It seems like it was only “yesterday” when I wrote my last “What to expect next year” piece. Like birthdays, these events come around sooner each year.
As I sit down to reflect on the past year’s uncertainties, how we navigated them, and opportunities for us to improve upon, I am astounded by the number of events and the degree of uncertainty that unfolded in 2023: the Artificial Intelligence (“AI”) revolution, bank failures, war in the middle east, etc. But before we delve into our 2024 outlook, it is always helpful to understand where we were at the beginning of the year and our expectations at that time for 2023.
We began the year with the following three questions in mind: Will the world's major economies fall into recession? Will inflation recede? How far will central banks have to raise interest rates?
On the question of recessions, we expected demand to weaken as the full effects of the substantial monetary tightening that occurred over 2022 had yet to be felt. We expected a substantial hit to interest rate-sensitive sectors (notably housing). In the case of the U.S. and Canada at least, we anticipated a relatively mild recession. In Europe, we expected a deeper recession. But, even here, the contraction in GDP would be much smaller than the Global Financial Crisis (2007-2009) and Pandemic (2020) recessions. In addition, we expected that the economic recovery would commence over the second half of 2023.
“We have seen GDP growth across developed countries slow and in some cases such as Canada, become negative in some quarters.”
So how did we fare? Of the four recession types that we identified in our previous commentaries, we expected a growth recession where GDP growth slowed sharply for several quarters. GDP would not fall, but remain below trend for several quarters, causing unemployment to rise. We have seen GDP growth across developed countries slow and in some cases such as Canada, become negative in some quarters. We have also seen unemployment rise, albeit later than what we anticipated and to a smaller degree, reminding us that monetary policy works on long and variable lags.
On the topic of interest rates, we had anticipated that that the conditions would be in place for the Bank of Canada and the Fed to begin cutting interest rates, at a gradual pace, by the final quarter of the year. As 2023 went on, we saw that advanced economies were showing resilience in the face of higher rates. Unemployment remained low and financial activity remained high, likely due to pent-up savings and consumer demand from the pandemic. As a result, our expectations for rate cuts from central banks moved out to mid-2024 and we adjusted our portfolios accordingly. We were correct in our estimation that rates would peak early in 2023, as central banks would hold and let the effects of higher rates work through the economic system.
“We believe that market participants have abandoned the “higher for longer narrative” and are now starting to come around to our expectation of a late Q1/Q2 rate cut.”
We believe that market participants have abandoned the “higher for longer narrative” and are now starting to come around to our expectation of a late Q1/Q2 rate cut. Our expectation is the U.S. Fed and the Bank of Canada will be among the first central banks to cut interest rates, but in truth, we wouldn’t put much weight on the timing of rate cuts – the key point is that most central banks are likely to be lowering interest rates by around the second quarter of next year. While recessions have not yet taken hold to the extent that we had anticipated, this seems to reflect temporary factors including households running down their savings and producers working off backlogs now that shortages have abated. With accumulated savings having been largely exhausted in the U.S. and Canada, most supply-side distortions have now unwound and interest rate hikes clearly weighing on credit growth and raising debt servicing costs, it seems very likely that a sharper slowdown is to come in advanced economies. Accordingly, and with few exceptions, we think that the rate hiking cycle is already over and see cuts coming next year.
However, the unusual nature of this cycle and uncertainties surrounding the transmission of monetary policy mean that the biggest risks relate to central banks. On the upside, previous interest rate hikes might fail to take a significant toll as many borrowers sit out the effects of the tightening cycle. But on the downside, policymakers might keep interest rates too high for too long and finally spark a labour market downturn.
“…we think equities, especially in the U.S., will rally strongly over the subsequent couple of years as economies recover, interest rates fall and enthusiasm about AI continues to grow.”
In short, our expectations for 2024 are generally below consensus on GDP growth in most major regions and we anticipate interest rate cuts in most economies. We think sluggish global growth will cause corporate earnings to disappoint and appetite for risk will worsen, meaning risky assets will struggle over the next few months. However, we think equities, especially in the U.S., will rally strongly over the subsequent couple of years as economies recover, interest rates fall and enthusiasm about AI continues to grow.
As always, there are risks in both directions. Here, we set out what we see as the biggest threats and opportunities for the year ahead.
Opportunities in the Year Ahead
Starting on the optimistic side, we think the biggest upside risk to our forecasts is that previous interest rate hikes never take a major toll, and inflation returns to target, nonetheless. Like most others, we have been surprised by the resilience of the world’s major economies this year against a backdrop of aggressive monetary policy tightening. Our view is that this partly reflects the longer maturity of debt, and we think that some of the pain has yet to come, but perhaps not. It is possible that many firms and households will sit out the policy tightening cycle altogether as by the time they need to refinance, market interest rates will be falling. This would raise concerns about the impotence of monetary policy and its power to deal with the next crisis. But in the meantime, it would mean stronger growth in advanced economies and no recessions.
The next upside risk is that falling inflation provides a significant boost to consumer spending. Easing pandemic-related disruptions or decreases in oil prices might prompt a sharper decline in inflation than we have assumed. If wage growth remains healthy at the same time, real incomes would rise sharply. This possibility is stronger in the euro zone than in the U.S., where wage growth is already slowing. Note, too, that euro-zone households still have significant excess savings, which they might eventually decide to spend. Admittedly, the positive effects of lower oil prices for consumers would be partly offset by the adverse impact on producers at the global level. However, we would anticipate a net positive impact given the higher propensity to save.
