Annual outlook for 2024

Subdued growth but sticky inflation

The economic environment isn’t particularly promising: stagnating growth in developed economies, rising joblessness and inflation that stubbornly refuses to return to central bank targets will be prominent features of the investment landscape. 

We expect developed economy inflation to fall back – we’re forecasting a rate of 3.0 per cent for 2024 from 4.7 per cent this year. But with central banks still smarting from having let inflation get out of control, as long as it remains above target, they’re unlikely to throw themselves into an aggressive easing cycle. 

That said, the Bank of England looks likely to be the first major central bank to cut rates. The threat of recession could mean it starts to ease as early as May. We expect the US Federal Reserve to be more cautious in delivering cuts than the market currently expects, but still see it trimming twice in the latter half of the year and the European Central Bank doing the same. 

If there’s a silver lining, it’s that, by and large, the world's largest economies will avoid recession. We expect developed economies to grow by 0.8 per cent after expanding 1.5 per cent in 2023, with the US's growth slowing to 0.9 per cent from 2.4 per cent. We think the market is vacillating between a US recession and a soft landing, underestimating the possibility of anaemic growth. At the same time, the fact that there aren’t any clear market bubbles – corporate balance sheets are solid, valuations aren’t excessive and there’s no sign of investor euphoria – any downturn isn’t likely to trigger an ugly negative feedback cycle.

Economic conditions will be considerably better in the emerging world. We see emerging market economies posting robust growth of 3.9 per cent next year, up from 3.7 per cent in 2023 and 2.8 per cent the previous year. That’s likely to be underpinned by China’s recovery from this year’s low point. 

Backing bonds

As nominal economic growth slows in the developed world so too will corporate earnings growth, particularly during the first half of the year. But even with a rebound later in the year, we see global equity returns of around 5 per cent for the year, down from double digits in 2023.MSCI All Country World Index, in local currency terms.  

By contrast, bonds should benefit from a drop in inflation and a start to central banks’ easing cycle. We see global bond yields dropping by around 50 basis points, which should deliver investors a 7 per cent total return from basically zero so far this year.FTSE World Government Bond Index, in local currency terms. 

We see a pause, if not an end to US exceptionalism – a significant shift from what investors have grown used to. The US economy is set to slow dramatically, while Europe is likely to beat investors’ gloomy expectations. With equity valuations depressed within the single currency zone, European stocks have a solid prospect of outperforming during the coming year. Meanwhile, although robust economic growth in emerging markets bodes well for stocks there, the risks in China – the economy is only slowly recovering and remains vulnerable to its highly leveraged property market – tilt us in favour of EM bonds rather than equities.

When it comes to currencies, we see the US dollar softening by at least 5 per cent during the year on disappointment with the US economy’s progress and valuation that – on almost any metric- remains well above neutral levels (see Fig. 2).

Among alternatives, we think gold should be well supported by a weak dollar, a peak in US interest rates and lingering geopolitical risks, but the upside appears limited by relatively high valuation on our models. Private equity is being challenged: too much capital is chasing too few attractive opportunities and high interest rates make life hard for leverage-driven businesses.

Tail risks

It would be imprudent, however, to ignore the tail risks to the scenario we set out. There’s a significant likelihood that, in being too eager to bring inflation back to target, central banks over-tighten monetary policy, triggering a recession – the risk of which we estimate at 25 per cent. Alternatively, we figure there’s a 15 per cent chance of stagflation, where inflation reaccelerates even as the economy slows, especially if there’s an energy shock triggered by global events.

Then there are the geopolitical risks. Regional flashpoints are multiplying. There is no sign of a resolution to the Russia-Ukraine conflict. Israel’s war with Hamas in Gaza threatens to become something bigger.

In a nutshell, 2024 will be a good year for investors to focus back on country and sector fundamentals, take a granular approach, with a focus on quality stocks and credits and a higher weighting to sovereign bonds.

We also see potential in Japan, where earnings revisions have held up better than elsewhere in the developed world, and tailwinds of positive corporate governance reform and the economy breaking out of deflation remain in place (for more detail, see: Japan Inc ripe for change)

When it comes to emerging economies, valuations for stocks are relatively attractive according to our framework. However, we have to balance this against growing geopolitical risks and uncertainty over China – in terms of both the outlook for the all important property market and potential for the trade friction with the US remaining on top of mind for investors. We therefore prefer to hold EM exposure via bonds rather than stocks.

Swiss stability

Given the risks stemming from China and beyond, we believe it’s prudent to include some high quality defensive positions within a portfolio.

