The big picture

Navigating disinflation

The global economy looks set to slow in 2024, as fiscal policy starts to drag on growth and higher interest rates weigh on household and business activity, with excess savings built up during the pandemic largely spent. We expect global growth of around 2.75 per cent in 2024, down from around 3.25 per cent this year.

However, once again, recessions ought to be avoided as rising real incomes support household consumption, outweighing the impact of higher mortgage costs. Private-sector balance sheets are not particularly stretched in major economies. As such, the danger of a deleveraging-driven deep recession remains low.

Growth is likely to slow to below trend in the United States – although our projection is somewhat better than current market expectations – with the Chinese and Japanese economies expected to weaken as well. As in 2023, growth is likely to be sluggish in both the euro zone and UK.

Headline rates of inflation have fallen significantly over the course of 2023, as the impact of higher energy and food prices has subsided, and globally traded goods supply chains have normalised.

With growth expected to be subdued, this decline in inflation, combined with signs of softer labour markets, should open the door for major central banks to start cutting interest rates. The European Central Bank is likely to be the first to move, possibly as soon as April, with the US Federal Reserve unlikely to be far behind. As for the Bank of England, it could follow in the third quarter.

While there should be scope for interest rates to decline appreciably from current levels, they are unlikely to fall nearly as low as in the years that followed the global financial crisis. We see them hovering between two and three per cent rather than approaching zero.

Figure 1: Aviva Investors growth projections

Source: Aviva Investors Macrobond, as at 31 December 2023.

What this means for asset allocation

Equities

As we have highlighted previously, while yields have been a catalyst for recent gyrations in equity prices, company profits will likely be the key driver of returns in 2024. Valuations have little room to go higher, especially in the US market, where in the last 20 years shares have only appeared more richly valued on one previous occasion.

The US experienced declining profits earlier than other countries at the start of 2022 and appears to have come out on the other side with earnings growth having resumed in recent months. US economic data, which has remained fairly buoyant, provides reason for optimism.

Assuming interest rates have peaked and earnings troughed, there should be scope for equities to continue the rally seen in recent months.

Figure 2: Asset allocation - Equities

Figure 2. Asset allocation - Equities

Source: Aviva Investors, as at 31 December 2023.

Government bonds

Inflation appears to have proved less hard to eradicate than many feared, thanks to tighter monetary policy and the normalisation of supply chains and labour markets. The prospect of easier monetary conditions has already led to a sharp decline in the yields offered by government bonds from this autumn’s peak.

While that limits upside potential for investors in some markets, most notably the US, other markets such as the UK and Europe look to offer more value. While bond prices have recovered strongly in these markets as well in recent weeks, the challenging economic environment, coupled with the prospect of a further sharp fall in inflation, suggests this recovery could have further to go.

A comparatively healthier economic backdrop in the US means the risks and rewards of investing in US Treasuries are far more finely balanced given the extent to which the market is pricing in rate cuts in 2024.

As for Japan, the prospect of a long-awaited normalisation of monetary policy by the Bank of Japan in the face of stubbornly high inflation, following years of negative interest rates, leads us to be heavily underweight.

Figure 3: Asset allocation - Government bonds

Figure 3. Asset allocation - Government bonds

Source: Aviva Investors, as at 31 December 2023.

Credit

We are neutral on credit markets, with the yield differential relative to more highly rated government debt broadly where we would expect it to be given the economic backdrop. Within credit markets, we favour higher-yielding debt issued by less creditworthy borrowers.

The result of the US Presidential election in 2024 will be worth keeping a close eye on as it could have a material impact on the US bond market. On the one hand, tax cuts and increased protectionism could be positive for US companies. Then again, any signs of political interference with the Federal Reserve, or increased fiscal profligacy, has the potential to damage bonds.

Figure 4: Asset allocation - Credit

Figure 4. Asset allocation - Credit

Source: Aviva Investors, as at 31 December 2023.

Key investment themes

1.  Rate cuts on the horizon

The most aggressive increase in interest rates in more than four decades helped quell inflation in 2023 and has opened the door to rate cuts. With headline rates in major economies still uncomfortably high, the inflation battle has not yet been completely won. However, recent data suggests inflation may fall back to central bank targets quicker than previously anticipated.

That would enable central banks to start cutting rates. Where economic growth is already weak – as in the euro zone and UK – a return to two per cent inflation could open the door to earlier and deeper rate cuts. In the United States, where inflation has fallen back despite growth being above potential, we expect rate cuts to be more limited in 2024.

Should recessions materialise, rates might be cut much more aggressively. The risk is that central banks fall behind the curve in cutting rates, at least initially. In an alternative risk scenario, if inflation stays stubbornly high, this could prevent or delay rate cuts.

 

Figure 5: Market pricing rate cuts

Source: Aviva Investors, Macrobond as at 31 December 2023.

2. Geopolitical tension and financial fragmentation

The communique that followed the annual G7 meetings in May 2023 was significant for its inclusion of the following phrase: “[to] coordinate our approach to economic resilience and economic security that is based on diversifying and deepening partnerships and de-risking, not de-coupling.”

De-risking, rather than de-coupling, is a diplomatic way of saying there is no desire to eliminate all trade with less-trustworthy partners. Instead, the goal is to reduce or remove the reliance on them for critical minerals, the manufacture of essential technology and healthcare goods. At the same time, there is a wish to limit some countries’ ability to threaten national security objectives by developing certain technologies.

 

Figure 6: Explosion in harmful trade interventions

Number of trade restrictions imposed annually worldwide

Source: Global Trade Alert as at 31 December 2023.

3. Intervention and industrial policy

Governments have been turning to various forms of intervention and industrial policies as they increasingly focus on long-term national and economic security objectives and combatting climate change. While such policies are not particularly groundbreaking, it is their scale and scope that makes them extraordinary.

From China’s “dual circulation” policy of subsidising investment in technology (in particular semiconductors), to the US’s CHIPS Act (again focused on technology) and Inflation Reduction Act (focused on climate change policies), to Europe’s Next Generation EU funds (tech and climate change) and Japan’s recent initiatives on carbon reduction and defence, most major economic powers plan to spend vast sums or provide tax breaks to deliver these objectives.

While these policies could equate to one per cent of GDP every year for the next decade if fully utilised, they threaten to sacrifice long-term efficiency and/or economic growth. They may also create inflationary tailwinds that last for many years, putting upward pressure on interest rates, and come at a significant fiscal cost that must be managed to ensure long-term stability.

 

Figure 7: US investment in manufacturing structures has boomed

Source: Aviva Investors, Macrobond as at 31 December 2023.

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House View 2024 Outlook

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The global economy avoided recession in 2023, despite the ongoing effects of tighter monetary policy and elevated energy prices. Much of that was down to the resilience of the US, which is now expected to have grown more quickly in 2023 than in 2022.

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