Feature Stories | Dec 20 2023
Soft landing? Recession? Inflation falling? Central banks easing? There remain questions as to how 2024 will play out.
-Fed pivot changes the tone
-Soft landing a popular expectation
-Can China recover?
-Fiscal impacts in Australia
By Greg Peel
The Fed’s decision to leave rates on hold again at its December meeting was exactly what markets expected. What was not expected was a clearly dovish shift in rhetoric.
While the Fed has now left its cash rate on hold at four of the past five meetings, the language has remained that of “there may be more work to do yet to bring inflation down to target”.
Jerome Powell offered the slightest glimmer of hope at the November meeting the hiking cycle may now be done, while still warning it may not be. But that press conference, and subsequent US data, were sufficient for the market to decide the Fed was indeed done, and rate cuts would begin next year. Maybe as early as March.
November saw the US ten-year yield crash from just over 5% to around 4.25%. The adage is “don’t fight the Fed,” but clearly the market was now pricing in rate cuts the Fed refused to be drawn on. The expectation at the December meeting was that Jerome Powell would “push back” on such a move, and remain stubborn in not flagging any rate cuts in the near term.
But he didn’t. Instead, Jerome Powell indicated rate cut talks have begun. The FOMC “dot plots” showed a consensus expectation of -75 points, or three cuts, in 2024. The Fed “pivoted”, and came to meet the market, rather than the other way around.
The market immediately priced in four 2024 rate cuts. The ten-year yield fell close to 4%. Now the market is pricing in as many as six.
In writing their 2024 outlook reports, ahead of the December Fed meeting, brokers/researchers/economists were largely working on the assumption the Fed was done hiking, and that 2024 would bring rate cuts. As to how many and exactly how early they would begin, views varied.
There are two reasons the Fed can begin cutting rates in 2024, and Powell acknowledged this at his December press conference. Typically a cutting cycle begins because the economy has slid into recession, and needs rescuing. But rates can also be cut in order to “normalise” policy, if the need to be as restrictive eases. That would be driven by falling inflation.
The latter case implies a “soft landing” for the US economy – an expression that has been bandied about all year. While it is the Fed’s ultimate goal to bring the economy in for a “soft landing”, which would be considered a Goldilocks achievement, there is no strict definition as to what a soft landing actually is.
The popular definition is one of a slowing economy, but not an actual recession. Others assume a “mild” recession is a soft landing, compared to a deep recession or “hard landing”.
Still others suggest 2023 has seen the US economy in a “rolling recession” – some sectors have hit hard time while others haven’t, but are now coming out. Or it can be considered the US economy, as of December, is already in the middle of its soft landing.
Not that any of it really matters.
What Went Right?
2023 was supposed to be the year of the global economic slowdown, DBS Group notes, led by the US. High interest rates, fiscal correction after the largesse of the pandemic years, and lingering lockdown-related friction in China, were all on course to sap global economic momentum, with shadows over asset markets.
The electronics cycle was undergoing a painful correction and tech stocks were reeling from the 2022 sell-off. Emerging economies and markets appeared highly vulnerable to high commodity prices, a strong US dollar, rising interest rates, along with a plethora of geopolitical risks.
Despite taking all those punches, the global economy fared relatively okay this year, DBS suggests, slowing modestly. Global growth may be a tad lower this year than in 2022, but that misses the fact the largest economy in the world, the US, will end 2023 with a stronger GDP result than the previous year (2.4% versus 2.1%, as per DBS’ forecast).
What drove the better-than-expected outcome?
In the case of the US, the answer boils down to cash and liquidity, DBS notes. Despite rising rates and quantitative tightening, US consumers and businesses, with most of their debt tied to rates from the zero-rate era, fared fine. Consumers still had cash unspent from the stimulus-related transfers and credits, while businesses found ample credit and funding available.
For the rest of the world, and to some extent for Americans, steady or declining commodity prices came in as a welcome surprise, supporting purchasing power. Post-pandemic spikes in travel, tourism, and events continued to act as a tailwind to a wide range of services worldwide.
Recession talk first emerged when the Fed started raising rates in March 2022, having insisted up to that point it was “not even thinking about thinking about” raising rates. Not at least until 2024. Given the subsequent pace and extent of rate hikes, a US recession was initially seen as inevitable – the only way to get inflation down, having peaked over 9%.
But by this time last year, it hadn’t happened. This did lead some to wonder whether maybe it wouldn’t after all, while others were sure 2023 would see a recession. It’s about that time debate over soft and hard landings emerged.
