We still anticipate a slowdown in global growth versus the trend level and for this to be accompanied by reduced but still above-trend inflation.
Our recent research suggests that if past tightening cycles are any guide, the peak impact on GDP growth from rate hikes already implemented in the US, eurozone and UK, is not likely to be felt until later this year or early in 2024. While the precise timing is uncertain, we are confident that from here on economic activity will increasingly feel the drag of prior monetary tightening.
This suggests a positive fundamental outlook for core government bonds, where yield premiums are historically high compared with long-term GDP forecasts. We are constructive on the asset class but nevertheless expect volatility to remain elevated. The Bank of England is currently alone in pursuing an aggressive pace of selling bonds back to the market in the form of quantitative tightening (QT), whereas other central banks seem content with running down their balance sheets by letting bonds mature and not reinvesting the proceeds.
If, at some point, the Federal Reserve and the European Central Bank decide to increase the pace of their QT programmes, the supply of bonds that need to be absorbed by the market will further increase. This, combined with governments having to finance larger budget deficits, means the volume of bonds brought to market could multiply further which would continue to put pressure on bond prices. For corporate credit, where valuations look reasonable rather than compelling, the low-growth outlook should result in below-average – but still positive – excess returns over core bonds in the year ahead.
A tougher outlook for Europe
US Inflation has come down a long way and with no discernible worsening in the labour market, this dramatically increases the chances of a soft landing for the US economy. At 3.7%, September’s CPI rate, year-on-year, remains above the Federal Reserve’s target of 2.0% but it is significantly down from the 6.4% reading we began the year with. The encouraging blend of disinflation and economic growth (the US economy grew at an annualised rate of 2.1% in the second quarter of 2023) is reason enough for a more constructive outlook on US equities than was the case a few months ago.
That’s not to say we aren’t somewhat cautious on the asset class as a whole. Sluggish growth presents a mild risk to company earnings. And of more concern, global equity valuations on a price-to-earnings basis look high in an historical context, both in absolute terms and relative to other asset classes. Although the US economy continues to surprise to the upside, we remain mindful that there could be some speed bumps along the way; the impact of student debt repayments, signs of weakness in the employment market and the continuing impact of higher rates on consumers and corporate balance sheets, the three most visible ones presently. Meanwhile, Europe looks set for tougher times, more so due to core countries than the periphery for once, as survey data continues to point to a contraction, especially across manufacturing.
External pressures are a constant
As ever, geopolitical concerns remain a constant worry. The ongoing conflict in Ukraine shows no signs of ending soon and the escalation of tensions in the Middle East suggests that geopolitical risk will continue to dominate the headlines for the foreseeable future. What this means for asset prices is hard to predict, however, the clearest passthrough is likely via commodity prices, particularly oil. Given the ubiquitous presence of oil at different stages of economic activity, higher oil prices could be another friction stopping inflation falling as fast as people expect.