By Kari Vatanen, CIO of Veritas: Throughout the past year, economists have been debating whether the economy is heading to a soft landing or a hard landing as a result of tighter monetary policy. As no landing was observed by the end of 2023, the dispute will be resolved within this year.
The year 2023 began in an environment of high inflation and low growth expectations. In the previous year, central banks had already started to defend price stability, i.e. the fight against inflation, in accordance with their mandate, by raising their key interest rates.
Economic growth in the United States turned out to be stronger than expected last year due to a robust labor market and rising wages, which supported private consumption. In contrast, in Europe economic growth was stagnant and growth prospects were weak, especially in countries with a higher dependence on the export industry. China no longer is the global growth engine for European industrial exports as it was in the 2010s.
Headline inflation fell steadily throughout the year and is soon approaching the target level of the central banks.
The positive surprise towards the end of the year was the clearly faster-than-expected slowing of inflation. Headline inflation fell steadily throughout the year and is soon approaching the target level of the central banks. However, core inflation, excluding energy and food prices, is still well above the central banks’ target level.
As a result of the tightening monetary policy of central banks, interest rates have risen rapidly, pushing up the cost of borrowing in the financial markets. Corporate profitability has been burdened not only by higher borrowing costs but also by higher production costs, resulting from inflation. Few companies have been able to pass the twofold increase in costs directly to their prices. The number of bankruptcies increased in 2023, and the growth in bankruptcies will continue during the first half of 2024.
Macroeconomic environment and central bank actions in 2024
Global economic growth continues to slow down, but at the same time declining inflation keeps real economic growth positive. In the United States, economic growth lands softly during the first half of the year and a deeper recession will likely be avoided as a robust labor market supports private consumption. In Europe, the decline in economic growth is more severe and a recession can hardly be avoided in the first half of the year. In the first half of 2024, the export-driven economies of Northern Europe will suffer more than other regions and will plunge into a deeper recession. Towards the end of the year, economic growth expectations improve, supported by a gradual easing of monetary policy and an increase in investment demand.
Inflation will continue to ease and headline inflation will reach the target of the central banks by the summer.
Inflation will continue to ease and headline inflation will reach the target of the central banks by the summer. In the United States, core inflation slows down more gradually than headline inflation, as wage growth remains high and continues to support core inflation. The weaker economic growth in Europe reduces inflationary pressures, causing euro area core inflation to decrease faster than in the United States and to reach the ECB’s target level during 2024.
Central bank interest rates hikes ended in autumn 2023, as inflation calmed down faster than anticipated. However, the gradual reduction of central bank balance sheets has continued, which has tightened monetary policy. As inflation continues to calm, central banks will gradually begin to lower their key interest rates and it will ease the prospects of companies facing upcoming refinancing needs. The U.S. Federal Reserve is expected to begin moderate interest rate cuts in the spring of 2024 and the European Central Bank will follow suit by the summer. By the end of the year, key interest rates will fall by about one percentage point.
Negative inflation surprises may occur if geopolitical tensions increase and protectionism grows.
The geopolitical developments between Western democracies and authoritarian powers significantly influences economic growth and inflation expectations towards the end of the year. Negative inflation surprises may occur if geopolitical tensions increase and protectionism grows. In such a scenario, central banks would continue to tighten monetary policy and interest rates would rise again. Rapidly deteriorating financial market conditions could worsen the refinancing problems of corporates and push investment markets into crisis.
Investment year 2024 for the major asset classes
The Fixed Income Investor harvested good returns towards the end of 2023, as long-term interest rates fell rapidly from their peak levels in the autumn. However, long-term rates seem to have overreacted to the easing of inflation expectations, as already inverted yield curves plunged even more sharply into negative territory. If the slowdown in economic growth remains soft and central bank interest rate cuts are moderate, the yield curves will gradually start to steepen. Long-term interest rates are still subject to upward pressure, although short-term rates may fall in the wake of central bank policy rate cuts. Expected returns for short-term rates are clearly positive and more attractive than those for long-term rates.
For the Credit Investor, the year 2023 provided particularly strong and steady returns. Credit spreads tightened over the year and severe default events were avoided in the markets. At the beginning of 2024, the credit investor starts the year with lower yield levels compared to the previous year, as both interest rates and credit spreads declined towards the end of the year 2023. However, expected returns for credit investments have remained relatively attractive and they can provide comparatively high single-digit returns even in the soft-landing scenario for the economy. In an environment of declining inflation and weakening economic growth, the correlation between credit spreads and interest rates may turn negative again, which would further increase the attractiveness of credit investments from the risk perspective.
For the Equity Investor, 2023 was a mixed year, even if the global equity market offered returns above the long-term average. Large US technology companies drove the equity market upward, while the performance of mid-sized and small companies remained quite subdued. At the beginning of 2024, the valuations of large technology companies have risen relatively high due to a strong surge of the market prices. In contrast, the valuations of mid-sized and small companies have remained at least moderate, if not favourable in some regions. The slowing economic growth and deteriorating earnings expectations seem to be priced into the stock prices of smaller companies. In the year 2024, expected returns are positive for the global equity markets, although slowing economic growth may cause turbulence in the markets, especially in the first half of the year. However, in times of positive interest rates, companies are required to have a sufficiently strong balance sheet and positive profitability to navigate through the deteriorating economic environment.
Illiquid investments have faced downward pressure on valuations due to rising discount rates in 2023. Market values of real estate and infrastructure investments, that provide steady cash flow returns, have been gradually written down throughout the year. Nevertheless, there have been no major changes in the valuations of private equity investments. In 2024, the discount rates of the illiquid investments will continue to rise in the first half of the year, but downward pressure on valuations will gradually ease towards the end of the year as central banks begin to cut their key interest rates. For private equity, write-downs are made more moderately, but the expected returns for the next few years will be lower than in previous years.
Expectations for investment market returns look positive if inflation continues to ease and economic growth faces soft landing.
Expectations for investment market returns look positive if inflation continues to ease and economic growth faces soft landing. It requires the central banks to be completely successful in fighting inflation without endangering economic growth. The risk of excessively prolonged tight monetary policy is a more significant decline in economic growth and, at worst, a financial market crisis. Conversely, monetary policy that is loosened too quickly may feed inflation into a new upsurge and trigger the need to tighten monetary policy again. While it is difficult for the central banks to succeed in their task, it is not impossible. Still, negative geopolitical surprises, if realized, can mess up the well-progressed mission of the central banks.
This article was originally published here.
