2024 H1: What investors should expect

‍Sustainability is, rightly, a top priority for commercial real estate investors. The industry accounts for approximately 40 percent of global carbon emissions, according to the United Nations. Building operation and construction are responsible for 70 percent and 30 percent of the sector’s emissions, respectively.  

The need to decarbonise is urgent in the face of rising occupier, investor and community expectations, increasingly stringent EU legislation and, of course, the severity of the climate crisis.

To deliver meaningful change, the industry must lower operational impacts through greater efficiencies and renewable energy use, and lower its construction-related impacts by adaptively reusing assets when their existing use becomes unviable – rather than demolishing and rebuilding from scratch. When that is not possible, primacy should be given to new construction on previously developed brownfield land, using sustainable construction materials such as wood and recycled resources.

On operations, the industry has achieved some success. Building-related greenhouse gas emissions have fallen over the last decade in the largest European real estate markets. As the first chart shows, these declines range from 4 percent in the UK to 37 percent in the Netherlands. ‍

On adaptive reuse, Europe has been concentrating more people and businesses into smaller areas to protect greenfield land over the last 20 years.  

However, given the scale of the challenge, the pace of change is too slow. As our final chart shows, construction remains wasteful, with the use of circular material woefully low – plateauing after steady increases a decade ago.  ‍

We must do much better.  

2024 is a crucial year. Sustainability considerations are being factored into investment processes like never before and will be the major performance driver for most assets, in our view.  

Investors that fail to adapt inefficient assets, that rely on traditional comprehensive redevelopment rather than adaptive reuse, or that use virgin undeveloped land rather than previously developed land will find it extremely tough to attract occupiers, capital, funding and buyers. Those executing investment strategies that meaningfully deliver sustainability improvements are destined to outperform.  

This philosophy explains why, in 2024, we see value in densifying, improving or adaptively reusing existing real estate assets; timber buildings; and enacting asset-level environmental improvements to reduce utility demand, minimise waste and introduce renewable energy.

‍Economists have been waiting for the other shoe to drop for over a year, nervously wringing their hands over the likelihood of a recession. And yet the American consumer endured.

Excess savings from a historic infusion of fiscal stimulus buoyed household balance sheets as inflation hit a fever pitch last year. The subsequent cooling in price growth – combined with continued strong spending – has turned bears into bulls, with quiet whispers about a soft landing turning into anxious celebration that the economy may avoid a recession. That would be a welcome development.

But there are reasons to worry that we may be sitting in the calm before the storm. As the chart below indicates, consumers lost an incredible amount of purchasing power over the last four years. In fact, households are significantly worse off by this metric than they were at the same point post-global financial crisis. Consumers have seen 6.6 percent of their purchasing power erode over the course of the pandemic and subsequent recovery – due entirely to a surge in inflation.

That lost purchasing power stands in stark contrast to the continued strength in spending. It begs the question: how have households continued to spend while purchasing power eroded rapidly?

The answer: that huge savings buffer. By most estimates, we’re nearing the end of that buffer, and it’s likely that consumers will pull back long before their bank accounts run dry.

And while real wage growth will continue to improve, it will take years for consumers to get back to their pre-pandemic level of purchasing power. That spells a significant slowdown – or outright contraction – in household spending next year.

Not all is lost, and many of us have so far been wrong about a recession. But there is reason to be concerned that the music is about to stop. If it does, it will be the American economy left without a chair.

There is now a broad consensus that the Federal Reserve has finished raising interest rates, that Treasury yields have peaked, and that policy rate cuts –  more or less,depending on the macroeconomic scenario - are on the cards for 2024. But will this decline affect the entire yield curve?

The short end of the yield curve, which is the most sensitive to changes in the central bank's policy rate, could see particularly marked easing next year – probably even greater than markets anticipate. Three to four rate cuts of 25 basis points are being priced in between now and December 2024, with the first priced in for June.

Admittedly, this is two more cuts than the Fed itself is predicting, but it's still not much if the economy suffers a sharp deterioration. And the latest US employment figures point to a downturn in the labour market that could be brutal.  

A quick rise in 15-weeks-and-over unemployment, a sharp drop in the use of temporary help services, fewer and fewer sectors creating jobs: the list of red flags is growing, pointing to a recessionary scenario far more severe than the moderate slowdown anticipated by the market consensus. (The next chart shows how such sharp increases in joblessness have correlated with recessions.)  

Such a scenario would inevitably lead to rate cuts surpassing 100 basis points by the end of 2024.

However, the impact on the long end of the curve is uncertain. Indeed, several months ago, the Fed hinted that the start of rate cuts would not necessarily mean the end of quantitative tightening.  

It is therefore conceivable that the Fed could cut rates while continuing to gradually reduce the size of its balance sheet – or, at the very least, stabilise it without resorting to massive asset-purchase programs.  

This would translate into a further decline in the proportion of public debt held by the Fed, since at the same time (given a recessionary scenario and an election year) we would certainly see an increase in the budget deficit, and hence, the US Treasury's financing requirements.  

More debt issuance – without the central bank increasing its absorption capacity, or even continuing to reduce it: the resulting “scissor” effect would be particularly unfavourable to the long end of the curve.

In other words, while a recessionary scenario seems far from out of the question next year, the downside potential is significant for short rates, but much less obvious for long rates.

The market remains pessimistic on China after a cumulative contraction of almost 20 percent in property investment through 2022 and 2023 and with exports down over the year. While we’re conscious of the risks to activity and sentiment, we instead remain optimistic – forecasting economic growth of 5.3 percent in 2024. Putting the aforementioned facts in context explains why.

In stark contrast to property, China’s productive capacity is seeing a rapid rate of investment to take advantage of multi-decade global megatrends – such as the green transition and the next wave of economic development across Asia.  

