Forecast for 2024: volatility and geopolitical uncertainty

At the beginning of the year, we said that volatility and geopolitical uncertainty will persist.

Stocks and bonds were nearly flat by the end of October and are now up 10 per cent and 5 per cent respectively in just 30 days. That is volatility.

We now have not one, but two wars with potential geopolitical consequences. That is uncertainty.

Geopolitical tensions and geoeconomic fragmentation will linger

We finish 2023 with two major wars, as well as increasingly tighter global trade conditions.

Slow growth and increasing borrowing needs will conserve the competition between key economic actors, incentivising governments to use any economic means at their disposal.

As the pursuit of economic influence and the technological edge between China and the US intensifies, western-based supply chains will continue to shift away from China (a very long and arduous process) and into other countries, such as India.

No sustainable bull market until QT stops

While we often do not notice a bull market until mid-way into the next bear market, quantitative tightening prevents sustainably high equity returns.

Quantitative easing was the foremost driver of equity performance for the 14 years prior to 2022. It stands to reason that the opposite - QT - by and large precludes a lasting equity bull market.

With rate cuts now considerably priced in, it would take a significant catalyst for the next leg-up that would bring equities near their all-time highs.

As conditions are not dire enough to initiate a bear market (bar a serious financial accident) and QT prevents a lasting bull market, equity markets will very likely continue to range-trade, even with a slight upward tilt.

The movement is likely to have a clear floor due to residual liquidity and decent fundamentals and a clear ceiling as animal spirits remain caged due to the persistent liquidity drain.

Something may yet break. Central banks will probably react fast

Real rates (ex-inflation), which matter for the economy, continue to rise, as nominal rates stay steady and inflation is falling.

All other things being equal, monetary conditions should thus continue to tighten until inflation has dropped sufficiently to force central banks to climb down from the peak, towards the natural rate of interest.

This means economic conditions will continue to deteriorate for the foreseeable future.

The combination of an economic slowdown and the abrupt end to the previous regime may uncover unexpected weaknesses in some corners of the market, like commercial real estate, much like it did with US peripheral banks earlier in the year.

Rates will begin to come down in mid/late H2 in the US. Europe will follow

The rate outlook is murky and data/event-driven. As such, the market’s confidence level in predicting rates is low. US markets are pricing in rate cuts beginning mid-2024.

While it is possible, especially if we see a financial accident, our main scenario suggests rate cuts cannot begin until later in the year.

Geoeconomic fragmentation considered, we believe that rate-cutting cycles between Europe and the US will not be synchronised.

And while European inflation is lower than the US – that is closer to the 2 per cent mark – EU interest rates at 4.5 per cent are not nearly as restrictive as US ones at 5.5 per cent.

When the time for cuts is near, the US Federal Reserve will lead the move, with Europe following, and in terms of UK rates, despite the economic slowdown, the labour market remains tighter and wage inflation is much higher. The UK is more likely to ease rates along with Europe.

Quantitative tightening will end roughly around the time rate cuts begin

Markets care less about rates and more about QT. Central banks, which have reduced their balance sheets aggressively in the past year and a half, have been rather silent about discontinuing the practice.

Given the high level of rate uncertainty, it is difficult to predict the end of QT; however, once rate cuts do happen, they will most likely bring an end to it.

As QT persists, the reserves commercial banks hold with the central bank are dwindling.

Non-borrowed reserves currently stand at $3.5tn (£2.7tn), $500bn above the upper limit of the Fed’s comfort level, which Gavekal estimates to be at 8 to 10 per cent of nominal GDP.

The end of QT should help markets rebound, and possibly even allow a sustainable equity bull market.

Short yields to come down, curve to bull steepen

When rate cuts begin, we expect that short rates will come down faster than long rates, allowing the yield curve to bull steepen (the whole curve comes down, but faster at the shorter end).

There is also a probability of bear steepening (the curve moving up faster at the longer end) in case a financial accident forces central banks to cut rates, rather than the economy moving at its present course.

Yield curve steepening is necessary for the profitability of financial institutions, credit flow and the ability of pension funds to meet their long-term obligations, and thus it is very desirable by central banks. This will probably happen naturally.

Economies will slow down in H1 and begin to recover in later H2. No deep recession

The economic slowdown has been well underway since mid-year 2023. However, at least in the US and possibly in the UK we will not see a deep recession.

The reason is that both countries have been running extended fiscal deficits, exactly to mitigate the worst effects of the slowdown.

As central banks begin to communicate rate cuts nearer the end of 2024, we expect consumption to pick up, and economic activity to rebound.

Manufacturing, which leads economic cycles, has already shown evidence of stabilisation and could begin to recover earlier in the year. The services sector should follow.

2024 and possibly 2025 are still expected to see growth below trend, however, as higher-than-average inflation and high interest payments eat into real economic output.

Inflation to stabilise, bar geopolitical turbulence

Inflation has become de-anchored from its lows in the previous decade and a half, as the pandemic accelerated deglobalisation and various centrifugal forces.

This means that mean-reversion (with the mean around 1 to 2 per cent) to a steady inflation regime remains elusive.

Simply put, it is difficult to see a return to a regime where central banks were trying, and failing, to stoke some inflation.

Instead, much like the 1970s, we are looking at inflation in waves.

With that in mind, the consensus moves towards moderate stabilisation at levels around 2.5 to 3.5 per cent in 2024.

Deficits will persist, and debt will continue to climb

Global debt to GDP is 340 per cent, nearly 120 per cent higher than it was two decades ago.

Despite high levels of GDP and interest payments exceeding output growth, many countries have opted to maintain high levels of fiscal spending to mitigate the effects of the economic slowdown. The OECD has already issued a warning that the trend may not be sustainable.

We are reaching levels where debt is issued to pay for debt, a process that is self-accelerating. At some point fiscal restraint is necessary, pushing countries towards primary deficits; the economic slowdown precludes a return to fiscal prudence at least in the next few months.

China will rebound

Although the scenarios vary, we believe that China will see the smoothing of its real estate market crash and a slow return towards growth normality.

Economic growth, much of which is still manufacturing-based, is already somewhat rebounding, which can be corroborated by improving industrial data in Asia and other sources.

Additionally, the government and central bank have been stimulating the economy for the past few months, which should translate into improved consumption in the near future.

Having said that, geopolitical fragmentation brings a slow removal of China from the heart of the global supply chain, which should have some significant repercussions in terms of trend growth.

This geopolitical shift should cap the economic rebound somewhat in 2024, but overall we think the year will be a better one for the world’s biggest manufacturer and second-biggest economy.

The dollar will remain the world’s reserve currency

Despite efforts to dislodge the US dollar from its natural perch at the top of the global currencies food chain, the greenback will remain the world’s choice as a global reserve in years to come.

Despite China amassing gold reserves and some deals in Asia to trade commodities in local currencies, China and other economies still hold huge amounts of dollar reserves.

Reducing that number abruptly creates a supply problem for all other currencies.

If the dollar’s value were to lower due to massive de-dollarisation, then the value of most countries’ reserves would drop dramatically.

In behavioural terms, the stability of the dollar is still deeply ingrained within consumer mentality.

George Lagarias is chief economist of Mazars Wealth Management