent with an outlook where inflation is likely to settle higher than in the recent past.
We expect H1 2024 to favour fixed income returns over equity returns, as growth and inflation continue to moderate. This should set the scene for lower interest rates in H2 2024.
We expect H1 2024 to favour fixed income returns over equity returns, as growth and inflation continue to moderate. This should set the scene for lower interest rates in H2 2024. If major central banks start signalling the next move in rates is down, as we expect in H1 2024, government bonds and investment grade credit should deliver strong returns.
For equities, while the prospect of lower interest rates removes one of the headwinds to performance, we suspect the impact of slowing growth on the current buoyant outlook for equity earnings will present new challenges. We favour non-US markets like Australia and emerging markets, where valuations and earnings risks appear less troublesome ahead.
Indeed, as the turning point to a new phase of slower growth and lower inflation evolves through early 2024, we expect market disruption and volatility to persist. This suggests that a focus on quality and tactical opportunism may prove more rewarding than traditional asset class positioning. Within the fixed income asset class, this might look like capturing the 6.25-6.50% yields, fixed for five years, which are on offer in subordinated tier 2 major bank paper. In equities, it might look like focusing on unloved sectors of the market, such as Australian healthcare. In unlisted alternatives, it might be getting exposure to distressed assets as the lagged impact of policy tightening comes through.
The opportunity to take a more positive view on equities may emerge as 2024 progresses. This is likely to depend on the extent that confidence surrounding a ‘softish’ landing for the global economy grows, and the extent to which this leaves the earnings outlook only modestly damaged. However, it may also depend on the extent to which equities experience a correction in H1 2024.
Of course, our outlook for moderating growth and inflation (arguably a ‘muddle through’ for the world economy) is not without risks. At a macro level, more time is required to be assured that inflation will not re-accelerate in the near term. In the other direction, the consumer could stumble more aggressively in early 2024 as a ‘stimulus cliff’ emerges. 2024 also holds the potential for renewed geo-political volatility, as twin wars in Europe are augmented by elections in the US and Taiwan, and the evolving structural forces of AI and the energy transition impact markets and economies.
2023 will likely be remembered as a year of heightened volatility in bond yields. Markets tried to price in both aggressive central bank tightening, while also searching for a future (now delayed) path of easing that would avoid significant slowdown in the economies.
As we enter 2024, our tactical allocation to fixed income is overweight, with an emphasis on adding duration within high quality, investment grade asset classes. We now believe that the terminal cash rate for most economies has been reached, and 2024 will be a year where markets look to price the timing of central banks easing. Moreover, as inflation cools, downside risks to growth remain, with restrictive rates continuing to transmit into the real economy and excess savings evaporating post the pandemic.
From a tactical perspective, the outlook for equities, at least for H1 2024, remains challenging. A number of countervailing forces have seen us retain our neutral tactical positioning in an absolute sense, and a less preferred stance relative to fixed income.
Headwinds for equities include ongoing tight monetary policy, and consumers faced with a fading savings buffer and tightening lending standards. Additionally, valuations are rich (if not in absolute terms, then relative to fixed income). As discussed earlier, a likely further slowing in consumer demand, driving weakening pricing power and margin pressure for corporates, argues that consensus expectations for 10% earnings per share (EPS) growth for global equities in 2024 are already on the optimistic side.
Given the now comparatively attractive returns on offer from other asset classes, the compensation equity investors are demanding above the yields on offer in risk-free government bonds and investment grade credit has been historically low. Indeed, the equity risk premium is at its lowest level seen since the turn of the century.
More constructively for equities, perspectives on valuations are being impacted by concentration bias. Global indices, both in the US and Europe, are being distorted by extreme concentration among just a handful of stocks. In the US, the so-called Magnificent 7 explain the majority of 2023 returns. Without them, the S&P 500 index would be up just 8% this year (not 20%). As such, valuations are not as stretched as they may seem at face value. The S&P 500, excluding the Magnificent 7, trades at 17.2x, which is below its five-year average of 17.7x. This suggests that there are significant opportunities beyond the mega-cap cohort. Global small and mid-cap equities are unchanged over the past 18 months, and now trade at a 12% discount to the MSCI World index, their largest discount since the GFC.
Some non-US equity markets also portray value. For domestic equities, the relative price/earnings (P/E) ratio of the S&P/ASX 200 versus the MSCI World ex-Australia index is -12%. This is more than one standard deviation from its 10-year average and close to its maximum 15% historic discount. Looser financial conditions in China may support resources, while peaking rates should aid a previously underperforming banking sector.
Headwinds for equities include ongoing tight monetary policy, and consumers faced with a fading savings buffer and tightening lending standards.
For 2024, and in a similar vein to the current value dynamic between public equities and bonds, the opportunity set for alternatives favours more defensive and diversifying exposures. We particularly favour private debt, where total returns have been bolstered by sharp increases in policy rates, spreads (the margin paid to lenders above the policy rate), and upfront fees, all of which flow through to end-investors. Investors may be able to secure unlevered yields in excess of 10% for senior private debt with a meaningful equity cushion backed by credible private equity sponsors. With private debt now around 12% of the USD 12.2 trillion alternative investment market, we expect the asset class to play a more prominent, long-term role in portfolios, with today a highly attractive entry point.
Elsewhere, ongoing economic uncertainty and greater asset price dispersion support the case for diversifying hedge fund strategies, with higher rates also likely to drive higher risk-adjusted returns through underlying strategies. While more mid-risk, infrastructure assets with long-term, inflation-linked contracts, typically monopolistic positions and greater offshore investment flows, also look attractive, particularly those backed by the significant tailwind of the transition to a net-zero economy. Conversely, real estate looks more challenged at this juncture, though pockets of value may emerge as valuations normalise.
For growthier segments, namely private equity and venture, the valuation environment has improved materially since early 2022. As such, we favour maintaining exposures. The secondary market is poised to provide attractive opportunities for skilled allocators that can assess the true value of funds or direct company positions and not focus solely on discounts. This is of particular importance in venture secondaries, which could present one of the highest return opportunities of 2024, albeit not without commensurate risk.
The opportunity set for alternatives favours exposures that are more defensive and diversifying.
Sustainable Investing faced significant headwinds in 2023, including an energy crisis, surging fossil fuel prices, and the rise of the anti-ESG (environmental, social and governance) movement in the US. But despite this, sustainability has remained firmly entrenched in government policy and regulation, corporate sustainability commitments, and shareholder demands. Legislation is pushing for more, not less, sustainable solutions. We have seen that in the US via the Inflation Reduction Act, and globally via the European Union sustainability taxonomy, as well as various commitments in China and Japan.
There is no doubt, however, that heightened geo-political risk remains, with twin wars in Europe, augmented by elections in the US and Taiwan, and the tail risk of oil prices remaining higher for longer in 2024. All of these could provide further headwinds to the sector next year. However, we still see good sustainable investment opportunities in the energy transition. We favour net-zero infrastructure in proven, mature technologies like solar, wind, and battery storage. We are also bullish on the outlook for many of the critical minerals required in the transition to net zero.
We still see good sustainable investment opportunities in the energy transition. We favour net-zero infrastructure in proven mature technologies like solar, wind, and battery storage.
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