As of October, utilities investment was up 25 percent year-to-date, while capacity in key high-tech manufacturing sectors expanded between 13 percent and 37 percent on the same basis, as our first chart shows. Further aiding connectivity and productivity, the infrastructure sector (excluding utilities) is compounding at a 6 percent pace year-to-date.  

This investment is occurring to allow margins to be sustained or increased while prices are cut and production is grown rapidly. The sharp decline in Chinese export prices shown in the next chart, therefore, has at least as much to do with gains in productivity and efficiency as it does with softer global demand.  

This is important because by lowering the price of goods and expanding production, Chinese firms are opening up new markets – particularly across the developing world. Highlighting this is the fact that over the year to October 2023, China’s trade surplus with Asia was almost as large as its surplus with the US, and larger than that with the EU.  

Given that developing Asia has the capacity to sustainably grow at a multiple of the US and European pace, and with most countries in the region open to expansive trade and investment, income gains for China should be robust and enduring. The next chart shows how Asia has been taking a greater share of China’s trade surplus.  

The key downside risk for China is not with investment or trade, but consumption. The NBS PMI’s employment series makes this clear. A slow re-opening from COVID-19 – paired with the wealth and sentiment effects of regulatory reform in housing and tech – has left services employment weak. Absent a quick turn, the growth trajectory of other sectors will be put at risk.  

We have been pleased to see the PMI employment series stabilise in recent months and households become less cautious. Announced and mooted support for housing should further aid this trend into 2024. However, we expect it will be difficult for China to fully win back the market’s confidence.

On both sides of the Atlantic, Central Banks should start to cut rates next year, but monetary policy conditions are expected to remain restrictive for the majority of 2024. This is putting downward pressure on economic activity and inflation.

As the monetary cycle likely peaked in 2023, the prevailing question in financial markets revolves around when and to what extent the US policy rate will fall. 

A key concept in monetary policy guidance is R-star, which represents the real short-term interest rate consistent with an economy in equilibrium (at potential output and stable inflation). It allows us to judge whether the policy is restrictive or stimulative. 

Unfortunately, the R-star is an unobservable variable, and the uncertainty about its value fuels the debate between those arguing for a higher level and those predicting that it will remain at historically low levels. 

To gauge the natural rate, we can rely on three types of approaches: macroeconomic models, like the New York Fed’s Holston, Laubach and Williams (HLW) model; the FOMC’s projections for the long-run federal funds rate; and market-based model expectations.

Our first chart tracks the Fed funds rate and the (nominal) R-star implied by the HLW, the FOMC and the markets. The latter is the average R-star derived from two market models: the Fed’s DKW (D’Amico, Kim and Wei) model and the ACM (Adrian, Crump and Moench) model. 

The first takeaway is that markets are discounting an R-star slightly above 4 percent, in line with pre-GFC levels. The second takeaway is that after 15 years of easy financial conditions, monetary policy is now restrictive by historical standards, regardless of the approach taken. 

The third takeaway is that according to current market models, it would take at least 125 basis points of rate cuts to neutralise monetary policy, but much more if we consider the other approaches. In other words, even with significant action, monetary policy is likely to remain restrictive in 2024. 

This is important as it further increases the likelihood that growth will land below its potential. More substantial easing would likely be associated with the materialisation of a worse landing scenario for the US economy.

As the second chart shows, the R-star is much lower in the eurozone than in the US, and the monetary policy stance looks even tighter on our continent. 

To neutralise monetary policy, there would probably need to be a cut in interest rates by at least 200 basis points. However, this scenario is less likely: inflation in the eurozone is likely to slow more gradually than in the US, wage dynamics are currently peaking, and the European Central Bank is historically less reactive than the Federal Reserve. 

All in all, the expected contractionary stance of monetary policy reduces the chances of a strong rebound in eurozone activity.

East Asian economies have long been geared to the economic rise of China. But China’s slowdown has weighed on much of Asia’s exports. Moreover, the much-expected pick-up in outbound Chinese tourism has also fallen short of expectations, holding back the post-pandemic recovery for many Asian economies. 

However, fundamental dependencies are steadily and inexorably changing. This is most evident in the export performance (and prospects) of Taiwan and South Korea. In these countries, the rising share of semiconductors and high-end electronics in total exports and value-added manufacturing is likely to sustain a further de-coupling of their prospects with those of China.

The brief history here is one of a trend reduction for China’s import intensity (or units of imports per exports) alongside its rising heft in the global economy (as measured by its share in global GDP). The trend here has been interspersed by big declines and bounce-backs depending on the business cycle. 

For instance, as our first chart shows, import intensity collapsed during China’s last property downturn in 2014-15, and then bounced back in 2016. Things remained volatile through the Sino-US trade war in 2018-19 and the pandemic. But up until 2022, the long-term trend was clear: China’s import intensity fell even as its heft in global GDP rose. 

What’s different now (and has been for the last year and a half) is that a renewed slump in import intensity has also been accompanied by a fall in China’s heft. This leaves many Asian economies in an even tighter spot -- especially those economies closely linked to China that have been slow in adapting to new sources of external demand. 

However, Taiwan and South Korea have already been lowering their dependence on China. We believe these two countries are poised to reap bigger gains from their linkages with AI-related global chip demand. Our second chart shows how, together, these two economies lowered their export value dependence on China from as high as 27 percent of total exports as recently as 2021 to 21 percent in October of this year. Meanwhile, in the same timeframe, the export shares of the US and the euro area have risen 2.5 and 2 percentage points respectively to 17 percent and 9 percent of total exports. 

Another positive driver is the reduction in manufacturing and semiconductor inventories – relative to order books that are stabilising and even swelling. As a result, production and shipments have already begun recovering and seem poised to rise further through 2024. This inventory trend is highlighted in our third chart.  

Admittedly, the recent downshift in global PMIs is a concern. We highlight this in the lower panel of chart 3. But as long as developed market economies do not crater (which is not our base case), we think a base is forming for the macro prospects and equity prices of Taiwan and Korea as we head into 2024. 