It still hasn’t happened. Yet, the bears stoically believe there will be a recession, now in 2024. The bears are nevertheless diminishing in number.
The sticking point is the “lag effect”. When the Fed began hiking, it was quickly pointed out the impact of rate-hike cycles is not felt until some 12-18 months afterwards, or even 24 months. This largely lends itself to the fact corporations usually borrow money over two to five year periods. For some time, as the Fed was relentlessly hiking, they were still paying interest based on a zero cash rate. But once those loans matured…
For the bears, this is still the expectation: we are yet to see the full impact, that will take the US economy into recession.
This Time It’s Different?
The golden rule in economics or markets is never say “this time it’s different,” as it never is, and you’ll only come out looking the fool. But is there a case to say, with respect to traditional economic cycles (boom-bust), this time it’s different?
Typically rate-hike cycles lead to rising unemployment. Fewer jobs mean less consumer spending, means recession. But in 2022-23, it hasn’t. US (and Australian) unemployment remains at historically low levels, despite historic rate hike runs.
The pandemic, for all intents and purposes, was an historic first. Yes – the Spanish flu means it wasn’t, but that was so long ago, and the nature of financial markets has changed so much in the meantime, as to accept covid and its lockdowns as a first. The upending of economies, the choke on supply chains, and the extent of fiscal support thrown at households and businesses was sufficiently unprecedented.
And then to have a war…
The impact on the labour market has simply not been as expected. The extent of the resilience of consumers, flush with handouts, was not expected. It’s not the way it’s meant to be, history suggests, when central banks start raising rates.
The bears remain adamant a typical rate-hike response is still coming. When that lag effect fully bites, unemployment will rise, and when it first begins to rise, it then accelerates. Consumers will soon run out of their cash holdings, and go to ground. A recession will ensue.
Thus, this time is not different, it’s just taken longer, under unusual circumstances, to play out.
This is the question heading into 2024.
The Global Economy
DBS ascribes a base case 60% probability of a soft landing for the global economy in 2024. The burden of high rates will weigh, but a recession is unlikely in either the US or EU. China manages to clean up its act and remain in positive growth.
DBS ascribes a 15% chance of a hard landing, noting one-in-six is not trivial proposition. The risk would come from a rebound in inflation – that which the Fed so fears. Jerome Powell has taken heed of the experience of the 1970s, when the Fed hiked rates but then eased back too soon, allowing inflation to rise again.
A possible driver of an inflation bounce could be commodity prices. Falling US yields and a falling dollar implies higher USD commodity prices, and with geopolitical risks still prevalent, oil prices could be the problem.
A bounce in inflation would lead to central banks holding off on rate cuts. The world is sitting on a mountain of public and private debt, notes DBS. If central banks fail to bring rates down, this could take the global economy on a dangerous path.
Amundi believes investors will need to navigate a fragmented economic outlook and higher volatility risk in 2024.
Global growth will decelerate, driven by slowing developed economies and a mild recession in the US in the first half, Amundi forecasts. The growth differential between Emerging and Developed Markets will reach a five year-high. India will grow faster than China.
A reversal in monetary policy is expected, with Fed rate cuts towards the end of the first half. Fiscal policy will be less supportive in Developed Markets than it has been, amid high debt, mostly targeted to energy transition.
Morgan Stanley foresees a baseline scenario of below-trend growth in Developed Markets, and a mixed Emerging Markets growth picture. Most of the slowing is in DM, with some EM outperformance outside of China partially offsetting.
In the US, subdued growth over the forecast period reflects monetary policy working its way through the economy, ie the lag effect. In Europe, Morgan Stanley sees only barely positive growth.
China should weigh on headline EM growth. In EM Asia, India, Indonesia, and the Philippines remain the fastest-growing economies, but combined they are less than half the size of China’s economy.
Morgan Stanley sees inflation close to but not quite at target in most DM economies, with the final stage of inflation normalisation only reached in 2025. Consequently, the broker sees central banks only nearing their neutral rates at the end of 2025.
While recessions remain a risk everywhere, Morgan Stanley expects any recession in its baseline scenario (such as in the UK) to be shallow because inflation is falling with full employment, so real incomes are buoyed, leaving consumption resilient, despite more volatile investment spending.
