Santa Claus is comin’ to town – for now

The following is an extract from our latest CIO outlook.

Consensus views aren’t always all they are cracked up to be. As fixed income investors know only too well, 2023 was meant to be the year of the bond. The logic went something like this: tighter monetary conditions in 2022 would induce a recession, leading to a subsequent taming in inflation and a fall in interest rates.

Furthermore, after a 30-year period of palpably low fixed-income yields, starting yields for the beginning of 2023 were looking perkier, making entry points relatively more attractive for bond holders, with the promise – finally – of some income without having to take excessive amounts of risk.

That was the theory. The reality, as we know, has been somewhat different. Inflation proved stickier than first thought, while a recession in the US, courtesy of a buoyant labour market, was impressively averted. So, as market commentators find themselves in the unenviable position of penning yet another outlook, how is the macroeconomic background shaping up as we enter 2024?

Some short-term comfort…

At the time of writing, the combination of technical and fundamental factors has served to fuel a rally in both bonds and equities. Positive flow dynamics are expected to continue into the quieter holiday period, making us reluctant to be on the wrong side of the rally.

Fuelling that rally is the belief (once again) that we have reached ‘peak interest rates' and that inflation will soon be yesterday’s problem.’ Goldilocks, it seems, is alive and well. But just as the little girl had to contend with her own kind of bears, market watchers will be aware that the rosy soft-landing narrative is being baked into financial markets, leaving little room for pessimism.

Moreover, falls in yields and tighter credit spreads on a ‘peak rates’ narrative are likely to be self-defeating as lower yields and looser credit conditions make central bank hawkishness more likely. If we’ve learnt anything in in 2023, it's surely to beware the 'consensus' narrative.

…but little long-term joy

Positioning ourselves against the consensus, just for the sake of it, isn’t a clever thing to do. But when all minds think alike, it’s important to hold fast to the things that may break the consensus. For example:

• We believe the inflation problem has not been solved and has plenty of potential to re-introduce volatility into markets. Core inflation rates have stalled over the last few months. We don’t think we’re many data points away from widespread concern that inflation is stuck at levels that are too high to be compatible with stable inflation expectations
• As we head into 2024, we expect fundamental corporate strength to be increasingly challenged by weaker earnings growth and we've already seen this starting to come through in Europe and in the US. Additionally, we find current analyst expectations of robust earnings growth difficult to square with (consensus) declining nominal GDP growth

2024: the year of the election

An important feature of 2024 will be the fact that in the next 12 to 18 months, two fifths of the world’s population – and roughly the same proportion of the world’s GDP – will go to the polls.[1] That’s not traditionally the time for politicians to turn Scrooge-like. So, in terms of macroeconomic framework, a combination of fiscal policy to fuel growth, coupled with monetary policy to act as a brake, seems a distinct possibility.

In the long run, however, this fiscal largesse means that economies will struggle to cope with real interest rates that are in excess of real growth. Of course, in the short run, interest rates that stay high because growth is higher than expected (and as long as they’re just staying high and not jumping higher), might not seem too bad. That said, the period leading up to any election, US or otherwise, typically produces higher volatility as investors cope with uncertainty.

The last word

So, how does all the above shape our thinking? We believe there are grounds for short-term optimism. Real wage growth and cooling, not frozen, labour markets make the slowdown in developed market growth more palatable.

Over the longer term, though, we cannot help but adopt a more cautious stance. Elections, heightened geopolitical tensions and deteriorating corporate fundamentals make us wary. Our watchwords for 2024 should be ‘caution’ and ‘selectivity’. In this regard, we have increased exposure via non-cyclical, higher-rated credits and senior bank exposure.

The above is an extract from our latest CIO outlook.

[1] According to Bloomberg economics, voters in countries representing 41% of the world’s population and 42% of its gross domestic product have a chance to elect new leaders next year.