Moreover, any stabilisation in China itself (though we are not expecting a strong rebound) would constitute another modest tailwind – even though China’s overall importance continues to incrementally diminish.

Equity returns for Taiwan and Korea have exceeded those of China by far this year – as our final chart shows. 

We think that firming global semiconductor demand and rising export shipments will boost earnings. In turn this will allow the recent run-up in Taiwanese and Korean P/E ratios to ease from near-three-year highs in the months ahead – even as their overall equity returns hew to growth-oriented and AI-driven returns in the US.‍

Chart 4: Easing semis inventories and firming global chip demand to spur production and earnings growth at Taiwanese and Korean companies which will ensure their relative equity outperformance.

Despite a sustained period of monetary tightening, the economic slowdown in Australia has not been a bad as many feared. The economy remains on track for a soft landing, with surging population growth providing substantial momentum as we head into 2024.

While resilient economic growth has been welcomed, it has been accompanied by persistent inflation and high interest rates, which continue to take a toll on sentiment in commercial property markets.

It has been a tumultuous period with value declines in both listed and private markets, as our first chart shows.

However, the market can look ahead to consolidation and to the prospect of recovery emerging in 2024. Higher cap rates provide a more attractive entry point for investors, generating the prospect of higher returns going forward. Furthermore, the recent decline in long-term bond yields (as seen in our final chart) from their October highs signals more favourable financial conditions globally, and this will gradually feed through to improved sentiment in property markets.

In terms of strategy, investors are seeking greater diversification into alternative sectors. The so-called living sectors are at the front of the queue, led by build-to-rent – but also encompassing co-living, student accommodation and retirement living. The shift to living sectors partly reflects a preference for defensive strategies at this point in the cycle, but is also due to structural under-supply in rental markets and the ability to adjust rental income streams more quickly than other sectors in response to high inflation.

Industrial property markets also remain in favour, supported by continued rental growth and an ongoing need for new developments to accommodate the latest technology surrounding warehousing, distribution and stock tracking.

Meanwhile, in the office market, the smaller markets of Brisbane and Perth are currently outperforming the larger markets of Sydney and Melbourne. The strength of the Queensland and Western Australian economies will remain supportive in 2024, as evidenced by strong population growth of 2.8 percent and 2.3 percent respectively over the past year.

In spite of a challenging environment for property globally, underlying demand for Australian real estate remains high and we expect a strong resurgence in activity once central banks clearly signal a peak and formal valuations adjust to narrow the current bid-ask spreads.

We look back at the end of a very turbulent 2023 on a cautiously optimistic note. With a few exceptions (i.e., the Bank of Japan), developed market central banks have come to the end of the tightening cycle. They are now signaling that some relief on rates is not too far off.

We had long argued that monetary-policy nimbleness, and a willingness to calibrate rates lower once progress on inflation permitted, was critical to maintaining a path to a soft landing. As recently as three months ago, that willingness was still in question – but no more.

At their December meetings, the Federal Reserve and the European Central Bank both signaled in no uncertain terms that, barring truly unexpected events, the next move in rates would be lower. While domestic conditions will dictate the pace at which other developed-market central banks can join the bandwagon, the direction of travel will be the same for all.

In 2023, we described the global disinflation trend as a “different speeds, same direction” phenomenon.

The 2024 global monetary easing cycle can be thought of in the same way. This will not magically solve all challenges, but will help put a floor under the ongoing global slowdown and reduce downside risks.

Timing remains important, and the soft landing is by no means guaranteed. However, the odds of achieving it have improved yet again following the December dovish pivot.

Canada’s economy has slowed down appreciably. In Q3 2023, growth fell by an annualized rate of 1 percent. With a slight upward revision to Q2 growth (which was initially estimated as a modest decline), the country narrowly avoided a technical recession. Facing materially higher borrowing costs, highly indebted consumers in Canada were barely able to contribute to domestic growth during Q3, while non-residential business spending contracted by nearly 10 percent.  

As a result, government spending was the only component keeping Canadian domestic demand afloat, even after accounting for the strongest population growth in recent Canadian history.  

All told, the likelihood that Canada is or will be entering into recession by 2024, is high. This is especially true given that per capita GDP growth in Canada has already contracted for five consecutive quarters – the weakest pace in the developed world.

While policymakers such as the Bank of Canada continue to point to a historically low unemployment rate as a reflection of continued excessive demand and inflationary pressure in the Canadian economy, it is important to also note that the labour market may not be as tight as the unemployment rate implies. Although population growth is surging, the unemployment rate has been distorted by unusually low labour force participation rates.  

Meanwhile, the employment rate – or the percentage of the overall population with a job – has been steadily eroding, and is now below what could be considered a “full employment” level.  Given rapid population growth, Canada will need to produce even more jobs than it has in the past, just to prevent a further slackening of labour market conditions.  

Like other central banks around the world, the Bank of Canada forcefully lifted policy interest rates to combat the global surge in inflation. Although the bank remains concerned about sticky domestic inflation – given that its core measure remains above its 2 percent target – underlying inflationary pressures have now largely receded in Canada.

In fact, the only major components of inflation that have heated up over the past year are mortgage interest costs and residential rental prices. Ironically, the Bank of Canada’s sharp rate increases have largely been responsible for the flare-ups in both segments. If these two components were excluded from the Bank of Canada’s core inflation estimate, inflation would actually be running slightly below the Bank of Canada’s target rate of 2 percent – reflecting the underlying disinflationary pressures building up in Canada.

Given growing recession risks and receding non-policy induced inflation, the Bank of Canada may be forced to cut its policy interest rate in 2024 to provide some accommodation.  

Indeed, at its current 5 percent level, policy rates are too restrictive for an economy that is now stumbling and developing slack across various sectors.  