Global markets have exceeded expectations in 2023, notes Russell Investments, thanks in large part to the mega-cap technology stocks known as the Magnificent Seven (Apple, Amazon, Google, Microsoft, Meta, Nvidia, Tesla).
Investor sentiment has shifted from “a recession is coming” to “a soft landing is around the corner.” Russell’s market psychology index indicates high investor optimism, even though market gains have been concentrated in 2023. Too much optimism can make the markets more vulnerable to over-corrections. Russell’s outlook for 2024 is more cautious due to (still) restrictive monetary policy, slowing growth, and geopolitical tensions.
Note that the November rally in the US saw a widening of market breadth, leading to stalled rallies from the Mag7 and renewed interest in the so-called S&P493 and small caps. That trend has accelerated post the December Fed pivot.
Still high Fed rates will likely strain finances in the year ahead, impacting borrowers and refinancers. Meanwhile, Russell expects Europe and the UK to continue contending with weak demand, high inflation, manufacturing slumps, and Brexit.
China, although stabilising, will continue to grapple with the long-term issues of debt, property markets and demographics (ageing population).
Despite all this, markets are pricing closer to a smooth landing in 2024. Russell Investments is not as confident about that, but still sees opportunities in a total-portfolio context.
The above is but a small selection of views, but there is a notable consistency. Slowing global growth or mild recession in 2024 (either of which could be labeled a “soft landing”), central bank rate cutting, with variations in timing the only differentiator, and ongoing volatility due to geopolitical risk.
Any acceleration of Middle East tensions could upset the apple cart, especially with regard to oil prices – the primary inflation risk.
China
China heads into 2024 with relatively loose policy settings, but private sector sentiment is constrained by property pessimism. Stimulus will reduce tail risks but Oxford Economics does not expect it will be sufficient to prevent the growth downtrend persisting. Oxford believes three key themes will shape the macro outlook in 2024.
Firstly, the economy will muddle through a tightly managed, multi-year clean-up process. The old “pre-sales” housing model is no more.
During 2023, Chinese buyers of apartments off-the-plan were left stranded without a dwelling, as property developers became bogged down in a mire of debt. They responded by refusing to make any further incremental payments, only making the situation worse.
Transitioning to a new model that boosts the role of state-directed public and social housing could prompt further consolidation among onshore property developers, Oxford suggests. There may be bouts of credit stress, but they're unlikely to be systemic.
Secondly, China is no longer the “spender of last resort” for the global economy, so don't expect robust reflation. A more disciplined approach to capital allocation will drive only a small uptick in the overall fiscal impulse, Oxford suggests. Inflation should stage an unspectacular ascent as supply-side disinflationary pressures fade.
Lastly, the investment recovery will be very sector-specific. The persistence of domestic regulatory uncertainties will temper the investment recovery, excluding property, in 2024. Sectors that benefit from policy tailwinds, plus high value-added manufacturing such as consumer electronics and autos, are likely to outperform.
Oxford Economics’ forecasts China’s GDP to slow to 4.4% growth in 2024. The forecast is in line with general views.
Australia
While consensus has it the Fed will not hike any further and rather 2024 will bring rate cuts, more likely from around mid-year than March as the market is currently forecasting, the same cannot be said with regard the RBA.
The new agreement on the conduct of monetary policy between the Treasurer and RBA Governor is more hawkish in the short and medium term, Citi suggests, as it requires inflation to anchor at the 2.5% midpoint of the target rather than settle between 2 and 3%. This suggests monetary policy will need to remain tighter for longer or the cash rate will need to increase further before peaking. Citi therefore reaffirms a central 4.60% cash rate target forecast for the March quarter, and no cut until the December quarter at the earliest.
Rabobank is one of several houses that believe the risk remains to the upside for the cash rate, and the RBA will continue to talk tough, but no further rate hike will be forthcoming.
But whereas the Fed is expected to begin cutting by at least mid next year, consensus has the first RBA rate cut in November.
Morgan Stanley is another that nevertheless foresees another hike, in February, and does not see the RBA cutting until 2025.
A critical factor is the RBA does not meet again until February, given the usual January break, by which time data on Christmas retail spending will be known, aside from further inflation numbers.
There is plenty of scope for the economy to weaken further over the Christmas period, Rabobank notes, and real consumer spending per capita has been falling since the final quarter of 2022 as debtors digest 425 basis points of cumulative tightening. That has meant that recent growth in retail turnover has been the weakest in the history of the series, despite surging nominal prices and record levels of population growth.