Switzerland's equity market looks like the only true safe haven in the global economy, benefiting from non-inflationary growth, a strong currency and good fiscal discipline. On the face of it, this all comes at a price – Switzerland is the second most expensive equity market on forward price to earnings measures. However, when you consider its defensive qualities, including some 60 per cent index weighing in healthcare and consumer staples companies, and adjusted for growth prospects, the valuation actually starts to look attractive. Furthermore, the Swiss equities trade below trend relative to domestic bonds, while in the rest of Europe and in the US the opposite is true.

Our defensive stance extends to sector allocation. We retain a preference for quality as a style, keeping in mind the anaemic growth and high interest rates backdrop. We also have a tilt towards value, given the unjustified premium demanded by growth stocks. In our view, analyst expectations are too optimistic for growth and policy priorities over the medium term – such as re-shoring and near-shoring, the green transition and tech regulation – are supportive of the value style.

We are overweight energy as a hedge against an escalation of the conflict in the Middle East. Energy also stands out as the only sector able to match the yield from cash. In communication services we see supportive earnings dynamics and the opportunity to gain exposure to the artificial intelligence theme at a reasonable price.

Going into a growth slowdown, albeit a shallow one, we are also overweight defensive consumer staples and high quality healthcare stocks. Conversely, we are more cautious on real estate and consumer discretionary.

Japanese and Swiss bond markets are likely to buck the positive trend. They are both low-yielding markets where the outlook for annualised return after inflation – or real yields - is negative.

Investors should avoid Japanese government bonds in particular as the Bank of Japan appears set to normalise its monetary policy, ending negative interest rates in the new year before raising short-term borrowing costs over the course of 2024. We expect Japan to be the only country that will see its benchmark yields rise between now and end-2024.

Keeping an eye on deficits

The risk for developed market government bonds comes in the form of rising budget deficits and a resulting rise in bond supply.

Already in the US, the Treasury has been boosting the size of auction for bills, notes and bonds to plug a growing gap in the country’s budget deficit, which is worsening in part because of the Fed’s interest rate hikes.

At the same time, its valuation is no longer attractive after global bonds have attracted over USD240 billion of inflows since January, at least twice more than equities did. What is more, a record share of investors in surveys are overweight the asset class and expect bond yields to fall – this could reduce the upside risks to bond prices.

In corporate debt, we like high quality corporate bonds. As we enter a period of softer inflation and slowing growth, we prefer investment grade credit to high yield bonds. US high yield spreads stand at 400 basis points, which are too narrow to be justified given our expectation that default rates are likely to rise above the historical average of 3.6 per cent. According to our calculations, the current spread of 400 basis points is consistent with US GDP growth above 3 per cent, full normalisation of credit standards and well below-average default rates, a scenario that is unlikely to materialise.

Elsewhere, the case for allocating capital to EM bonds is strong, especially in Latin America. EM local currency debt has already benefited from interest rate cuts. Having moved earlier than their developed counterparts to control inflation, emerging central banks are better placed to support growth with easier monetary policy, a cycle which we believe will accelerate.

The prospect of an appreciation in EM currencies means such bonds could gain even more, especially when emerging economies are likely to outgrow their developed peers. We expect the growth gap between the EM and developed world to widen to 3 percentage points next year.

Our models show EM currencies are trading at as much as 20 per cent below fair value. While yield differentials –an important driver of currencies – may narrow in favour of the dollar, we think the emerging world’s superior growth should help their currencies appreciate in the coming year.

EM hard currency debt should also outperform given that its current yield stands at 9 per cent, the highest in the sovereign bond market and some 200 basis points above its 10-year average.

We expect marginal tightening of EM bond spreads, which, coupled with a decline in US yields, should result in a total return well above 10 per cent in 2024.

Dollar decline

In the foreign exchange markets, we expect the dollar to enter a period of a slow but sustained decline. The currency’s yield advantage over its developed market peers will disappear as US GDP growth falls below that of most other developed economies in 2024.

We expect the dollar to fall at least 5 per cent against its basket of currencies next year.

The yen should gain the most from the dollar’s weakness. Its real effective exchange rate is more than 20 per cent below its 10-year average, while on a purchasing power parity basis the Japanese currency is some 40 per cent below its fair value.

Falling US-Japan yield differentials in favour of the yen should help narrow this valuation gap in the coming year.

Gold’s investment appeal is also on the rise. Falling US real rates and a weaker dollar should benefit the precious metal, even though its valuation is no longer attractive after a near 10-per cent gain this year especially in the wake of the Israel-Hamas war.

_{Information, opinions and estimates contained in this document reflect a judgement at the original date of publication and are subject to risks and uncertainties that could cause actual results to differ materially from those presented herein.}