To get back to a neutral level of interest rates, the Bank of Canada would ultimately need to cut its policy rate by a cumulative 200 to 250 basis points. Financial markets are already beginning to price in the first of these potential rate cuts in March 2024 – a timeline well ahead of the US Fed.

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The incessant recession debate misses the point.

As we see in the first chart, the corporate sector has already experienced a three-quarter contraction, as measured by the private enterprise net operating surplus contribution to gross domestic income (GDI). The S&P 500 suffered an earnings recession that ended in 3Q23.

The real question for 2024: whether we suffer a contraction in output and employment deep enough to cause a double-dip earnings recession.

There are several trends that are unique to the current business cycle. First, services contracted more than goods consumption during the deepest, briefest NBER recession on record. The magnitude of fiscal stimulus and direct transfers to households was also unprecedented. Although spending was erratic in 2023, it appears that the rebalancing and “revenge travel” is winding down. ‍

‍‍Pandemic-related supply-chain disruptions led to the most extreme inventory cycle since the post-WWII period. Supply chains cleared in early ’22, leaving retailers with truckloads of goods in their parking lots and negative contributions to real GDP of 2.05 percent in 2Q22 and 0.66 percent in 3Q22. Both the aggregate numbers and retailer commentary imply inventories are now clean and unlikely to exacerbate a softening in consumer demand.

Then, there’s the property market. Just as the inventory liquidation process was winding down, residential investment collapsed due to the shock associated with the beginning of the most aggressive rate hike cycle since the early ‘80s. Residential investment subtracted 1.41 percent from GDP in 3Q22 and 1.23 percent in 4Q22. Further downside is likely limited by strong demographic tailwinds, however. Unless there is a reversal of at least 100 basis points of Fed rate hikes, a significant positive contribution from residential real estate investment is unlikely.

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Finally, there is government spending, where the quarterly annualized pace has been exceptionally robust; 3Q was 5.5 percent, 2Q 4.6 percent, 1Q 3.3 percent, 4Q22 4.8 percent and 3Q22 5.3 percent contributing 74 basis points per quarter on average to GDP.

There is likely to be a change in contribution in 2023, direct transfer payments to individuals are cooling modestly (though most of this is not discretionary). However, the government has considerable discretion to disperse Congressional authorized funds from the industrial policy bills (renewable energy, semiconductors, infrastructure).

Whether these outlays are productivity-enhancing in the long run is a question that won’t be answered in 2024. We are skeptical, but in the near term, the CHIPS, Infrastructure and Inflation Reduction (renewables) acts are likely to increase expenditures, employment, and inflation.‍

“Demand for labor continued to ease, as most Districts reported flat to modest increases in overall employment.” November Beige Book

Wages peaked at the end of 2Q22. While the Bureau of Labor Statistics measures of net payroll growth and unemployment pointed to a ‘tight’ market, decelerating wage growth was the strongest signal that demand was weaker than these widely watched measures implied.

Even as evidence mounted that demand has moved past balance to the verge of contraction, FOMC participants continued to describe the market as tight. The unemployment rate is close to triggering the Sahm Rule (3-month average 0.5 percent increase from the cycle low). Net revisions to nonfarm payrolls have been negative nine of 10 months in 2023. Continuing claims are 16 percent above their early September level, at the highest reading since the last of the pandemic activity restrictions ended in the fall of 2021.

Most notably, nominal labor income, hours worked multiplied by nonsupervisory average hourly earnings, cooled from 8.9 percent in January to 5.3 percent in October. These trends hint that small business employment is being overestimated and the labor market could continue to deteriorate throughout 2024.

The labor market is the biggest economic risk for next year. If it appears the Fed is missing their employment mandate, they will respond aggressively.‍

The Australian economy of 2023 has continued to expand, and while the economy is bigger, it is not necessarily better. Population growth has been a key driver, with real GDP growth declining on a per-capita basis.

This will continue in 2024, with the risk that persistent inflation will keep the Reserve Bank of Australia (RBA) from turning to an easing bias until very late in the year.

Australia’s economic resilience in 2023 is borne from a dramatic rebound in population growth. Concerns around the imbalances it is causing (housing and infrastructure are two notable sectors) were cast aside as the demand for labour to address skills shortages remained a priority.  

To date, the labour market has been able to absorb unprecedented increases in labour supply, with the unemployment rate remaining well below 4 percent.  

The outlook for 2024 remains uncertain. Technical recession (two consecutive quarters of negative growth) in Australia is unlikely, given population growth. But GDP per capita risks extending its run of negative growth and further weighing on living standards/national income already under pressure as the terms of trade likely also falls.  

We look for real GDP growth in the year at around 1½ percent. But this is lazy growth – with the more important question being whether poor productivity performance can improve, which will add to growth and take pressure off inflation. This will have to come from businesses under pressure from higher rates (headcount or hours reductions while producing the same output) or importing better productivity outcomes from other advanced economies.

It seems unlikely that any government initiatives, should they come, or ill-defined references to technology and artificial intelligence will move the needle in the near term. Population growth is also a risk to the labour market because if labour demand falters, a strong labour supply risks increasing the unemployment rate. Only a fall in participation could prevent this. A rise in the unemployment rate risks unravelling consumer spending, which is a key downside to growth.

Disinflation in Australia is running behind other advanced economies. We may just be lagging, but we risk being different - likely a combination of both. Goods disinflation is in train, but may be slower to come down than elsewhere as population growth will underpin demand so businesses don’t need to lower prices as readily.

We don’t buy the assertion of the RBA that population growth offsets this demand in the near term by adding to supply. This is not evident in the labour market nor wage growth as of yet. Inflation will also be supported by fiscal policy, with tax cuts due mid-year that were promised during an election when the federal budget was in vastly worse shape than it is now.