A point to note, with regard Christmas spending, is that while we have seen inflation trending down into December, it’s only the rate of growth of inflation that is falling (disinflation) and not inflation per se (deflation). Aside from some individual categories experiencing their own specific price impacts, food and beverage costs are no lower for the most part than they were last year.
Christmas 2022 was the first since 2019 without any further border closures, international or interstate, or social distancing rules, allowing the first unhindered family get-togethers and general Christmas parties since covid. The pressure valve had been released, and Australians were happy to spend up, cost be damned.
A year later, following several more RBA hikes, the mood is more constrained.
Surging population growth in 2023 has also helped to ensure that trend growth in the labour force has exceeded growth in employment since October 2022, notes Rabobank. This growth gap is widening as employment falters in the face of tepid consumer demand and the cumulative impact of rate hikes. The trend pace of employment growth has now halved since May 2022, while growth in the labour force has proven more resilient and is working to introduce some much-needed slack into the jobs market.
We note the government has moved to now halve the annual migrant intake, with the housing crisis the primary driver.
One of the more surprising outcomes over the past 18 months for UBS has been the ability of companies to maintain profit margins in such an inflationary environment. The low unemployment rate, which UBS expects will prevail through 2024 is supportive of end-demand, however the loss of momentum in pricing power suggests companies’ ability to pass on costs will deteriorate.
This is a commonly held view: inflation can be positive for retailers as it provides the excuse for price rises, which consumers are forced to accept under the circumstances. However, there is a point at which prices can no longer be raised or demand is “destroyed”.
As inflation falls, there is no longer an excuse to raise prices. Indeed the pressure is on to start cutting. Companies with sufficient “pricing power” will unlikely feel the need to cut, but companies in more competitive sectors may be forced to.
The Fiscal Factor
While the Labor government remains under pressure not to proceed with the Coalition’s stage three tax cuts for the wealthy this year, due to the cost of living and housing crises impacting on mid-to-low income earners, there appears no wavering in the Treasurer’s position at this point.
High income earners will be the major beneficiaries of the cuts because the progressive nature of the tax system means high earners pay (by far) the most income tax, and therefore receive the biggest discount in dollar terms when tax rates are cut. This has generated much political controversy and prompted some MPs to advocate for the cancellation or amendment of the cuts on the basis they are unequitable and could add to inflation.
But Rabobank points out high income earners have a high marginal propensity to save. If the tax cuts are predominantly saved (rather than spent) the inflation impact will be minor. If the tax cuts are cancelled and redirected into subsidies for lower-income households, the quantum of spending will be proportionally larger and the inflationary impact greater.
Savings ultimately equals investment, Rabobank notes, and investment raises the economic speed limit by boosting the supply side. This reduces inflation in the long run. Australia has been experiencing a mini investment boom since early 2021 as the large stock of pandemic-era savings is deployed in the investment decisions of firms. At some point, this mini boom will help to arrest the decline in the nation’s productivity performance, and provide a lift in real wages. This will be particularly the case as the labour market softens, and the most marginally productive workers and firms exit the market, raising the average rate of productivity in the economy.
While there will no doubt be heated debate about the merits of the tax cuts leading up to the July 1 implementation date, what has not drawn much focus is that on the same day the Stage three tax cuts are due to come into effect the compulsory Superannuation Guarantee will be lifted from 11% to 11.5%. This means workers will be forced to save an extra 0.5 percentage points of their pay packets into defined contribution pension schemes, notes Rabobank.
In the absence of offsetting pay increases (some will get this, many won’t), the increase to the Guarantee will provide a 50 basis point monetary tightening for almost every wage earner in the economy.
Given that some two-thirds of Australians have a job, two-thirds will see their take-home pay reduced by the increased super requirement. However, only one third of Australians have a mortgage, with the majority either owning or renting their homes, RBA rate hikes only impact that one third.
Consequently, Rabobank estimates the tightening effect of the increase to the Superannuation Guarantee is greater than two RBA rate hikes, and the deflationary impact will more than offset any short-run inflationary impact of the Stage three tax cuts.
In the long run, both measures will help to reduce inflation and increase productivity by increasing the stock of savings and the availability of investment capital.
UBS economists forecast the Australian economy to have grown by just 1.6% in 2023, which aside from the 2020 covid lockdown year represents the slowest pace of growth since 1991. That said, Australia’s growth trajectory is still one of the best among advanced economies.
