Although the market consensus for the new year tends towards a «soft landing» for the economy, J.P. Morgan Asset Management capital market strategist Tilmann Galler is rather less optimistic about 2024.
«We think that it is too early for central banks to declare that inflation has been beaten for good. Despite interest rate cuts, it will probably not be possible to prevent a period of economic weakness in 2024,» Tilmann Galler, capital market strategist at J.P. Morgan Asset Management, writes in his outlook for the year.
He set out a total of ten theories on how the economy will develop in 2024 when elections are due to be held in more than 40 countries. These include four of the five most populous countries in the world, including the US, Indonesia, and India, as well as elections in Europe and the UK. In total, elections will concern more than 40 percent of the world's population and global gross domestic product.
End of the Sugar Rush
Although a difficult 2023 was expected in terms of the economy, the US economy managed to grow, beating the trend. The equity markets also significantly exceeded expectations. Galler believes that this growth was driven in part by a very expansive fiscal policy.
Increased financing costs and central banks’ ongoing efforts to reduce their balance sheets will give the US and countries in the eurozone less room for maneuver in 2024. According to J.P. Morgan's expert, this is likely to result in weaker growth or possibly even a recession. Purchasing managers' indices remain weak, a further indication of sluggish demand.
The capital market strategist states that economies have proven very resilient over the past year, with the slowdown effect of high-interest rates only gradually unfolding. The US residential real estate market is a good illustration of this. While prices have remained relatively stable so far, sales of existing properties have fallen even more sharply than during the 2007-2009 housing crisis.
This is due to the significant rise in mortgage interest rates, affecting all households taking out new mortgages and remortgaging. Only a few households are affected by this for now, but the longer interest rates remain high, the more negative the effects on household income will be.
«So far, US consumers have been able to draw on surplus savings from the pandemic, and hefty pay rises have also supported consumer spending. However, momentum will wane over the year,» Galler explains. The EU has rather more fiscal flexibility than the US
A lot of EU Recovery Fund money has not yet been used, which means that further grants are still available. This should support growth in peripheral areas in particular. Real wages are also expected to rise significantly in the coming months. The growth gap between the US economy and Europe should start to close.
Central Banks Herald Turnaround in Interest Rates
Although inflation has decreased considerably in recent months, some areas of services are still being propped up by measures such as pay rises. According to Galler, the final step towards reaching the target rate of inflation will be hard. However, the expert stresses that interest rates peaked in 2023 and a turnaround should be seen this year, making it a good time for investors to take advantage of attractive interest rates.
With central banks recently having put their rate hike cycle on hold, the market currently expects the first rate cuts as soon as March. «We think this is a bit early, but in the event of an economic downturn, significant cuts are likely over the year,» Galler explains.
However, the expert adds that with more than five interest rate cuts now priced in the US, this suggests a gloomy economic outlook rather than a soft landing, even if this is currently being feted by the equity market. «Monetary tightening usually goes hand in hand with recession,» warns the expert.
Falling Bond Yields
For anyone wanting to protect their investment portfolio against weak growth or even a recession next year, it makes sense to invest in the security of long-term investment-grade bonds. According to Galler, investors who have secured the current attractive interest rates for their portfolio will benefit from the fact that bond yields fall in a disinflationary recession scenario – when central banks lower the base rate and investors seek refuge in investment-grade bonds.
Yield Curve Returns to Normal
Galler thinks the inverted yield curve should return to normal next year. Central banks will respond to the expected slowdown in economic demand and therefore also in inflation by cutting interest rates significantly. This means that yields at the short end of the curve are likely to fall below those at the long end over the year.
Cash is not King
Even though a positive real return can currently be achieved with cash – whether overnight money or money market investments – the expert believes this is an illusion: According to Galler, it makes sense to focus on longer-term bonds after the end of a tightening cycle, with a turnaround in interest rates expected as early as next year.
The economist recognizes the foresight of the financial markets in this: «The central bank's latest interest rate move is expected to have a dampening effect on the economy, which could even lead to a recession. Enthusiasm about higher short-term rates is often short-lived, while bonds benefit from emerging hopes of lower interest rates.
