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As we end another turbulent year and prepare for a fresh start, 2023 will be remembered as a humbling and challenging year for financial market participants.
Market prognosticators anticipated a housing market crash, global recession and runaway inflation, all of which failed to materialise.
The word resilience would feature on the report cards of global economies in the face of quick transitions to higher interest rates, while monetary policy is taking longer to affect the broader economy than forecasted.
The Covid-inspired fiscal stimulus and decade-long ultra-easy monetary policy has provided the necessary buffer to bolster balance sheets, as most assets enjoyed handsome returns over that period.
This resilience has also played havoc with attempts at calling an end to the US hiking cycle, with market participants having priced in a dovish pivot from the US Federal Reserve seven times over the past two years. The world will look to the US for direction on the timing of an easing in interest rate policy.
Of the last nine interest rate cutting cycles dating back to 1974, the previous eight began with the US Federal Reserve, followed by the Bank of England and then the European Central Bank.
The fear of missing out on the start of the next cyclical interest rate easing cycle, combined with the importance of lower bond yields, was underscored over the past month, with a spectacular rally across all financial assets.
Currently, short-term interest rates in the US are pricing in more than 100 basis points of rate cuts for 2024.
Despite the numerous false dawns, the latest pivot to interest rate cuts may have more validity. Core inflation has fallen sharply from its pandemic peak, with expectations that it will begin its final leg lower in 2024 as disinflation persists via rents and the labour market.
The US employment market will also be the key determinant of the likely recession, and among the litany of recessionary indicators that get deployed, the “Sahm Rule” features prominently, as it has called the early stage of every recession since 1970.
The rule is that when the three-month moving average rate of unemployment increases by 0.5 per cent relative to its low during the prior 12 months, it is likely that the economy is already in the early phases of a recession. Since April, on a three-month average basis, the unemployment rate has increased by 0.33 per cent and the recent softening of the jobs market could well see us there in the next three months.
The monetary tightening has pushed the global credit impulse to its weakest level since the Global Financial Crisis, which implies weaker demand growth moving forward placing, putting pressure on the job market.
High delinquency rates and credit card balances currently support anaemic consumer confidence and may begin testing both consumer resilience and the ability of employers to maintain employment, with margins under pressure. The job market into 2024 will be the main determinant of whether we travel down the path of a ‘‘hard landing’’ with the commensurate aggressive easing of short-term interest rates and much higher bond prices.
The ‘‘soft landing’’ path would require another year of consumer resilience and would be likely to keep central banks on a ‘‘higher for longer’’ trajectory. This would see a repeat of the waxing and waning in the direction of short-term interest rates that we have witnessed this year.
Price action from various asset classes can provide further evidence of the direction of travel for the global economy; the last month has provided some telling information particularly in the global bond market and the energy market.
In November, the S&P G7 Sovereign Bond Index (high grade bonds are those with a high credit rating, indicating a lower risk of default) delivered its best return since 1995 at 3.21 per cent, with an emphatic rejection of the compelling 5 per cent level on US 10-year yields. Buyers were comforted with the lower inflation readings and the weaker set of economic data, and bond vigilantes drew a line in the sand and staked their claims for a peak in the yield cycle and an end to the global hiking regime.
Bond supply dynamics also played a part, as the heightened narrative of a tsunami of debt being unleashed into the market to finance government spending was alleviated, with US Treasury projections in the order of $US100bn less than the market was expecting.
Domestically, the Australian government continues to benefit from its conservative estimates for iron ore (almost half the current trading levels at only $60-$65/tonne). This will top up the coffers and reduce the need for issuance going forward, as it remains in a healthy fiscal position.
Movements in the energy sector have also confounded market participants this year. A solid rally in crude was expected this year and even with the geopolitical concerns in the Middle East, the market has failed to deliver the performance expected from China reopening and OPEC supply cuts.
Crude remains a pivotal part of the macroeconomic landscape given that it feeds into the inflation framework quite heavily and is also used as a barometer for the level of global economic growth. The weakness in the energy sector this year is not only a boon for weaker inflation; it is reflective of a global economy that is cooling.
Heading into 2024, the asset allocation playbook will come down to which direction the global economic slowdown takes and the potential inflection point of the positive bond equity correlation.
The higher inflation of the past two years has reduced the potency of bonds as a hedge against weaker risk assets.
Assuming inflation continues to come off the boil next year and risk sentiment sours, we would anticipate that the relationship of weaker equity prices and stronger bond prices is restored as an important lever in multi-asset portfolios. In essence, it underscores the importance of monitoring economic trends and adjusting investment strategies accordingly for potential market shifts.