ANZ Bank economists have Australia’s GDP growing by only 1.4% in 2023, slowing to 1.2% in 2024, before rebounding to 2.3% in 2025 as RBA rate cuts begin to impact.
Corporate Earnings
The low bar analysts have on earnings over the next year is one of the more bullish signs UBS has on equities into 2024. Historically earnings growth for the ASX200 has averaged 5.5% per year. The fact earnings growth for FY23 was 0%, and analysts now expect -6% for FY24, shows a fair amount of pessimism already exists in consensus numbers. UBS expects flat earnings growth over the 2024 calendar year.
As we get closer to the point of the first rate cut, which UBS expects in November, share prices will begin to more confidently “look through” the cycle. Historically, sectors across the domestic consumer/housing complex have seen their share prices bottom and turn upwards around three months before the RBA's first rate cut.
The growth challenged and worry-beset environment which investors have faced this year has some eerie similarities to what global equities faced back in the mid-1990s, UBS notes. In 1994 the RBA hiked aggressively through the second half of the year which caused equities to de-rate sharply. But fears over a subsequent hard landing proved incorrect. Not only did the economy avoid a recession, but Australian stocks managed to post positive annual returns for the following seven consecutive years, 1995 to 2001.
UBS has set a 2024 year-end target of 7660 for the ASX200, incorporating an increase in the market PE multiple to 16.5x from 15.5x. That’s around 3% capital growth.
Morgan Stanley has a twelve-month target of 7350 as its base case. Morgan Stanley’s bear case target is 5720, brought about by further rate hikes required and thus a sharper economic slowdown, while the bull case of 8580 would be driven by a soft landing and stronger cycle beyond that point.
Speaking from a more global perspective, Macquarie believes the cycle has shifted to Slowdown, which is often when equities peak. Coupled with seasonality, this high could be around April 2024.
Thereafter will begin a Downturn, Macquarie suggests, which is likely to drive up volatility and accelerate the outperformance of defensives.
The shift to Slowdown is a key inflection point in the market cycle, Macquarie notes, as it marks the end of the two best phases for equity returns (Recovery & Expansion). Returns in a Slowdown tend to be positive and the cycle's high often occur in this phase.
On Macquarie's projection, consensus hopes for a soft landing next year are likely to peak with stock prices.
Volatility tends to rise in a Downturn, Macquarie notes, as that's when recession fears are heightened. Stock returns tend to be negative and the outperformance of defensives that starts in a Slowdown is highly likely to accelerate in a Downturn. Health, Staples and Gold have been the best performers in past Slowdown/Downturn phases.
This is consistent with the rotation after an RBA pause. Macquarie also expects home prices to fall in 2024, which will be a headwind for equities after rising prices averted the 2023 mortgage cliff.
In its last Portfolio Update in October, Macquarie was already positioned for a Slowdown phase, but had also reacted to the upside risk to bond yields (which has passed faster than expected). The portfolio overweights include Health, Staples and Gold.
Macquarie will review the portfolio after the shift to Slowdown is confirmed. The changes the broker would consider are adding to defensives and software ahead of Fed cuts, while reducing Financials exposure as bond yields fall.
While near term economic growth and earnings are forecast to be solid, the strength of consumer sentiment will increasingly be tested as we move through 2024, suggests Equity Trustees Asset Management. This will begin to impinge on many companies’ ability to maintain margins as costs rise and price increases become more difficult to sustain.
While not all companies are created equal, this will be a headwind for corporate earnings and potentially a greater impact on dividends as boards exercise caution in a less certain environment, ETAM warns.
The asset manager expects the Australian market will be impacted by three significant factors:
1) the significant weighting to the Bank sector, which is anticipated to have earnings decline due to a combination of anaemic credit growth, higher costs, increased competition, and a tick up in bad debts;
2) margin pressures for many businesses as rising costs are less able to be passed on to a weakening consumer and;
3) potential weaknesses in commodity prices, notably iron ore. The latter factor being volatile and heavily dependent on China policy and economic conditions.
As a result, ETAM expects equities to trade on reasonable valuation multiples. However, they may come under pressure if the market’s consensus view of a soft landing fails to materialise and economic conditions worsen.
So in conclusion, the outlook all depends on the possibly elusive “soft landing”, here and in the US, which as noted has no strict definition. There are many variables at play.
If there is a consistency in views, globally, it is that investors should navigate the uncertainty by weighting to “quality”, in both equities and fixed income (sovereign, high-grade corporate).
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