This year should see a weakening global economy with slower growth and moderating inflation (but still above central bank targets).
The US, Eurozone and UK are all likely to decelerate further, and we see a high probability of a shallow recession – more likely in the Eurozone than in the US, with the UK in between. As the impact of past rate increases feeds through to the economy and further slows inflation, however, rate cuts in the Western world could take place as of midyear.
For investors, the key question is not whether a recession will occur, but rather to what extent it is expected by markets and, in turn, whether that is reflected in asset prices.
If an asset is attractively priced, then there is an opportunity, as we see with high-quality government bonds. If an asset is overpriced based on the risk taken, it is best to avoid, as is currently the case with riskier credit markets.
Given that a faster slowdown and/or a deeper recession compared to market expectations is more likely than a boom in economic growth, we are staying invested in US and European low-volatility stocks. These tend to outperform the broader market during a slowdown.
The US economy has been defying gravity for some time, with very strong growth and high inflation. This is now changing, and we think both trends will likely come back to Earth. With high interest rates feeding through and supply chains working better, inflation has steadily fallen over the past year.
But the economy has remained surprisingly resilient. Having said that, the US labour market has started to weaken, and manufacturing activity has contracted for a year. Services activity is only growing marginally.
This is important because services have kept US growth ahead of the other major regions. In turn, this means we are unlikely to see the US Federal Reserve reach its two percent inflation target this year. More likely is that we will see a stabilisation between 2-3 percent, a much lower level than the 9-10 percent experienced a year ago.
As with the other major Western central banks, the Fed is at peak rates. To keep downward pressure on inflation, we believe it will keep rates elevated over the coming months before cutting from mid-2024 to support growth.
The Eurozone is currently in a mild technical recession. Manufacturing activity has been contracting since the start of 2023, while services have started decelerating more visibly in recent months.
However, inflation has recently continued to fall further than expected, leading to speculation about when the European Central Bank could start cutting rates. Our view is that the central bank will hold rates during the first part of 2024, before it begins lowering them to stimulate growth from midyear.
The rapid rise in interest rates has fuelled volatility in UK financial markets, and there are concerns that the British economy could soon stall or enter a mild recession. This is something the UK flirted with for most of 2023, with quarterly growth near zero throughout last year.
Services activity remained fairly resilient in the first half of 2023, which counterbalanced weak manufacturing activity. However, now that services activity is slowing, a recession is on the cards, despite the efforts of the Autumn Budget to mitigate that risk.
Higher rates are putting downward pressure on the UK economy and inflation – which has been much stickier than in the US and Eurozone – is now falling more decisively. While it remains above the two percent target, pressure to grow the economy will likely outweigh pressure to hit that target.
We therefore believe the Bank of England will maintain rates as they are before cutting them from mid-2024 in an effort to revive growth.
All this implies that, after years of low yields, bonds are finally returning to portfolios as a source of diversification and return. Now that interest rates have peaked, bonds are even more attractive. Government bonds yields tend to fall around peak rates (just before or at). This will push the prices of today’s higher yielding bonds up.
Therefore, we are maintaining our current exposure to longer-dated high-quality government bonds in the Eurozone and the UK. These tend to outperform shorter-dated bonds after the peak in interest rates in a scenario of slower growth and inflation. Recently, we bought more US Treasuries. These not only provide a good return for very low risk, but also help protect against any sharp downturn in markets.
Throughout 2023, we held fewer corporate bonds relative to our long-term asset allocation and, at the turn of the year, we have decided to reduce that further. Given our expectation of a mild recession in the Western world and for interest rates to remain well above pre-Covid levels, the difference in yield between safe and risky bonds could widen in 2024.
Although our base case is for defaults to peak throughout the course of the year, any downside risk to growth could lead to a further widening of that differential.
In summary, high-quality bonds make sense to us as they provide a useful diversifier in the context of a weakening economy at a time when most equity markets are either expensive or not cheap.
That said, markets have largely anticipated the central banks’ moves and, likely, are now extrapolating too many rate cuts too soon. At the time of writing, market pricing for the Fed is six or even close to seven rate cuts before year-end, starting in March.
This implies that the 10-year Treasury yield has probably overshot to the downside in the short term. On a 6-12 month horizon, however, bonds appear to be a good hedge against recession.
Daniele Antonucci is chief investment officer at Quintet Private Bank. The statements and views expressed in this document are those of the author as of the date of this article and are subject to change. This article is also of a general nature and does not constitute legal, accounting, tax or investment advice. All investors should keep in mind that past performance is no indication of future performance, and that the value of investments may go up or down. Changes in exchange rates may also cause the value of underlying investments to go up or down.