Indeed, the risk also seems to be that May’s budget (or perhaps measures taken before then) seeks to address the perceived inequity of the tax cuts by distributing some of the expected budget surplus to lower-income households via initiatives to alleviate the cost-of-living pressures.

Services inflation may also prove more ‘sticky’ in Australia due to energy prices, rents and other services where cost increases are being passed through. Inflation risks remaining above the RBA’s upper bound of 3 percent, and its mid-point of 2.5 percent year on year is unlikely to be realised until 2025 at the earliest.  

Given this outlook, we don’t expect the RBA will be comfortable shifting to an outright easing bias until very late in the year – unless there’s a material downside surprise on inflation or an upside surprise to unemployment (or both). This will likely leave the RBA one of the last – if not the last – advanced economy central bank to ease policy.

Against a backdrop of long-simmering concerns over US debt sustainability, increases in Treasury coupon auction sizes contributed to rates market volatility over recent months, particularly late summer and into the fall.  

The outlook for deficits and supply will likely remain a driver of rates market volatility in 2024, especially around quarterly refunding announcements and longer-dated Treasury auctions. Federal Reserve balance sheet policy may also contribute to investor hand-wringing over the supply picture, as the central bank will continue to run off its holdings of Treasuries and mortgage-backed securities, at least through the first half of next year.  

The Treasury Department will also need to increase issuance to offset the loss of income on the Federal Reserve’s securities portfolio, as the central bank continues to fund low-yielding assets with expensive bank reserves. This later dynamic may remain in place for several more years.

Still, any market volatility related to fiscal news may ultimately prove limited, at least in 2024. First, estimates of the Treasury term premium have risen notably this year, suggesting that a worsening supply outlook may already be largely discounted.  

In addition, some factors that drove the significant increase in the fiscal year 2023 deficit will not repeat, namely, the inflation adjustment to social security outlays and weak capital gains tax revenues.

Further, the growth slowdown we anticipate should put downward pressure on rates. We suspect this will be a more significant driver of fixed income markets, especially as moderating inflation open the door to monetary policy easing in the first half of the year.  

Finally, the Treasury Department has already demonstrated sensitivity to market concerns over the supply picture, limiting the increase in long-term Treasury auction sizes in the most recent refunding announcement. Secretary Yellen may continue with this more flexible approach, within the context of regular and predictable issuance.

One important caveat revolves around the presidential election, and the possibility that former President Trump returns to office. This scenario could precipitate a material rise in yields, as a Trump presidency – especially if it coincides with Republican control of Congress – would dampen any move toward entitlement reform, raise market expectations that the 2017 tax cuts will be extended, and increase the odds that corporate tax increases in the Inflation Reduction Act will be eliminated.  

Markets would also likely price in leadership changes at the central bank under a Trump presidency. The uncertainty around any such changes could pressure the Treasury term premium higher.  

Even if supply-related volatility proves limited in the near term, market concerns over the growing federal debt burden are entirely warranted. Some crowding out of private investment remains a real possibility, and could dampen potential growth in the years ahead.

In addition, the low-rate environment in place before Covid-19 is unlikely to return. This suggests that higher interest payments on the debt will interact with demographic challenges to create ever-worsening debt dynamics over time. And a political environment that disfavors compromise makes entitlement and tax reform less likely.

These may be issues for another day, but there are nearer-term implications. Most importantly, if deficits are becoming an increasing source of concern among voters and politicians, then the fiscal response to the next recession is likely to be quite limited. And if that recession occurs with inflation still elevated, the monetary response may also underwhelm. Investors may expect the next recession will be shallow. But the potential lack of meaningful policy supports implies that the recovery could be sluggish.

In 2023, Japan experienced broadening, sticky inflation. The key driver is on the way to rotating from goods prices – due to rising energy and food costs – to services, which are affected by growing operating expenses. Our first chart shows the surge in prices for services.

Since the probability of achieving the Bank of Japan’s target of 2 percent inflation in a sustainable way is rising, the central bank has begun discussing policy normalisation.  

The BoJ outlined specific conditions for abandoning yield curve control (YCC) and the negative interest rate policy (NIRP), citing 1) the need for continued changes in Japanese firms’ wage-setting behaviour, especially during the spring wage negotiations for FY2024, and 2) the pass-through of rising wage costs to companies’ sales prices to attain a virtuous cycle between wages and consumer prices.  

The BoJ will likely abandon both YCC and NIRP in July 2024, but the shift could come as early as April.  

In 2021 the BoJ presented a simulation of its average inflation target (AIT) rules on a two- or three year average of CPI inflation as optimal –  justifying what was then a more cautious approach – as shown in Figure 2.

However, the current rapid inflationary environment will likely prompt the BoJ to shift away from that reliance on AIT rules, taking a more forward-looking approach that draws lessons from recent developments in the United States.

Once we exit the current framework, a crucial question emerges: to what extent will the policy rate increase?

The next chart uses two formulations of the Taylor Rule, a basic guideline for monetary policy, to show how the BoJ deliberately adopted a behind-the-curve stance.  

With r* (the real short-term interest rate at which economic activity and prices neither accelerate nor decelerate) hovering around 0 percent, and a 2 percent price stability target, the neutral rate is estimated to be approximately 2 percent.  

After the BoJ decides to remove YCC and NIRP, a more rapid policy rate increase than market expectations will likely become imperative to some extent.

Turning our attention to long-term interest rates, the calculation involves the long-term neutral rate (r* + trend inflation + term premium).  

Anticipating trend inflation slightly lower than 2 percent in the long term by factoring in potential future instances of the effective lower bound during recessions, and assuming the BoJ's controllability over long-term rates returns to the pre-quantitative and qualitative monetary easing level, the expected 10-year JGB yield post-exit is estimated to be slightly below 2 percent.  

This is consistent with the recent 5 year-5 year forward rate pointing to around 1.5 percent, as the final chart shows.  

