2024 H1 Macro Outlook - Part 2

22 January 2024

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10 minute read

In Part 1 of our 2024 H1 Outlook, we dove into the prospects for the US economy and the markets in the year ahead as the Federal Reserve attempts to achieve a “soft landing” for the US economy.

Now, in Part 2, we explore the risks and opportunities that lie elsewhere around the globe, and identify the broader investment themes – souvenirs, if you will – from this trip around the world’s largest economies.

Key takeaways:

  • Europe, similar to the US, is seeing inflation falling and economic growth weakening. But with recession risk higher in the EU, we see risks of weaker equity returns and euro depreciation versus the US dollar as the European Central Bank (ECB) cuts interest rates sooner than the Fed.
  • In Japan, a revival in both growth and inflation, paired with a series of governance reforms, have revived foreign investor interest in the country’s equity markets. And while the weak yen was a tailwind in 2023, the currency may provide less of a lift going forward.
  • China’s economy continues to face headwinds from a downturn in the property sector and a slowdown in global growth. And heading into 2024, the government’s latest signals suggest maintaining a gradual approach to stimulus. So while China is on a loosening path, a sustained recovery is yet to be seen in the data.
  • Putting it all together, we believe investors can focus on 3 key themes for the year ahead: 1. Consider fixed income as interest rates have peaked in major economies, 2. Stay invested in US risk assets amid weaker growth prospects elsewhere, and 3. Invest in markets with strong domestic stories — especially those undergoing structural shifts, like Japan and India.

Europe: A weaker economy puts equities on the back foot

In 2023, the European economy faced many of the same headwinds as the US: an energy-price-driven surge in inflation leading to a similarly rapid rate hike cycle from the ECB, a tight labour market pushing up wages, and even its own banking crisis with the collapse of Credit Suisse.

Heading into 2024, Europe is now also seeing similar tailwinds as the US. Inflation is heading down toward the ECB’s 2% target (the headline inflation rate stood at 2.9% as of December, while the core measure at 3.4%), and the central bank is also poised to start cutting rates in the months ahead.

That said, there are key differences between the two economies. In particular, the impact of higher prices and interest rates – plus a slowing global economy – has hit Europe harder. Growth momentum stagnated in the latter part of last year due to Europe’s larger exposure to the industrial sector and its greater sensitivity to higher energy costs.

The composite Purchasing Managers’ Indexes (PMIs) for the region’s biggest economies highlight how Europe’s larger exposure to the manufacturing sector has dragged down growth, reflected by the red readings in the heatmap below. Meanwhile, a stronger services sector has kept the US economy in the green.

Currently, market analysts are also forecasting a higher probability of recession in the year ahead for the EU (65%) versus the US (50%) – though some argue that the Eurozone may already be in recession.

Ultimately, this combination of easing inflationary pressures and a weaker economy suggests that the ECB should start cutting interest rates sooner than the Fed.

What does this mean for investors? These conditions point to weaker equity returns for Europe relative to the US. Just over half of the MSCI EMU Index is tied to financial, industrial, and consumer discretionary companies – three very cyclical sectors, which do not tend to perform well during downturns. For currency markets, this should also contribute to a flat to slightly weaker euro versus the USD, on balance.

Japan: Reform could point to a new dawn for markets

Moving eastward, we see a different economic trajectory unfolding in Japan. Here, growth has been holding up as the Bank of Japan (BOJ) has kept monetary policy loose to encourage inflation, in contrast to the rest of the world. 

The resulting wide interest rate gap between Japan and the US contributed to a steady depreciation in the yen over the course of 2023. And yen weakness was a huge tailwind for corporate profits and equity markets, with the MSCI Japan Index up 20% in USD terms. For more on currencies, check out CIO Insights: Where the currents of currencies flow.

Now, looking to 2024 and beyond, we see progress in structural and corporate reforms as another source of support for Japanese equities. Improvements in corporate governance practices don’t make for flashy headlines, but they’ve been an important driver behind renewed investor interest in the country’s markets. That’s because Japanese companies have been known to hoard cash since the country’s economic crash in the 1990s and the ensuing decades of deflation –  not great for shareholder value. 

Indeed, Japan Inc. has been steadily increasing stock buybacks and dividends over the past decade. But a more recent development has been especially exciting for investors: an initiative from the Tokyo Stock Exchange (TSE) urging companies to lift their price-to-book (P/B) ratio. This has the potential to encourage more buybacks and dividends in the short-run, and higher profitability in the long-run.

The chart below shows that Japanese returns do have a lot of room to improve – with the MSCI Japan’s P/B ratio at only 1.4x and return on equity (ROE) at 8.6%, versus 2.8x and 13.6%, respectively, for the MSCI All Country World Index.

On top of corporate reforms, policy makers’ efforts to revamp the Nippon Individual Savings Account (NISA) tax-free investment scheme could provide an additional lift for Japanese equities. Currently, more than half of the 2.1 quadrillion yen ($14 trillion) in Japanese household wealth is held in cash – with only 17% invested in equities, bonds and investment trusts.

