GROWING HOPES OF A SOFT LANDING

11 December 2023

P. Blackburne

Geopolitical developments took somewhat of a backseat during November and, with inflation continuing to move down amid still resilient US activity, bond and – especially – equity markets have been in a festive mood. The odds of an economic soft landing have indeed improved, although whether current investor hopes come true will depend largely on central banks’ leeway to cut interest rates in 2024. Which in turn will be a function of inflation indices and, notably, the oil price trajectory.

The latest CPI releases delivered positive surprises on both sides of the Atlantic. For the month of October, US headline inflation stood at 3.2% year-on-year, down from 3.7% in September. As for the core CPI index (excluding food and energy), it was up 4% – its lowest year-on-year rate since September 2021. In the eurozone, meanwhile, headline inflation fell from 2.9% year-on-year in October to 2.4% in November, with the core CPI index down from 4.2% to 3.6%.

Capitalising on these supportive inflation figures, financial markets are now pricing in earlier and faster interest rate cuts by the Federal Reserve and the European Central Bank. Hence the strong November rally. But while a mid-2024 pivot in monetary policy may be possible, it is by no means a done deal, given how thin a line the central banks are walking.

The global economy could well manage a soft landing over the next quarters. But, given the massive public and private leverage in the system, and high interest rates starting to bite, things could almost as easily go wrong. Excess savings accumulated by US consumers during the Covid period have now been largely depleted, at least when it comes to the lower and middle class, as evidenced by the recent pick up in credit card debt. Investment banks, which are generally the first to lay off employees in the face of slowing M&A and IPO business, have just begun implementing such measures, possibly signalling a loosening of the US labour market. And although housing prices continue to hold up, volumes of transactions have dropped markedly, suggesting that it may be only a matter of time before forced sales (owing to the strong rise in mortgage rates) start to materialise.

The sharp slowdown suffered by the industrial and construction segments of the economy, which typically precedes a similar down move in services, argues for inflation remaining pretty much under control throughout 2024. That said, and as we have written previously, the pullback in headline inflation over the past few months also has much to do with base effects. Energy prices have been comparing to their highs of a year or so ago. As we move into 2024, and year-on-year comparisons shift to post-peak months, these energy base effects stand to turn from negative to positive, which would exert upward pressure on CPI numbers.

The trajectory that oil prices follow over the next few quarters will thus be crucial in determining how much leeway central banks actually have to cut rates – and within what timeframe. On this count, a detailed analysis of current oil market dynamics reveals a rather balanced situation. On the demand side, jet fuel is back to pre-Covid levels, but Chinese oil consumption remains erratic and warmer-than-usual recent weather conditions have held back US demand. On the supply side, US output increased by 700-800’000 barrels per day in 2023 (a trend that could continue until late 2024, before the massive slowdown of private activity and a plateau in production efficiency puts a halt), Russian production has been (somewhat surprisingly) stable, ditto for Iranian shipments (likely due more to geology reasons though), and it has taken regular voluntary OPEC production cuts to uphold the oil price. All told, the recent USD 70-80 price range for WTI crude seems likely to prevail over the next 12 months or so – meaning that upward base effects on headline CPI figures could prove limited.

Turning to portfolios, in hindsight, our positioning going into year-end was a little too cautious. Increasing bond exposure and duration was a good decision, but the magnitude of the Santa rally in equity markets dwarfed that of fixed income markets. Still, we stick to our bond call, believing that yields now available on longer dated top-quality (i.e. investment grade) credit are very decent. Having some exposure to gold and oil as a form of insurance against extreme geopolitical developments also continues in our view to make sense – particularly with the fighting having just resumed in the Middle East.

As regards equity markets, while the odds of a soft landing have admittedly improved, the fundamental backdrop has not changed that drastically over the past few weeks. The global economy is not out of the woods and, as we look to 2024, we continue to be concerned that both equity market multiples and consensus earnings expectations are excessive…

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