Cutting through the noise

The US economy has been defying gravity for some time, with very strong growth and high inflation. This is now changing, and we think both trends will likely come back to Earth. With high interest rates feeding through and supply chains working better, inflation has steadily fallen over the past year, though it remains fairly elevated. But the economy has remained surprisingly resilient. Having said that, the US labour market has started to weaken, and manufacturing activity has contracted for a year. Services activity is only growing marginally. This is important because services have kept US growth ahead of the other major regions. US services growth combined with some long-term structural shifts in the economy (such as supply-chain fragmentation) means we’re unlikely to see the US Federal Reserve (Fed) reach its 2% inflation target next year. More likely is that we’ll see a stabilisation between 2-3%, a much lower level than the 9-10% we experienced a year ago.

As with the other major Western central banks, the Fed is at peak rates. To keep downward pressure on inflation, we believe it will keep rates elevated over the coming months before cutting from mid-2024 to support growth.

As a result, some weakness is on the cards for the dollar once the Fed starts cutting rates, combined with some other fundamental factors such as an overvalued currency, and fiscal and trade deficits. However, as other central banks, too, will likely cut rates, any downside for the dollar could be limited.

The campaign trail for the US election in November 2024 will start in force in the early part of the year, and we expect this could make some noise in markets. Voters often put the economy at the top of their list of issues, so we expect this to be a hotly debated topic amongst the candidates. While this could cause some short-term market implications, it’s important to see it as such – short-term noise that will likely dissipate. While candidates may promise tax cuts (as Trump enacted at the start of his Presidency, leading to a strong equity rally), the US debt ceiling may have other ideas.

The Eurozone is currently in a mild technical recession. Manufacturing activity has been contracting since the start of 2023, while services have started decelerating more visibly in recent months. However, inflation has continued to fall further than expected lately, leading to speculation on when the European Central Bank (ECB) could start cutting rates. Our view is that the ECB will hold rates during the first part of 2024, before it begins lowering them to stimulate growth from mid-year.

As such, a shallow recovery seems likely for the second half of 2024. Until then, the tug of war between the euro and dollar will continue. Once the Fed starts to cut rates, we could see the euro gain back some ground.

The rapid rise in interest rates has fuelled volatility in UK financial markets, and there are concerns that the British economy could soon stall or enter a mild recession. This is something the UK has been flirting with for most of 2023, with quarterly growth near zero throughout the year. Services activity had remained fairly resilient in the first half of 2023, which has counterbalanced the weak manufacturing activity. However, now that services activity is slowing, a recession is on the cards, despite the efforts of the Autumn Budget to mitigate that risk.

Higher rates are putting downward pressure on the economy and inflation, which has been much stickier compared to the US and Eurozone, is now falling more decisively. While it remains above the 2% target, the pressure to grow the economy will likely outweigh the pressure to hit that target. As such, we believe the Bank of England (BoE) will keep rates as they are for now before cutting them from mid-2024 in an effort to revive growth. A shallow summer recovery may be on the horizon.

Unlike the US Presidential Election, we’re all still in the dark on the exact date of the UK General Election. Some commentators suggest that the recent tax cuts announced in the Autumn Budget point to a spring/summer election but, for now, only time will tell. Should UK Prime Minister, Rishi Sunak, bring the date forward (the official deadline isn’t until January 2025), expect some short-term market noise as economic growth will be a key battleground between parties. But it’s important to remember that campaign promises do not always come to fruition. So, while elections can move markets in the short term, we remain mindful of the risks and think in terms of scenarios, given the unpredictable nature of these events. 

The pick-up of the Chinese economy post-Covid didn’t materialise to the extent markets envisaged initially. Instead, China is suffering from a real estate crisis, low consumer confidence and lower-than-target inflation. Given the headwinds China is facing domestically and abroad, we’re forecasting that the pace of Chinese growth in the years ahead will fall below the average of the past decade. To turn things around, more stimulus is needed, and expected. The key question is how decisive it’s going to be. We think not too much.

Chinese policy rates (there are several) are in the 2-4% range, so the People’s Bank of China certainly has room for rate cuts, particularly as inflation is below target. Boosting domestic demand, and in turn economic growth, is vital – especially because global export demand remains depressed.

The waning export demand is unlikely to just be a short-term effect from Covid. More countries and economic blocs will start focusing on local control in key sectors and technologies, reducing their reliance on Chinese manufacturing. Foreign direct investment has continued to fall and is now at its lowest point since the early 1990s. Couple this with an ageing population and a shrinking workforce and China has to think about more than just cutting rates to turn this long-term trend around.

Another factor worth keeping in mind is the election in Taiwan in January, which adds another layer of uncertainty as the run looks quite open. The current ruling party – the Democratic Progressive Party (DPP) – prefers to strengthen Taiwanese identity, while the opposition parties aim to renew talks with China. With two conflicts ongoing, heightened tensions between China and Taiwan (and potentially the US) could increase market volatility. However, we have also seen how some of the geopolitical events had limited or no impact on markets, and so we think that, rather than timing and attempting to predict such outcomes, portfolio diversification (and a good dose of humility and open-mindedness) are the best defences.