In 2023, growth momentum weakened but remained resilient amid disinflation; meanwhile, central banks’ interest rates plateaued. However, 2024 will be notable as a crowded political year, with countries that account for 60 percent of global GDP heading to the polls. Amid rising populism, and with a lot of uncertain ballots, households and firms are likely to adopt a wait-and-see approach – postponing key economic decisions ranging from large purchases to major investments.

We expect a soft landing in the US; the Eurozone should muddle through, but with increasing risks of a prolonged recession in the first half of 2024 for the Old Continent – only 60 percent of the increase in key policy rates has been transmitted to borrowers in Europe.  

We forecast 2024 GDP growth at 1.4 percent in the US, 0.8 percent in the Eurozone, 4.6 percent in China and 0.6 percent in the UK.

Thanks to softening demand, negative base effects from energy prices and rapidly moderating goods inflation, disinflation is gaining traction. We anticipate that central banks will pivot in summer 2024, later than market expectations, as it takes time to cool down a hot labour market. Indeed, services inflation and wage growth continue to fuel inflationary pressures, especially in the US.

By the end of 2024, we expect policy rates to stand at 4.5 percent in the US, 3.5 percent in the Eurozone and 4.75 percent in the UK.

But a deeper recession in the Eurozone, economic contagion from a collapsing commercial real estate market or escalating geopolitical risk cannot be ruled out. In a world with multiple ongoing conflicts, the risk of escalation is a persistent threat. We see these risks and observe them closely, but they remain a downside scenario.

Current accounts adjusted sharply in central and eastern Europe (CEE) and Turkey in 2023. South Africa’s deficit also came in from its second-quarter wides.  

But with the big correction in energy prices largely done and domestic demand set to pick up in parts of the region, 2024 is likely to see current account adjustment stall or possibly reverse in CEE. The outperformance of HUF and PLN in 2023 is therefore unlikely to be repeated.  

For TRY, high interest rates and a more orthodox policy mix should mean a better performance in 2024, albeit with uncertainty related to the March local election.

Energy prices and demand recovery will curb further current-account improvement

The CE3 (Hungary, Poland and Czechia) plus Turkey benefitted as oil and gas prices fell from their 2022 highs. All four countries also benefitted from import compression due to weakness in domestic demand.  

Weak domestic demand was also a factor in South Africa’s improving current account in the third quarter. But as an energy exporter – and one heavily reliant on China – South Africa suffered from sluggish end-market demand, terms-of-trade weakness, and worsening logistical constraints.

Poland’s economy is already recovering. The second half saw a rebound in retail sales and industrial production; third-quarter growth reached a strong 1.4 percent pace quarter-on-quarter. Hungary, and particularly Czechia, have yet to see the same rebound, but momentum is nevertheless expected to improve in 2024, with real wage growth increasingly positive and lower interest rates triggering an improvement in weak credit dynamics.

Stronger domestic demand will see import growth improve from the current lows. Meanwhile, energy prices have levelled off; the meaning the 2023 benefit from lower energy prices is largely over.  

South African exports could pick up should we see a meaningful improvement in Chinese growth. But the country’s ongoing investment needs will limit the extent of any current-account improvement.

The investment-to-GDP ratio is now lower than the long-term average, and capital expenditure needs are high given the deep energy and logistics problems related to inefficiencies at Eskom and Transnet. External savings will therefore be needed going forward to finance South Africa’s savings-investment gap.  

Fiscal dynamics will also determine the current-account adjustment in 2024. Poland again stands out as the country where the 2023 current-account correction could reverse, with expectations for the 2024 fiscal deficit increasingly approaching 6 percent of GDP.

For Turkey, reconstruction costs from the February 2023 earthquake and potential spending ahead of local elections will mean the fiscal deficit remains large, at around 6 percent of GDP. But fiscal policy is unlikely to be more expansionary than in 2023, leaving the fiscal stance broadly neutral.

The diverging current-account dynamics across CEEMEA in 2024 leave us with a mixed outlook for regional currencies. For a full discussion of our views on PLN, HUF, CZK, ZAR and TRY {{nofollow}}please see our full article.

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After inflation soared to the highest rates in several decades, the big question for 2024 is how quickly it will continue to fall – and thus when (and more importantly, how quickly) will central banks begin easing monetary policy?  

The pandemic and the subsequent inflation surge saw an incredible synchronisation of monetary policy across advanced economies, with all central banks cutting policy rates to near zero and then simultaneously engaging in the fastest policy tightening in decades.  

By contrast, 2024 will see a decoupling of interest rates as inflation charts a more credible return to target in some countries than in others. But in many advanced economies, if not most, squeezing the last bit of excess inflation out of the system will be difficult. Policy will need to remain restrictive for some time.  

Policy makers’ current challenge comes from tight labour markets. Globally, jobless rates jumped significantly during the pandemic, but the sharp fall in unemployment afterwards was much more surprising. In many economies, unemployment quickly fell back to the lowest rates in many decades; in Australia, it reached the lowest in 50 years.  

Restrictive monetary policy and high inflation have slowed economic growth, but in most economies, activity and labour markets have been more resilient than expected, as the first chart shows.  

In Canada and the UK, the unemployment rate has increased by less than 1 percentage point, while in the US and Australia the increase has been less than half a percentage point. Job vacancies and advertisements and cyclical measures of labour demand also point to a gentle easing in the labour market.  

The question is whether this moderate slowing in economic activity and increase in unemployment is sufficient to bring wage growth, and thus sustained inflation, back down. For some time, the evidence suggested that Philips curves had become flatter. But for the soft-landing narrative to play out, we need a Philips curve that is not flat after all. On that front, the jury is still out.

The latest available data on unit labour costs, which are admittedly dated, highlight central banks’ inflation challenge. In most advanced economies, unit labour costs have been growing at more than double their historical averages, as the next chart shows.

