Plus ça change...

Sometimes, the more things change, the more they stay the same. The past year has been confounding for most economists. Economic data and historical precedent suggested that a US recession was likely. Yet the year came to an end with continued strength in economic activity. At the same time, inflation declined rapidly and, by some measures, reached the Fed’s target by year-end. The “soft landing” which had appeared as a narrow possibility, suddenly seemed probable. Unsurprisingly, the markets rallied.  

At moments like this, it is tempting to recall the words of John Kenneth Galbraith: “The only function of economic forecasting is to make astrology look respectable.” But this would be facile. The strength of economic models lies not in the precision of their forecasts, but in understanding the relationships between different variables. The accuracy of any prediction is only as good as the assumptions on which it is based. Undoubtedly, COVID era developments challenged many assumptions. 

The question at this stage is how the economy – and markets – are likely to perform in the year ahead. There are four points that give us reason to remain somewhat cautious. 

First, it might be premature to declare that inflation is dead and buried. Looking at inflation month-on-month, some measures are within the Fed’s target range, but others are not. There is a compelling argument that much of the lingering measured inflation is due to how shelter is considered, including considerable lags. Nonetheless, headline CPI has been stuck around 3% since June, and still growing at a monthly clip that suggests an annualised rate of 3%.  

Second, the market is pricing in aggressive rate cuts by the Fed starting in March, taking the federal funds rate below 4% by December. The Fed’s own dot-plot projections show that only a minority of Committee Members expect this to happen before end 2025.  

Third, financial conditions – as measured by bond and equity market developments – have eased considerably since November. Such easing of economic conditions can boost economic activity at a time when unemployment is close to one of its lowest levels in the last 50 years, and overall wage growth is about 5%. A boost to economic activity at this time would be unwelcome, as it can easily reignite inflationary pressures.  

Finally, the US fiscal stance is not able to assume an active role in an economic downturn. Net interest expenditure has doubled since 2019, owing to the refinancing of Treasury bonds at higher rates. This implies that to contain the deficit, the government cannot be overly generous with expenditures. It also means that Treasuries are more exposed to shifts in sentiment.  

In other regions, the economic outlook is also complex. In Europe, economic growth has been sluggish, and while Germany has so far escaped the technical definition of a recession, growth was negative in 2023. This said, Europe has managed a faster-than-expected transition away from dependence on Russian energy supplies. Inflationary pressures are now also well contained. Unlike the US, where trajectory entails uncertainties, fiscal policy in the key Eurozone economies is contractionary. This supports the efforts to reduce inflation and puts the ECB in a better position to cut rates in line with market expectations. 

The largest source of uncertainty around global growth is emanating from China. The real estate sector had been a pillar of growth of the economy. The problems emanating from overleverage are well understood. But it is not clear that China’s economic model is fit for purpose any longer. State-directed economic planning will not ignite a more balanced consumption-driven growth, nor rapid growth in the private sector. With inflation having turned to deflation, an aging population, and declining growth, the risk of a Japan-like economic morass is significant.  

Against this background, the probability of a recession in the US may be less relevant than the reality that all major economic regions in the world are experiencing tepid or decelerating growth.  

There has been much media attention to the fact that the electoral calendar in 2024 is also packed, with more people going to the polls than in any other year in history. But some elections matter more than others. The US elections are consequential. India’s and the UK’s are important. The European Parliaments will be interesting to watch for signals of potential future change at the national level. It doesn’t really matter that Russia and Iran even have an electoral calendar. From an economic perspective, however, elections matter because these are years in which difficult decisions are rarely made. In other words, if there is an unforeseen shock, it is more likely for policy makers to kick the can down the road than do what’s necessary. From a market perspective, political risks are notoriously difficult to price. 

Where does all this leave investors in 2024? Market sentiment can drive performance in a multitude of directions. However, there are two salient features of current market pricing.  

First, by almost all measures, overall equity valuations are high.  

Second, the Fed and ECB interest rates are more likely to decline than increase.  

Taken at face value, the above would suggest that this is a year in which bonds will outperform equities. However, we think that such oversimplification would miss important factors. 

First, if inflation continues to decline while GDP growth remains robust, the current level of interest rates is not that far from neutral, and the Fed will need to cut rates by less than it is currently signalling. This means there will be a meaningful risk of a sell-off in bonds as rates adjust across the yield curve.  

Second, while equity valuations are high overall, they mask considerable divergence within the market between the largest cap companies and all others. In addition, valuations outside the US, especially in Europe, are also reasonable.  

Third, credit spreads are tight across the board. Unlike equities, where some segments offer reasonable valuations, it is not at all apparent that the same is true of investment grade or high yield spreads.  

Taken together, the above suggests that investors will be well advised to maintain an appropriate level of diversification and minimise asymmetric risks. The overall equity market may be priced for blue skies continuing for a long time, but segments within the market will offer greater upside. In credit, the absence of room for spread compression in an environment of decelerating growth argues for maintaining focus on high-quality bonds. In government bonds, a strategy that combines ultra-short-term bills, and very long-term bonds may offer greater protection than a focus on intermediate durations.