Although rate cuts may come later than the market currently expects, we suspect the central banks will eventually cut further than predicted.

It is extraordinary how the market narrative swung over the course of 2023. Coming into the year the predominant view was that we were stuck in the grips of 1970s-style stagflation. With central banks slamming on the brakes it is no wonder so many, ourselves included, expected a recession. That is usually what happens when interest rates rise so sharply.

However, economies have so far coped remarkably well with higher rates. Coupled with signs that pandemic-related inflation is easing, the market narrative has shifted towards the prospect of a soft landing. Bond markets are excited about rate cuts, spreads are at or below historical averages in most areas of credit, and equity analysts are forecasting double-digit earnings growth for 2024.

Were this to play out, it would represent an extraordinary success for central banks. But we would urge caution against taking a victory lap too early. It is the “long and variable lags” in monetary policy that so often plague economic forecasters. When consumer confidence turns, it turns quickly. Averaging the last 12 recessions, US GDP growth in the quarter prior to a recession was 3% in real terms and 7% in nominal terms. Forecasting the direction of economies is hard, but forecasting the timing of a recession is even harder.

Long and variable lags

Anyone forming a view for 2024 has to start with the following question: do interest rates still bite?

If economies can cope with higher interest rates, the impact on risk assets should be positive, but more trouble could be in store for core bonds given bond markets are still eagerly looking forward to lower rates. However, if what we have seen in 2023 is the usual “long and variable lags” in monetary policy transmission, then investors should be cautious about risk assets and instead focus their attention on the insurance provided by high quality bonds as expected rate cuts, and more besides, get delivered.

There are reasons Western economies are slightly less interest rate sensitive than in the past. Overall private sector debt is a little lower than the last time interest rates reached these levels. The big accumulation of debt in recent years has been by the government.

Existing mortgage debt has also been financed on longer-term interest rates. Many US households took advantage of the low interest rates on offer in the pandemic and the typical mortgage is locked for 30 years. Unless those households choose, or are forced, to move they are immune to what is going on at the Federal Reserve.

In Europe, households also made use of pandemic savings to pay down debt. A higher proportion of households in Europe are mortgage free relative to the US, and rates started rising from a much lower base. However, there are some regions where refinancing onto higher mortgage rates will still be a significant drag heading into 2024, notably in the UK.

The situation is not so benign when we look at non-mortgage debt, where rates are still largely variable. In the US, total spending on interest payments has picked up markedly in recent months and delinquencies on auto and credit card loans are the highest level in over 10 years.

Corporates also took advantage of lower rates a couple of years ago. But the amount of corporate debt that will have to be refinanced at higher rates starts to pick up more substantially over the next two years (see Locking in Yields).

The cost of new loans is punitive. US homeowners now face a 30-year mortgage rate of nearly 8%, which based on current house prices would eat up around 26% of median income1. In the UK, the equivalent figures are 5% (for a 5-year fixed rate) and 38% respectively2. Given this, it is no wonder housing activity is depressed. US developers have been relatively successful in keeping activity going by offering their own discounted rates, but these incentives seem unsustainable. Construction and housing-related spending is likely to remain lacklustre.

Overall, we would be cautious about the idea that economies can easily cope with interest rates of 5% or more in the US and UK, and 4% in the eurozone. We would expect the damage of higher interest rates to become increasingly evident in the consumer and business spending data in the coming months.

Fiscal spending is back in vogue

One factor that has been cushioning the impact of higher rates is ongoing expansionary fiscal policy. In the US, a number of pandemic-related tax moratoriums, such as student loan repayments, persisted for much of 2023. Additionally, we have seen the introduction of multi-year, multi trillion dollar stimulus programmes in the form of the CHIPS and Science Act, the JOBS Act and the Inflation Reduction Act.

In Europe, fiscal spending is also currently far more supportive than it has been over the last decade, although not of the scale seen in the US. In the eurozone, the key fiscal package was the European Union (EU) Recovery Fund, but that is only slowly being put to work, with 65% of funds yet to be disbursed.

While these infrastructure spending programmes will support economic activity for some time, governments will have to turn their attention to how they will balance the books at some point. A 6% budget deficit in the US at a time when unemployment is near a record low is simply not sustainable, particularly given the central banks are no longer buying government debt. A deficit at this level would also suggest that whoever ends up running for president in 2024 will not be doing so on the promise of major tax cuts.

