Introduction and market overview
The final months of last year saw a strong rally in markets amid optimism over interest rate cuts being potentially announced early this year. However, whilst the first quarter of 2024 saw further gains in equity markets, signs that central banks would not be cutting interest rates as quickly as hoped led to bonds giving up some of their gains from the final months of 2023. Markets had been looking at March for the first cut in US interest rates, but this has now been pushed back following the release of further robust economic data and inflation (notably services/shelter) remaining sticky.
Inflation and interest rates
There is no doubt inflation has long peaked and fallen sharply from its very high levels. Whilst the UK initially lagged the falls in the US and Eurozone, this was partly due to how the energy price cap operates, but it has now moved closer to its peers. There is an strong argument that the easy work has been done regarding lowering inflation, with goods prices no longer a concern, but services inflation has proved stickier, particularly with rents still increasing in the US and rising wages in general.
Nonetheless, inflation is expected to continue to ease overall in 2024 towards its target, although this is unlikely to be in a straight line. The situation in the UK also highlights this with the Bank of England (BoE) forecasting inflation to potentially fall below its 2% target during the second quarter (assisted by the expected decline in the energy price cap in April and the impact of base effects from 2023), but could then rise again in the second half of the year towards 3%.
Overall, the three main central banks (BoE, Fed and ECB) are likely to remain cautious and although they acknowledge the question is now how long to keep monetary policy tight, they will be reluctant to cut interest rates whilst inflation remains sticky. A severe economic downturn could also pressure the banks to act, though this isn’t forecast at this time. From a market point of view, the likely impacts are:
- Inflation remains sticky, interest rates remain on hold for longer – with markets having priced-in cuts, this could cause further short-term volatility particularly in bond markets and push yields higher. Equities and particular ‘growth’ stocks may also find this a headwind.
- Inflation falls quicker than expected, interest rate cuts take place sooner – this could potentially send bond yields lower and prices higher, whilst equities would also likely view this positively.
Economic growth/recession
There is currently a significant dispersion between the US and the UK/Eurozone, with US economic growth remaining robust in the second half of last year supported by consumer spending, as Covid payouts supplemented household income. A key question here is that the payouts are likely now spent, so will pace of US growth ease in 2024.
The situation in the UK and Eurozone is very different, with the UK confirmed as entering recession at the end of 2023 whilst the Eurozone as a whole barely saw any growth in the final months of last year. However, the recession wasn’t expected to be deep, with the UK economy already returning to a slight expansion in the early months of this year and is expected to grow during the course of 2024, although the rate is likely to be relatively anaemic. There is also the impact from China, where economic activity has slowed sharply and there are concerns over areas including the property sector, consumer confidence/spending, which also impact globally.
The key question for markets is whether there will, following the aggressive rate-hiking cycle, be a soft-landing (no recession) or a hard-landing (recession). There is also still the unknown lagged impact that could potentially still come from the interest rate rises and impact on economies in the near-term. The potential impacts of either scenario are as follows:
- Soft-landing – could mean a slower pace of interest rate cuts, meaning bonds may see steadier returns. However, this scenario should be positive for equities as there will be less impact on corporate margins/earnings etc.
- Hard-landing – depending on the severity, central banks could be forced to announce a more aggressive rate-cutting cycle. This should see government bonds (and possibly the highest rated credits) outperform as they provide protection to portfolios as well as benefiting from falling yields, but it is a more difficult environment for equities which historically suffer at the outset. Long-duration bonds could react positively, which may see DB transfer values recover some of their losses from recent years and recreate some interest in this area of the market.
Geopolitics
Last year saw geopolitics continue to influence investor sentiment and this is expected to remain the case during the course of 2024. Whilst there may be an unexpected event that impacts on markets, often lasting until there is greater clarity over the outcome, two of the known risks in 2024 are conflicts and elections.
Conflicts
The war in Ukraine has now passed two-years; it is unlikely that this will have a renewed impact on investor sentiment unless there is a severe escalation such as an attack on a NATO member. However, the Middle East conflict has appeared to have escalated of late and could have an impact, particularly if Iran should become directly involved. We have already seen the impact on shipping in the Red Sea and whilst this isn’t viewed as the same severity as the pandemic, it has already lengthened supply chains and increased freight costs, which could apply some upward pressure on inflation. The oil price is likely to be first affected from any escalation, , again a potentially inflationary outcome.
Overall, we cannot state with certainty the market impact from conflicts, but whilst the initial reaction can be sharply negative, it can be short-lived pending clarity over the severity of the scenario.
Elections
This year sees globally more voters than ever before in history go to the polls, with at least 64 countries seeing elections, plus the European Union, which overall represents just under half the people in the world. Whilst on an individual country basis, each election will have its own importance, the biggest potential impact will likely come from the US Presidential election.
In the US, it will be President Biden against former President Trump on 5 November. The rhetoric prior to the election will likely be extremely noisy and based on recent contests, probably quite bitter between the two parties. However, it is unlikely that the lead-up will significantly impact on investor sentiment, but the outcome could influence market movements:
- President Biden wins – likely to be the status quo outcome with his recent stimulus measures remaining unchanged. However, future policies will be dependent on whether the Democrats can retain the Senate and/or win the House, which if neither happen could severely hamper any further measures.
