The big picture
Approaching the summit
The global economy seems set to weaken in 2024 as the impact of interest rate rises continues to take its toll on household and business spending. We expect global growth to slow to 2.5 per cent from three per cent this year.
Growth is likely to be well below trend in developed economies, although the US seems likely to avoid recession. While the housing market has contracted in the face of higher rates, consumer spending has remained strong and business investment has been supported by government industrial policies to promote technology re-shoring and net-zero targets.
The situation is less rosy in Europe and the UK, where growth is already below trend. While the effect of the 2022 energy shock has largely worked its way through the system, the full impact of higher rates will take more time to come through and will adversely affect consumption and residential and business investment spending. However, deep recessions should be avoided.
Central banks have raised policy rates sharply over the last 18 months following the largest inflation shock in a generation. That reflected a combination of positive demand and negative supply factors across commodities, manufactured goods and services. While headline rates of inflation have been falling, core, or underlying, inflation remains high due to ongoing pressures in service sectors.
We expect these pressures to ease only gradually over the next year. While headline and core inflation should be much closer to central banks’ targets by the end of 2024, both measures of inflation are likely to remain above target in most major economies. Consequently, the risk is that central banks may need to tighten policy more than anticipated.
What this means for asset allocation
Equities look attractive relative to other asset classes currently following recent falls. Although by some measures the US stock market looks expensive relative to history, this is largely down to outsized gains by shares in leading technology companies. The fact the US economy is in relatively healthy shape should help support company profits in 2024 and suggests the US is not as expensive as it might appear.
As for other developed countries, European and Japanese shares as a multiple of company profits are trading well below their historical averages, while UK shares are offering a discount of around 16 per cent.
Government bonds, despite having fallen substantially since the start of 2022, face three main challenges, at least in the short to medium term. First, inflationary pressures are likely to continue; second, fiscal deficits have ballooned in recent years; and third, markets are having to contend with quantitative tightening, the process by which central banks are reducing the holdings of the huge quantity of bonds they have bought since the global financial crisis.
The US is one of the most challenged fixed-income markets due to the relative strength of the economy and size of its deficit. The prospect of monetary tightening in Japan, as the central bank looks to combat inflation, means Japanese government bonds also offer limited appeal. UK and German government bonds could present better opportunities as economic growth is weak and inflation is dropping rapidly in both countries. Canadian and Australian government bonds also might offer opportunities as these markets are pricing in far less future monetary policy easing than elsewhere.
We are broadly neutral on corporate bonds. But within that, we think high-yield bonds offer better opportunities than investment grade, which looks comparatively expensive. So long as the US economy can avoid recession next year, high-yield bond prices, which are not far from levels that might be expected in a mild recession, should perform reasonably, especially given most companies have little need to issue debt in 2024.
Key investment themes
1. Approaching peak policy rates
Major central banks have raised interest rates aggressively since the end of 2021 in an effort to bring inflation back towards target. Only once before, in the 1970s, have rate hikes been witnessed at this speed and magnitude. However, the starting point was very different this time, with rates having been cut to zero or thereabouts when the COVID-19 pandemic struck in spring 2020.
Real interest rates (nominal interest rates minus anticipated inflation) are at around two per cent in the US and UK, their highest levels in over a decade. By most economists’ estimates, this ought to be sufficient to slow economic growth to below trend and ease underlying inflation. However, while we also believe central banks have likely done enough, there remains a risk a modest amount of further rate increases may be required. We expect rates will need to stay elevated through 2024.
2. Global fragmentation
Geopolitical tensions show little sign of abating. Relations between the US and China may have improved in recent months, with visits to China from senior members of the US administration, but the desire in Washington to de-couple the US economy from China’s remains intense. President Biden in August issued an executive order prohibiting, or requiring notification, of investment in certain types of advanced technologies in China.
The rise in tensions between Washington and Beijing in recent years has already had a noticeable impact on cross-border capital flows. Foreign direct investment (FDI) flows to China have slowed dramatically over the past year, to the weakest level since records began in 2005 (Figure 6). Similarly, portfolio inflows have gone into reverse with significant outflows from Chinese bonds. We expect cross-border capital flows to continue to be impacted by these and other global geopolitical tensions, including the recent breakout of violence in Gaza and Israel. This poses a financial stability risk, particularly to poorer countries.
3. The return of industrial policy
Recent years have seen a revival of interest in industrial policies. The US and EU governments are spending large amounts of money to ensure they are self-reliant in certain technologies, in particular computer chips and green technologies.
These industrial policies create important trade-offs. Governments, by supporting national champions in particular industries for the purpose of security and self-sufficiency, may be sacrificing productivity gains and economic growth. There is a risk this subsidised investment translates into higher inflation.
These policies come with a significant cost that must be managed to ensure long-term sustainability. The likelihood is they will put upward pressure on interest rates and bond yields as central banks react to the threat of higher inflation and as governments are forced to issue more debt to pay for them.
Read the House View
House View Q4 2023
Since late 2021, the major developed market central banks have aggressively raised policy rates in an effort to curb excess demand and bring inflation back towards their two per cent target. The speed and magnitude of the rate increases over the last two years has only been seen before in the 1970s.
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About the House View
The Aviva Investors House View document is a comprehensive compilation of views and analysis from the major investment teams.
The document is produced quarterly by our investment professionals and is overseen by the Investment Strategy team. We hold a House View Forum biannually at which the main issues and arguments are introduced, discussed and debated. The process by which the House View is constructed is a collaborative one – everyone will be aware of the main themes and key aspects of the outlook. All team members have the right to challenge and all are encouraged to do so. The aim is to ensure that all contributors are fully aware of the thoughts of everyone else and that a broad consensus can be reached across the teams on the main aspects of the report.
The House View document serves two main purposes. First, its preparation provides a comprehensive and forward-looking framework for discussion among the investment teams. Secondly, it allows us to share our thinking and explain the reasons for our economic views and investment decisions to those whom they affect.
Not everyone will agree with all assumptions made and all of the conclusions reached. No-one can predict the future perfectly. But the contents of this report represent the best collective judgement of Aviva Investors on the current and future investment environment.