Forecasting human beings

The final, but potentially most important, component of the resilience story is human behaviour. Having been forced to stay at home for prolonged periods in the pandemic, many people understandably had a strong desire to make up for the experiences and holidays that they missed.

These ‘animal spirits’ effects, coupled with pent-up savings, cannot be captured by historical data and are something that our models simply cannot forecast. The unpredictable way in which consumers switch from over-optimism to over-pessimism is one of the main reasons for the long and variable lags in monetary policy, and is why forecasting the timing of the business cycle is so very hard.

A prolonged central bank pause

While we see the current resilience in economic activity as somewhat transitory, the good news is that there are signs that inflationary pressures are moderating, not only at the headline level but also in wages. As the labour market cools and cost-of-living pressures become less intense, workers are not hot-footing off to new jobs with the promise of higher pay in the way they were a year ago. This change is most evident in the US, but Europe is likely to see a similar phenomenon as headline inflation, and hiring, falls.

Global inflation has also been helped by the lack of a bounce-back in China. This weakness looks entrenched as Beijing appears to be struggling to find a new economic engine that does not rely on exports or property excess. While the Chinese government has announced a number of stimulus measures, none equate to the large-scale programmes of the past, so China looks likely to grow at much lower levels than in recent decades.

Despite these positive signs, we think the central banks would be unwise to declare an early victory on inflation. We certainly do not buy the “goldilocks is back” narrative. It is fair to say, however, that the risk that inflation would stay stuck nearer 5% is meaningfully lower than it appeared to be earlier in 2023.

Importantly, if inflation is not stuck at a high level the central banks will have the freedom to cut rates, if and when the economic data justify rate cuts.

It seems very unlikely that the central banks would cut pre-emptively without a significant slowdown in activity. With inflation having been above target for much of the last three years, we expect they will rather err on the side of easing too late, rather than too early, to negate the risk of restoking the inflation problem they worked so hard to eliminate. Recent work by the International Monetary Fund3 shows that there have been frequent episodes historically where central banks have made the mistake of celebrating prematurely, leading to inflation plateauing at an elevated level and then re-accelerating.

Although a more cautious approach would mean that rate cuts come later than the market currently expects, we suspect the central banks will eventually cut further than predicted. Hence, we are not worried that bond yields may continue to move higher, since the data will signify this is a timing, rather than direction of travel issue.

On top of these macro uncertainties, there are numerous political and geopolitical uncertainties that are hard to forecast at this stage. Wars are still raging on multiple frontiers that have the potential to deliver further commodity price shocks through the global economy. Hard fought elections will take place in the US and UK, while elections elsewhere, such as in Taiwan, may also be in focus given Chinese tensions (see Navigating the Political Calendar).

In the chapters that follow, we highlight the investment implications of this macro view. Being humble about the risks and preparing for all scenarios is key.

We believe investors should focus on locking in yields currently on offer in core bond markets. Although these yields are below current cash rates, investors should view this situation as an insurance premium that will pay out handsomely if the recession does happen with greater force than many anticipate (see Locking in Yields). Generally, we think investors should resist the temptation of optically attractive cash rates, which we see as a mirage (see Cash Rates are a Mirage).

Equities are not expensive, but they also are not cheap, particularly when we account for both a more cautious earnings outlook and the fact that the difference between the earnings yield on stocks and corporate bonds is the lowest it has been in over 10 years (see Equites: Problems at the Margins). Given there are upside scenarios, investors probably would not want to overly reduce their equity exposure, but instead focus attention on quality stocks and income payers.

Structurally, we also believe investors need to recognise that the relationship between the price of stocks and bonds will not be as reliably negative as it has been in the past, particularly when the global economy is subject to cost shocks that may be a more common feature of a more fragmented world. Certain assets found in the alternatives space, as well as commodities, could augment the role that bonds play in providing shelter from many different kinds of economic weather (see Targeted Alternatives for Targeted Risks).


1
 Calculated using the median existing single family home price and median family income, and assuming a 80% loan. Source: National Association of Realtors, J.P. Morgan Asset Management.
2 Calculated using the average first time buyer home price and the average post-tax earnings for a full-time adult worker, assuming a loan of 80%. Source: Nationwide, J.P. Morgan Asset Management.
3 International Monetary Fund, “One Hundred Inflation Shocks: Seven Stylized Facts”, IMF Working Paper 23/190 (September 2023).
 
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