A third potential source of optimism is that AI might start to boost productivity, and it’s possible that the boost will start to come through sooner than we expect. After all, the adoption lags before countries implement new technologies after they are invented have shortened over time and there is an outside chance that the recent strength in U.S. productivity already reflects some of this.
“…it is quite feasible that central banks will be slow to acknowledge weakness in their economies as they focus on stamping out any lingering inflation threat…”
Risks to the Downside
Unfortunately, though, we still think that the balance of risk is skewed to the downside. Chief among these is the possibility that central banks will not cut interest rates in 2024 as we anticipate. This could happen either because core inflation is sticky around current rates or because monetary policymakers choose to err on the side of caution. In the aftermath of such a severe inflation shock and given their current rhetoric, it is quite feasible that central banks will be slow to acknowledge weakness in their economies as they focus on stamping out any lingering inflation threat, however remote. If interest rates are kept at current levels and banks maintain a hawkish tone, bond yields are more likely to rise than fall as we anticipate. The ongoing tightness of financial conditions could prompt a rise in loan defaults and insolvencies, plus the sharp rise in unemployment that has so far been absent in this cycle, although we may have seen the first crack come in the Canadian labour force.
“Corporations might struggle to refinance once their long-term loans come due and a round of insolvencies would impair financial institutions’ assets.”
A second downside risk is that something breaks in the financial system. By and large, financial institutions seem to have adjusted to higher interest rates, and stress tests imply that major banks are well-positioned. If policy rates have peaked, we could be out of the woods. However, it is still possible that the lagged effects of previous hikes could cause a crisis. Corporations might struggle to refinance once their long-term loans come due and a round of insolvencies would impair financial institutions’ assets. These risks are perhaps greatest for commercial real estate companies and the investment funds that are exposed to them. Alternatively, we could yet see renewed declines in house prices once households come to remortgage at higher rates with knock-on effects for the financial sector.
“…global fracturing might intensify. Relations between the U.S. and China blocs could deteriorate further, perhaps due to tensions surrounding the election in Taiwan or in the run-up to the U.S. election.”
Third, there is a threat to public debt sustainability. If government borrowing remains elevated, market concerns about the fiscal position could grow. If serious stresses do start to appear in government bond markets, countries may be forced into an abrupt fiscal consolidation causing prolonged economic weakness. Or alternatively, they might resort to financial repression with adverse implications for inflation.
Fourth, global fracturing might intensify. Relations between the U.S. and China blocs could deteriorate further, perhaps due to tensions surrounding the election in Taiwan or in the run-up to the U.S. election. This could result in tariffs, sanctions, and limits on capital and technology flows, suggesting China’s growth would suffer in 2024 and beyond. The immediate economic impact on large developed markets should be small, though financial markets could react badly and some Western firms may lose Chinese market share. There is a much smaller risk of a far worse outcome involving conflict.
Finally, China might suffer a renewed downturn. We have assumed that the Chinese economy is past the worst and that a policy-induced cyclical recovery will continue. However it is notable that there has still been no major correction in construction activity despite the property crisis. This might yet materialize if structural factors weighing on demand take their toll faster than we have assumed. In that event, policymakers may struggle to provide an offsetting boost to demand since the fiscal deficit and public investment spending are already elevated. Besides China, trading partners in Asia and commodity producers would suffer.
In practice, the impact of any of the shocks would depend on its precise nature. In most cases, it is possible to think of more extreme versions of the scenarios above which are less likely to happen but would have far greater effects if they did. And crucially, the risks are not independent of each other. The realization of one may mean that the probability of others increases, such as higher rates prompting fiscal concerns and financial strains. It is under these circumstances that the economic repercussions would be greatest.
“…our sense is that 2024 will have been a year of low economic growth in advanced economies followed by falling interest rates (nearly) everywhere, but particularly in the U.S. and Canada.”
The one thing we can be reasonably sure about is that the economic backdrop is likely to look and feel very different in a year's time. Move the clock forward 12 months and our sense is that 2024 will have been a year of low economic growth in advanced economies followed by falling interest rates (nearly) everywhere, but particularly in the U.S. and Canada. The prospect of a moderate recovery commencing in the second half and the Bank of Canada and Federal Reserve cutting rates by the end of Q2 are the key themes that will shape 2024. We are more dovish than most market participants regarding the amount of rate cuts that the developed market central banks will deliver next year. Our sense is that risky asset valuations reflect an overly optimistic view the global economy will hold up well in the face of higher interest rates. So, if, as we expect, the economy falters instead, sentiment sours and valuations may take a tumble. Nonetheless, we think they will begin to rise again once growth worries ease and enthusiasm around AI returns. We have positioned ourselves to expect a faltering of expectations, which will benefit our fixed income positioning. If the macro backdrop does not worsen from our base case, we will use that opportunity to take on greater risky asset exposure, especially in the U.S. where enthusiasm over AI will push prices higher.
Wishing you and your loved ones a happy, healthy, and prosperous 2024.
Chief Investment Officer
IPC Portfolio Services