This means that cash is only king as long as the central banks are in the mood for rate hikes,» says Galler. The expert stresses that cash offers little added value, especially for long-term investments, as he shows. Since 1900, one dollar would have grown to just dollar 1.70 after inflation with a money market investment, or to dollar 9 over the same period with US bonds.
Equities offer the best real performance: one dollar invested in 1900 would be worth dollar 2,600 in real terms today.
Investment Grade Beats High Yield
Galler stresses that all investments should focus on quality next year, on both the equity and bond markets. When a company’s earnings deteriorate, it becomes clear how good quality it is. Higher interest costs will have a significant impact on earnings if companies' refinancing requirements increase in the coming years.
This applies initially to high-rated companies (investment grade) but also to the high-yield segment. Risk premiums in the high-yield segment currently still price in a soft landing, but this could prove deceptive. As for emerging market bonds, the expert believes there are good opportunities in the local currency segment, particularly in countries with high real yields at present.
However, the currency risk will be higher than in 2023 due to emerging economic weakness.
Margins Under Pressure
One of the factors driving equity market performance in 2023 was upward revisions in earnings forecasts. These indicate that positive earnings are expected. But can earnings forecasts reflect reality? «The economic downturn combined with inflation will weaken the economy, which will certainly put profits under pressure.
Consensus estimates are very optimistic, even just below double digits for the US. However, if the cyclical tailwind reverses at least partially in 2024, companies will no longer be able to pass on the rising costs of energy, intermediate goods, and labor as before,» says the expert, dampening expectations with the belief that profit forecasts for the year should be lowered.
Quality Before Cyclicals
Valuation metrics in most of the major equity markets are currently close to or slightly below their historical averages and slightly higher in the US. However, valuations include relatively optimistic assumptions about earnings growth over the next twelve months.
Even assuming that earnings stagnate, valuations are not particularly high. Although the fundamental general conditions are good, companies presenting high quality and low debt are generally better placed to deal with periods of economic weakness, and so Galler believes a selective approach is required.
The alignment in earnings yields for equities and corporate bonds also shows that equities are once again facing competition.
Dividend Stocks are Relative Winners
One segment that Galler still considers a good option is dividend stocks, which can be used as a defensive addition to a portfolio: «Global equities with stable, above-average dividend yields have been able to withstand the economic downturn better than the market as a whole over the last twenty years.
This was evident from 2000 to 2002, for example. The similarity with today's environment can be seen not only in high-tech valuations but also in companies’ low payout ratios. Currently, only 39 percent of profits are distributed globally, 3 percentage points below the 25-year average.
The current level of dividends therefore offers a buffer against a fall in profits in the event of a recession,» the economist explains.
Higher Volatility Equity Markets
The expert expects markets to fluctuate, not least due to the «super election year» in 2024, when elections will be held in several countries around the world. Volatility will be high, particularly in the context of current geopolitical uncertainties.
However, according to Galler, alternative investments can mitigate portfolio fluctuations. In principle, it is often hard to predict the outcome of elections, and even harder to predict what this will imply specifically for the capital markets.
In the long term, there is no clear correlation between the party in power and market performance. And so Galler's basic scenario for 2024 is the interest rate cycle coming to an end, and as the economy weakens, portfolios should become more defensive.
«It's worth opting for longer terms now instead of overnight money and the money market while interest rates are high. In addition, defensive, high-quality equities such as dividend stocks can help to navigate a portfolio through what is likely to be a somewhat more volatile period in 2024,» concludes Galler.
- The investment outlook for 2024 «Too early for a lap of honor» can be found here.
Tilmann Galler
CEFA/CFA is a global capital market strategist for German-speaking countries at J.P. Morgan Asset Management in Frankfurt. As part of the global Market Insights team, he prepares and analyses information about the global financial markets based on extensive research and draws implications for investment strategies.
He has over 20 years of professional experience in the financial sector and previously worked as a portfolio manager, among other roles.
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