- Former President Trump wins – from a policy point of view, this will be also be dependent on whether the Republican Party can win the Senate (viewed as a good possibility) and/or retain the House (less likely). If the Republican party could win both, this will enable President Trump to pursue policies that could undo (at least partly) some of the current Democrat measures, including those focusing on the Green energy transition. As such, companies currently benefiting from these policies could be negatively affected, whilst fossil fuel related companies may perform better. There would also be the possibility of tax cuts, which could support the economy but also apply inflationary pressures, so potentially boosting equities in the near term but may cause bonds some concerns further out. These could also weigh further on the US fiscal finances.
- There is also the concern over the US being more inward looking under a President Trump victory, with a negative impact on global trade. This could be from increased tensions with China or new tariffs being announced (not just China, but for example against the EU and UK), which would be negative for affected sectors/companies. Whilst it might not necessarily impact on markets, this scenario could see reduced (financial) support for Ukraine and an unknown impact on the conflict.
Overall, when looking at history there is no definitive answer to whether markets would prefer a Democrat or Republican winner, but the incumbent’s policies can impact on certain areas of markets.
There is also the question of a potential UK General Election, though the outcome is currently more certain than in the US with Labour widely expected to win. Regardless of who wins, the governing party will face a difficult in-tray with anaemic economic growth and if Labour do win, the size of their majority will potentially dictate the degree of radical measures they can consider.
US equities
Markets were driven higher in 2023 by first falls in inflation, then optimism over early interest rate cuts. The US market was one of the strongest performing last year, but it is worth highlighting that this was driven by the ‘Magnificent Seven’ stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla), which were responsible for nearly 90% of the S&P 500 return amid the excitement over AI. These stocks will be increasingly challenged to perform in line with their earnings expectations, so there is the potential for any disappointing update to be punished by a sharp fall. So far this year, we have already seen some dispersion with Apple and Tesla sharply underperforming the other five stocks. However, the rest of the US market is priced more modestly, so there is room for them to help offset any such falls, particularly as history suggests returns will tend to broaden over time.
Summary
Overall, notwithstanding geopolitical events, it is likely that the interest rate and economic outlook will be the dominant themes that impact on investor sentiment during the course of 2024. The timing of any interest rate cuts and the magnitude of the rate-cutting cycle will be key, but we have seen the first move pushed back already to later this year. This is has led to a probably change in order, with the European Central Bank expected to make the first cut, probably in June. Potentially, the Bank of England could be second during the summer months and the Federal Reserve, which was expected to be first at the beginning of the year, may not now cut rates until September. All these decisions will be impacted by economic data over the coming months, notably the inflation readings.
Market performance is likely to be volatile at times until there is greater clarity, although at this time there are no major known potential negative impacts, though sticky or indeed renewed increases inflation remains a threat, even if not a base case scenario. Potential market performance drivers and outcomes are as follows:
- Equities – should benefit from a rate-cutting cycle, particularly growth-related stocks, whilst a soft-landing would also be beneficial, especially more cyclical sectors. A hard-landing (not base case) would potentially lead to market falls, with pressure on earnings/margins.
- Fixed income – what happens to interest rates will be key for bond performance. Bonds had already priced in rate cuts, though some of these moves have been given back as central banks have pushed back over the timing of these falls in rates. In the event of a period of measured rate cuts, this will incrementally benefit fixed income as yields also move lower. Alternatively, if the rate-cutting cycle should be more aggressive, particularly if there is a more significant economic downturn, this should see sharper falls in government yields and the highest rated credits.
The main risk to both equities and fixed income markets is renewed inflation that results in interest rates having to be increased again. Whilst this is not viewed as likely in the near term, it remains a risk, particularly if the conflict in the Middle East should broaden out across the region.
Subject to no unforeseen events or inflation spikes, the overall outlook for this year should see at least one of equities and fixed income offer portfolios some upside, as even in the event of a hard-landing, this would benefit fixed income. Furthermore, with bond yields still at high levels, they can now offer a good income yield as well as protection during more difficult periods for equity markets. Looking at cash, the likelihood of falling interest rates should weigh on the interest that can be earned, as well as the opportunity cost of locking monies away for a period when rates could be lower at maturity, as well as the missed potential from markets.
It is likely that the market and economic environment going forward is going to be different to the one post the Global Financial Crisis, which was an era of low inflation/interest rates and modest economic growth. Instead, we could be looking at a new regime where inflation is more volatile with higher peaks than recent history, which should mean more active central banks with interest rates similarly moving in line with the inflationary backdrop. With inflation unlikely to be sustainably returning to its very low levels, for reasons such as the cost of the green energy transition and shift to closer onshoring of supply chains (the reversal of cheaper globalisation), this also means interest rates are similarly not expected to go back to near 0%.
The comments in this article were made as at April 2024. This article is intended to be for information only and before you take any action, you should seek advice to check the suitability and tax consequences of any actions you plan to take.
If you would like to review your investment portfolio or have any questions or concerns, please contact your Origen adviser or contact our Client Services Team on 0344 209 3925 or at ClientServices@origenfs.co.uk. Calls are charged at your phone company’s basic rate. All calls are recorded for business purposes.
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