Financial markets ended 2023 reckoning with an 80% probability that, starting in March, US interest rates would be cut five times in 2024. Just a couple of weeks into the New Year, that probability has shrunk to about 60%. It appears to be dawning on investors that such high expectations, the fuel behind the recent market rally, may have been excessive in pricing in too much good news.
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The minutes from the December meeting of the Federal Open Market Committee (FOMC) released early this month gave no real clarity on US monetary policy other than confirming the perception that interest rates are ‘at or near their peak’, implying that the market’s rate-cut expectations this year are not necessarily a done deal.
Other major central banks have also pushed back on hopes for rate cuts, with the European Central Bank (ECB) and the Bank of England remaining hawkish in their year-end policy communications. ECB President Christine Lagarde has acknowledged the possibility that eurozone interest rates have peaked, but has also emphasised the central bank’s reliance on economic data, noting ongoing uncertainties and inflation indicators not anchored at levels acceptable to the ECB.
Given the uncertain macroeconomic and policy outlook, we remain cautious on equities (but have moved our view to ‘neutral’ from ‘dislike’), with overweight positions in long-duration bonds and inflation-linked bonds as hedges against the combination of slowing growth with sticky/rising inflation.
What changed in December?
US activity data has largely surprised to the upside, with the latest (December) core consumer price index rising by 31bp to 3.9% and jobless claims data showing still-favourable labour market conditions. Eurozone growth has remained underwhelming, while inflation and labour cost growth remain too high for the ECB’s comfort. Only China’s fragile growth conditions are sending a clear signal that policy easing may be appropriate.
US employment data continue to suggest the labour markets remain in good shape. Non-farm payroll gains have slowed from a monthly average of 220 000 in the second and third quarter of 2023 to a still-solid average of 165 000 in the final quarter. December’s data surprised to the upside with an increase of 216 000 in payrolls.
Further evidence of ‘slower-growth-but-no-recession’ in the US is apparent in the continuing claims for unemployment insurance. Although they have drifted upward, initial claims have remained low (see Exhibit 1). This suggests that while those workers who have been laid off may be finding it difficult to be rehired, waves of new layoffs are not occurring.
This labour market backdrop reinforces our view that, barring any bouts of serious financial stress or downside surprises to inflation, the Fed is more likely to make its first cut to policy rates in May/June than in March.
The labour market in Europe appears even stronger than in the US. At 5% year-on-year, labour cost growth is higher than in the US (around 4.0%). While such costs are rising at a slower rate, they are not yet consistent with the stable 2.0% core inflation rate targeted by the ECB. This leads us to believe a shift is looser monetary policy is not imminent.
A new source of inflationary pressure?
Meanwhile, geopolitical risks from the shipping attacks in the Red Sea and the Middle East conflict carry the threat of a new energy supply-chain crisis, pushing up energy and trade costs and fuelling inflation.
If the fall-out from these conflicts is short-lived or remains localised, the central banks’ policy tightening of the past two years should slow demand and inflation in the coming months. It would then be a matter of when, not if, interest rate cuts commence.
China needs more easing
China’s ‘incremental easing’ approach over the last two years has not helped turn around its feeble economy. Granted, Beijing wants to quit the old debt-fuelled supply-expansion mode. It is willing to tolerate slower growth by focusing on structural reforms and debt reduction. However, this policy runs the risk of overevaluating the economy’s capacity to withstand negative shocks and deprives it of recovery momentum.
Realising that China’s property market woes are fuelling the risk of deflation, Beijing has ramped up its measures to stabilise the sector, notably by accelerating urban village renovation and social housing construction, relaxing property transaction restrictions, cutting mortgage rates and increasing financing for viable non state-owned developers.
The People’s Bank of China has announced a plan to inject more than RMB 1 trillion to fund property and infrastructure investment in major cities and has drawn up a ‘whitelist’ of 50 developers deemed suitable for credit support.
The risk, however, is the timing of implementation. Many of these measures are yet to be carried out at the time of writing.
Evidence shows that decisive policy stimulus and economic reforms can be effective in diffusing the risk of deflation when the private sector is not spending. In 1998-99, China experienced seven quarters of deflation due to industrial overcapacity and unsatisfactory demand during the Asian Financial Crisis.
To exit that economic quagmire, Beijing boosted its fiscal deficit by issuing long-term construction bonds, implemented structural reforms to increase productivity, and restructured debt by recapitalising state banks and establishing asset management companies to manage bad debt.
Those policies worked to revive GDP and price growth at the time (see Exhibit 2). If Beijing can keep up its assertive easing this time, repair confidence and convince markets that China’s outlook is improving, we believe there is a fair chance of a sustained rebound in economic growth and stock markets in 2024. If not, we could see growth stuck in low gear, weakening asset prices.
A resolution for the New Year
Let’s hope the prospects of the main central banks cutting interest rates and more Chinese policy measures will help avert a major global economic downturn.
Asian central banks will probably be able to start cutting interest rates before the Fed does as average inflation in the region has been much lower than in the main developed economies including the US.
This underscores our constructive view on the market outlook for emerging Asia within our overall neutral stance on equities.