For inflation to remain sustainably at central banks’ inflation targets, a cyclical upswing in productivity growth will help, but unit labour cost growth needs to slow to about 2 percent. Easing labour market conditions are resulting in slower wage growth in some countries, but in others, slowdowns exist only forecasts. In most advanced economies, we are unlikely to see unit labour cost growth slow to 2 percent this year.

Disinflation for goods has helped central banks in pursuit of their inflation targets; median goods price inflation across advanced economies is approaching 2 percent. By contrast, the strength of the labour market can be seen in high services inflation. Given the persistence of labour cost growth given wage-setting regimes and the length of employment contracts in many economies, services inflation looks like it will only slow very gradually through 2024 and remain above central banks’ targets.

Given this persistence of inflationary pressures, central banks will need to retain a restrictive policy stance. Recent evidence suggests that the elusive R* (the real short-term interest rate at which economic activity and prices neither accelerate nor decelerate) may not be as low as it appeared prior to the pandemic.

If real neutral interest rates are indeed low but positive – say, about 0.5 percent – then to maintain a restrictive stance, nominal policy rates can’t come down that quickly, even when central banks do begin to cut rates.

All in all, 2024 looks to be another chapter in the high-inflation story – not the epilogue.  

Throughout 2023, the US economy proved remarkably resilient, underpinned by strong government spending and a consumer that did not wilt in the face of the headwinds of falling real incomes, higher interest rates and tighter credit conditions.

Several important factors contributed to this resilience:

• The war chest of savings consumers built up during the pandemic;
• Easier fiscal policy at the state, local, and federal level;
• A mortgage market structure that dilutes the cash-flow impact of higher short-term rates;
• And a reasonably healthy corporate sector.

Some of these support pillars are durable, but others will likely be weaker in 2024 than they were in 2023. In particular, the savings war chest is now almost completely run down. Meanwhile, state and local government spending is likely to be weaker in 2024, as the next chart suggests.

At the same time, leading indicators are still signaling concern about the growth outlook. The yield curve remains inverted, monetary aggregates have slowed sharply, and credit conditions have tightened. The yield curve first inverted in April 2022, which is now 20 months ago.

While that has exceeded the 15-month post-1980 median for the inversion-recession time lag, it remains within the range of historical outcomes. The lag has ranged from five months to 23 months over this period, as this chart shows:

More broadly, history suggests the odds of a soft landing are low. Throughout most of the post-World War II period, whenever there has been a sharp increase in the federal funds rate, it has usually been followed by a recession. There are some exceptions, such as the famous soft landing achieved by Federal Reserve Chair Alan Greenspan in the mid-1990s, but they are the exception rather than the rule.

Soft landings are simply hard to do – even if we are, over time, improving both our policymaking skills and our understanding of how economies operate.

Finally, this hasn’t been a typical tightening cycle. Our last chart shows the progression of the policy rate in each of the Fed’s major tightening cycles over the past 45 years. The current one is much steeper than usual and is, in fact, the sharpest tightening cycle over that period, except for Fed Chair Paul Volcker’s “inflation-busting” 1979.

It is well understood that US homeowners are not feeling the impact of higher interest rates, as most are on long-term fixed-rate mortgages. The mortgage market is different in the UK, but it is still the case that few households are feeling the brunt of higher rates.  

Most homeowners have taken on repayment (rather than interest-only) mortgages in the last decade and reduced their outstanding debt. Thus, a tripling of rates will not mean GBP mortgage payments will increase by the same proportion. Many people have fixed-term mortgages of up to five years – and in some cases longer.  

Thus, the effective rate that UK households are paying on those loans has only gradually risen. This burden is still low by historical standards, as our chart comparing the weighted average interest rate to new fixed-rate mortgages shows.

As we can also see on the chart, new mortgage rates have started to fall. If the trend continues, Britons refinancing their mortgages will not experience the extreme shock some fear. Meanwhile, households have continued to engage in precautionary saving – meaning they have funds for a rainy day.

This does not mean one should expect a surge in UK consumer spending in 2024. But the  very bad news priced into small and mid-cap British stocks might be too pessimistic.

At the last policy meeting of 2023, Federal Reserve Chair Jerome Powell and his colleagues decided to give investors a Christmas gift. While they did not change policy, they did—for the first time in a couple of years—provide properly dovish guidance.  

Talk of “higher for longer” gave way to discussion of rate cuts in 2024. The key question for investors going into the new year is whether the data will continue to support this new trajectory.  

The dovish shift in guidance is real. As of the end of 2023, the median policymaker at the Federal Reserve projected that the Federal Funds rate will end 2024 at about 4.6 percent, down from an expectation of 5.1 percent in September.  

That amounts to three 25 basis point rate cuts in 2024. More importantly, Powell did nothing to counter, or even downplay, these projections as he sometimes has in the past. Of course, he made the obligatory comments that economic surprises are still possible, and that it is premature to confidently say the mission has been accomplished. Still, this didn’t stop the “mission accomplished” memes from circulating, and for some good reasons.  

First, Powell and his colleagues clearly think they have already hiked rates enough to bring inflation back down to 2 percent. Moreover, they think they will likely be able to ease off the brakes in 2024. Not only did policymakers submit projections for rate cuts next year, Powell told us that many also stood up at this meeting to defend their projections.  

In other words, they are now actively discussing rate cuts. Powell gave us a flavor of these discussions when he noted that rates could, and probably should, be cut before inflation is firmly back at 2 percent, given the inherent lags between policy and inflation. This is not something he would have said if he wanted to downplay the projected rate cuts.  

Second, recent data supports the Fed’s dovish shift. Payrolls continued to grow at a not-too-hot, not-too-cold rate in November. Had payrolls grown by as much as 300,000, the Fed would not likely have turned so dovish.  