As higher inflation erodes the value of savings, such incentives could help to encourage greater risk appetite among domestic Japanese investors. Analysts from SMBC Nikko estimate the NISA program could bring $14 billion in annual inflows to Japanese stocks. As reference, foreign inflows into the country’s equity markets in 2023 amounted to about $30 billion.

That said, one headwind for Japan comes from the potential for the Fed and the BOJ to both start normalising monetary policy this year – with the former expected to cut interest rates, and the latter seen to phase out its yield curve control (YCC) and raise rates out of negative territory (they’ve been at -0.1% since January 2016).

As shown in the chart below, markets expect these forces to bring the yen to around 135-140 per USD by year end, versus around 145 at the time of writing. A stronger yen would provide less support for equities.

What does this mean for investors? We believe that, on balance, Japanese equities remain attractive given the tailwinds from economic growth and corporate reforms. But yen appreciation may mean more moderate equity returns, compared to 2023’s large gains.

China: Weak data means the near-term upside for equities may be limited

Looking elsewhere in Asia, let’s revisit our deep dive into the Chinese economy from last year. For more, see CIO Insights: Reading between the headlines of China’s economic “crisis”.

In short, the economy does not appear to be faring much better. The downturn in the property sector is still weighing heavily on domestic demand, and the slowdown in global growth continues to put downward pressure on exports.

The chart below highlights this weak demand, with both the consumer and producer price indexes remaining in deflation. Meanwhile, the country’s manufacturing PMIs are near or below the 50 mark, which separates expansionary and contractionary conditions.

What could change the picture for China? The potential for more forceful government support could help to revive the economy. But the plan outlined at China’s annual economic planning conference in December suggests a more gradual approach is likely.

We also continue to see China’s government working to contain systemic risks. For example, local government financing vehicles (LGFVs) appear to be the biggest concern for investors after the property sector, especially as a record high 4.65 trillion yuan ($651 billion) in debt becomes due this year. But the authorities have shown that they have the ability to backstop any defaults to preserve financial stability, reflected by the narrow credit spreads for these bonds.

What does this mean for investors? While economic data still point to relatively weaker risk-asset returns, their cheap valuations offer a cushion for safety. Our analysis shows that the risk of a systemic meltdown is low – and while the road to recovery may be long, the patient investor could be rewarded.  

3 key investment themes from our trip across the global economy

So now that we’ve gone around the world and taken in its sights – its various investment risks and opportunities – let’s take stock of the souvenirs we’ve brought back. Here are 3 key themes we believe investors can focus on in the year ahead:

  1. Consider fixed income as central bank cycles shift. Global central banks are poised to start cutting interest rates in the months ahead as inflation continues to slow and growth weakens further. This environment is beneficial for fixed income, as declining rates make existing bonds more valuable, and investors tend to value the safety and stability of lower-risk assets during periods of economic uncertainty. For our latest deep dive into bonds, check out CIO Insights: How you can navigate the bond market’s choppy waters.
  2. Stay invested in US risk assets amid weaker growth prospects elsewhere. The resilience of the US economy versus much of the rest of the world was the main story of 2023. That’s likely to remain the case in 2024. Weaker growth prospects in the Eurozone and China – the two largest economies after the US – suggest that core portfolios should continue to be focused on US markets in the year ahead.
  3. Invest in economies that are undergoing structural reforms and shifts. When investing in global asset classes and geographies, opportunities can arise where big, structural shifts are taking place. We see strong potential in India for this reason. For more on that, check out CIO Insights: Here’s why you should consider investing in India. Progress in corporate governance reforms in Japan also bodes well for that economy’s equity market in 2024 and beyond.

Differing macroeconomic dynamics among the world’s biggest economies highlights the importance of building a portfolio that’s diversified across regions and industries. But for investors who want to take a more active role in their investments, the 3 themes above can guide you on how to take advantage of opportunities, while also navigating risks.

And while having an idea of where the world’s headed in the near term doesn’t hurt, it’s also important to keep a longer-term perspective. In the short term, weaker growth and declines in the markets can offer an opportunity to add to your portfolio. As always, we recommend a dollar-cost averaging strategy to help you stay invested – while the journey may have its ups and downs, keep in mind your destination: long-term wealth.

Glossary of Terms

PMI (Purchasing Managers’ Index):

A survey of managers across various industries, which boils down their insights into a single number: above 50 indicates business is improving, and below 50 signals a potential slowdown.

ROE (return on equity):

If you owned a business and put your own money into it, return on equity would measure how much profit you make for each dollar invested.

P/B ratio (price-to-book):

Imagine you’re buying a used car: the market value is what people would pay for it now, while the book value is the car’s original price, minus wear and tear. The price-to-book ratio compares these, and a lower value can suggest you’re getting more for your money.

Stock buyback:

When a company buys back its own shares from the marketplace. This typically raises the value of each share, benefiting shareholders.

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