It was welcome news for investors and consumers when inflation finally started to wane in 2023, but in many economies it is still too high. We should expect interest rates to remain higher for longer until central banks see clear evidence that inflation has been quelled.
The economic landscape in 2023 was a complex interplay of recovery, resilience and challenges. Still regaining its footing after the Covid-19 pandemic and the ongoing war in Ukraine, the global economy had to cope with steep rises in interest rates designed to combat high and persistent inflation.
It was also a year when few of the pundits’ predictions came to pass. While advanced economies defied consensus opinion that aggressive interest rate rises would trigger a recession, a much-anticipated post-pandemic recovery in China failed to take off. And few could have predicted that a handful of AI-related tech companies would account for most of the gains in the US equity market.
Inflation – beware premature victory celebrations, but the trajectory is positive
The aftermath of the pandemic brought the highest inflation rates in decades. Last year marked a pivotal moment in the global economic landscape when inflation started to fall. Much of the fall in inflation has been thanks to supply chains normalising in the wake of the pandemic, together with some reductions in high energy prices. While we can expect a bit more disinflation – a slowdown in the pace of inflation – from lower manufactured goods prices, much of the disinflation on the supply side has run its course. From here, higher interest rates and higher yields must take the lead in getting inflation to lower levels.
Looking forward to 2024, we expect inflation to remain a little higher than central banks would like.
A consequence of getting inflation to lower levels will be slower economic growth and fewer jobs. This is why we believe policymakers will aim to bring inflation down gradually and avoid tipping the economy into a recession.
Services and wage inflation are likely to decline steadily. Workers are trying to recover multiyear losses in real wages. The difficulty facing energy-importing economies is that permanently higher energy prices shrink the size of the economic pie, but demands for higher wages will continue. Housing rents in the UK and Australia are rising quickly, just as they did in the US two years ago. In the US, rent increases reached 9% per year and have taken time to normalise (Macrobond, April 2023).
While the trajectory for inflation is down, commodity markets, including food and energy markets, remain vulnerable to geopolitical risk. Jobs markets are still tight and higher labour costs – when not supported by productivity gains – can add to inflation. Further trade barriers and tariffs could also put upward pressure on inflation.
Economic growth could slow in 2024, but it’s not all bad news
Global economic growth in 2023 has outperformed expectations and was more uneven than anticipated. The most notable growth has been in the US, which has avoided a widely predicted recession and beat consensus expectations by a clear margin. Demand in the US has been fuelled by strong household consumption and the US government’s ballooning budget deficits, producing an impetus towards growth that even several banking failures failed to dent.
By contrast, growth has been modest in most European economies, including the UK. Tourism destinations such as France and Spain have benefited from increased spending on services and experiences after the period of Covid-19 restrictions. High demand for labour-intensive services has created many jobs, even in economies where growth has been weak.
Goods-manufacturing economies such as China and Germany have fared worse, with weak demand for goods and inventory overhangs creating an unpalatable cocktail for manufacturers. Energy prices remain high, pushing up operating costs for Germany’s energy-intensive industries, while China is contending with an oversupply of property, debt problems and tougher trade restrictions.
Global growth is likely to slow in 2024 as higher interest rates continue to curtail spending at the same time as some of the factors that have supported growth this year begin to fade. The boost to growth from pandemic-era savings and pent-up demand is tailing off, and tourism has returned to pre-pandemic levels, which will markedly slow the impetus this sector added to the global economy. Meanwhile, manufacturing still faces challenges from persistently higher energy costs, even though inventory destocking may ease. The good news is that most of the slower growth is expected to occur in the US, where the economy is operating above its long-run sustainable level. We also see the real estate sector, debt issues and broader trade tensions continuing to weigh on growth in China for some years.
Interest rates – higher for longer
As they continue to battle inflation, the message from the Federal Reserve (Fed), the European Central Bank and the Bank of England is that higher interest rates may be with us for some time.
Having been caught off guard by the strength of inflation in 2022, central banks were forced to rapidly reverse the economic stimulus that they had applied in response to economic shutdowns during the pandemic. This volte-face resulted in the most substantial increases in interest rates in over four decades. Now, however, the Fed seems content to hold interest rates at their current level until inflation falls below 2.5% and the unemployment rate has settled above 4%.
As interest rates have risen, so have bond yields (as bond yields rise, bond prices fall). This has created an opportunity to buy better-quality corporate bonds, particularly those issued by companies that were able to secure long-term finance at low rates prior to 2022. In the world of government bonds, however, spendthrift governments are being called to account by the bond markets, which are beginning to demand a higher return for lending money to them.
Governments are issuing bonds to fund ambitious spending programmes, with little regard for whether this is sustainable. At the same time, central banks are keen to reduce the stockpiles of assets they accumulated in order to support and stimulate the economy. They can therefore no longer be relied upon as natural buyers of the bonds that their governments are issuing. The result has been further upward pressure on bond yields. In October 2023 the 10-year US Treasury yield hit 5% for the first time in 16 years (Bloomberg – 23 October 2023).
While central banks in most major economies have used aggressive interest rate hikes to combat inflation, the Bank of Japan (BoJ) is a notable outlier. After decades of low growth and deflation, inflation has been rising in Japan, but the BoJ has kept short-term interest rates below zero, awaiting clear evidence that inflation can remain near its 2% target. But with even longer-term Japanese bond yields climbing, the BoJ has been obliged to relax its yield curve control programme lest speculators decide to test its resolve, further demonstrating the power of the bond markets.
As we venture into 2024, all central banks face the challenge of policy lag, whereby the effects of a decision taken today may not become apparent for months or even longer. This creates uncertainty about the extent to which interest rate rises have already influenced the economy and whether further impacts are yet to come. Navigating these uncertainties requires a forward-looking approach that balances current economic conditions with anticipated future trends.
In many economies, much of the impact of higher interest rates on growth has already taken effect. Given this, we believe that softer economic conditions could allow central banks to start cutting interest rates in the second half of 2024.
Where could returns be made – and lost?
As we enter 2024, investment returns will be heavily influenced by an array of economic, geopolitical and financial risks. A key concern everywhere is the lingering threat of inflation. Disruption in global supply chains, including commodity markets, could bring shortages of important inputs and accompanying price rises. Geopolitical risk remains elevated, especially in regions that produce key commodities and – in an increasingly divided world – further disruption could come from trade barriers, tariffs and sanctions. In this scenario, net importers of energy and food would be most adversely affected.
Large fiscal deficits could also contribute to higher inflation. The US fiscal deficit is nearly 6% of global domestic product (Macrobond, 15 November 2023) – a level of deficit spending more typically associated with wartime – and continues to deteriorate.
Volatility in financial markets is likely to remain elevated in 2024, particularly given China’s deep-seated issues with growth and debt. With economic growth and interest rates having diverged significantly across economies, the financial markets are working overtime to shift capital to where it is needed most. Add on geopolitical events and these capital flows could lead to market upsets and volatile asset prices – including the prices of some assets that policymakers would prefer to remain stable, such as currencies.
That said, volatile asset prices can provide significant opportunities for long-term investors who are able to embrace volatility as the fee paid for investing, rather than something to be feared.
Adam Hamilton is an economist at Sarasin & Partners
Charity Finance wishes to thank Sarasin & Partners for its support with this article