On the flip side, had payroll growth slowed to 100,000 or less, recession fears would have risen. Instead, payroll growth came in at 199,000 in November, roughly in line with expectations and in the middle of the range since February. This reinforced hopes that the Fed is pulling off the coveted “soft landing”.

Supply and demand in the labor market also appears to be coming back into balance. The ratio of job openings to unemployed fell to 1.3 in October. That remains well above a balanced ratio of 1.0, but it is down significantly from its peak of around 2.0 in 2022. Moreover, most leading indicators suggest the labor market will continue to cool in 2024.

Meanwhile, the consumer price index (CPI) rose by an average of just 2.2 percent annualized over the three months to November, which is basically on target—especially after accounting for the fact that CPI tends to run 25 to 30 basis points higher than the PCE index the Fed officially targets.

Core CPI is still too high, averaging 3.1 percent over the same period, but that will most likely, with a lag, follow headline inflation lower.  

For now, both labor and inflation data are consistent with a “soft landing” in the making. If it persists, the Fed’s guidance for moderate rate cuts next year will be justified and risk assets are likely to do well.  

The problem is that risk assets are already priced for this benign scenario. As equity prices have risen, US equity earnings yields have become very unattractive relative to expected real yields on US Treasury bills and bonds. US credit spreads are also historically thin. Thus, US risk assets need the “soft landing” scenario to continue to rally. So far, so good. But a deviation in either direction would likely lead to risk assets underperforming.  

Consider two alternative scenarios. If data surprises to the upside, the Fed could be forced back into a “higher for longer” position, which would weigh on equity multiples and push bond yields higher. Cash (or Treasury bills) would be king.  

Alternatively, if data surprises to the downside, it would force investors to consider the prospects of a recession and what that might do to cash flows. In that scenario, Treasury bonds would likely outperform.  

Leading indicators continue to suggest significant downside risk for the US economy. The bottom line is that risk assets are vulnerable to any deviation from the current “soft landing” scenario. Although 2024 is an election year, it could be economic data that has the biggest impact on markets.  

Despite many problems, the economy and financial markets coped better than expected in 2023. But they will once again face major challenges in the coming twelve months.

Inflation cannot yet be considered finally tamed, even after the central banks’ tap on the monetary policy brakes. The list of political risks is also long.  ‍

Nevertheless, light optimism prevails overall. There are signs of a soft landing for the US economy. In Europe, there are increasing signs that the painful inventory correction in the manufacturing sector will come to an end very soon. Chinese growth also appears to be stabilising – albeit at a weak level by China’s standards.

Inflation has eased so much on both sides of the Atlantic that the major central banks may start to loosen monetary policy – possibly earlier and more strongly in the USA and the UK than in the eurozone. Together with energy prices that are no longer quite so high, this may contribute to a better global economy in the second half of 2024.

In Europe, consumer incomes have been rising faster than prices since spring 2023. In view of the weak industrial economy, consumers have largely saved the increase so far. If the situation in the manufacturing sector improves again after the end of the inventory correction, this may encourage consumers to spend more money. We therefore expect a new upturn in Europe from this spring.

Contrary to common perception, high cash rates are a blessing, not a curse, for hedge funds. As they structurally maintain market exposures well below par, hedge funds are directly and/or synthetically long cash. When cash rates rise, hedge funds thus compare well with traditional assets’ declining excess yield, especially when alpha conditions are supportive.  

Some market segments still deliver attractive net-carry, but are generally riskier, including high yield or emerging-market debt. Hedge funds may provide appealing access to these segments at affordable risk.  

At its last meeting, the Federal Reserve switched to an easing bias earlier than most investors were expecting. While data justify a less restrictive policy, some wondered whether US elections might also have had a say.

A rate pivot would validate investors’ goldilocks scenario, i.e. weak growth but no recession and inflation returning to normal – both providing room for monetary easing and resulting in lower tail risks for rate- and credit-sensitive assets.

A faster pivot is good news for risky assets and bonds, but rich valuations suggest the upside repricing will not be linear.

These tectonics might have brought forward the sequence we had in mind for hedge funds by a quarter or so.

There are several reasons, therefore, why we expect hedge funds’ alpha to be strong in 2024:

1. As past rate hikes continue to feed through, slowing economies will foster greater asset differentiation, with a focus on traditional growth drivers.  
2. Cross-asset correlations should gradually decline, as growth takes over from inflation uncertainty, providing some room for thematic allocation. Rates remain in the driving seat for now, though.
3. Diverging central banks will likely provide multiple relative trades for top-down styles.  
4. Bonds, high yield and emerging markets will be key 2024 themes. Hedge funds in these fields, which favour relative arbitrage, will be appealing as flows intensify.
5. Corporate activity will bottom out once economies near their trough. This means more focus on event-driven strategies, except for distressed, which is likely to remain soft.
6. Cash rates will stay above-par in 2024, albeit down from their highs, providing 1 to 2 extra percentage points of return for hedge funds.

However, there are three factors to keep in mind:

1. Expanding global liquidity, given the valuation anomalies it produces, will partially erode the alpha potential.  
2. Equity and bond volatility regimes would both be lower than in 2023, resulting in lower alpha from market timing.
3. Geopolitics will still matter, but will be less concerned with the Middle East and Ukraine; instead, monitor US-China relations, Taiwan-related developments and the US elections.

For the first half of 2024, we expect a positive but volatile contribution from beta. Alpha has been surging since the second half of 2023 and still looks solid, but more selectively going forward.  

We favour:

• long-short equity-neutral strategies (likely to benefit from increased stock differentiation and strong fundamental pricing);
• fixed-income macro and global macro strategies (which will benefit from multiple relative trades in bonds, driven by the uneven paces of central bank easing and inflation normalisation);
• and emerging-market fixed-income strategies (due to lower macro vulnerability for emerging markets, declining reliance on US rates and rising economic fragmentation, which would help improve the ability to generate excess returns).