For the economy and markets, 2023 turned out to be a much better year than expected. Inflation fell steadily and global GDP continued to rise, despite very steep increases in interest rates in many countries. There were wobbles along the way, such as the stress we saw in the US banking sector early in the year. However, investor sentiment improved as it became apparent that a peak in interest rates was coming into view. Global equities rallied by just over 15%. And, after a volatile 12 months, government bond yields ended the year little changed.
What happened to Table Mountain?
A few months ago, the Bank of England’s Chief Economist warned that the outlook for interest rates looked more like Table Mountain than the Matterhorn. He was suggesting that central banks would need to keep interest rates at high levels for quite some time. However, as inflation has continued to fall, investors and many central bankers now expect them to decline more rapidly. We share the view that interest rates will be cut in 2024, but perhaps not at the pace – or to the extent – that markets are anticipating.
It is true that inflation has fallen significantly over the past year. In the US, prices were rising at an annualised pace of around 6% at the start of 2023. The figure now stands at just over 3%. However, this progress does not mean the job is finished, given the Federal Reserve’s inflation target of 2%. This final percentage point of inflation may prove to be the “hard yards” and require interest rates to remain elevated. In previous inflationary episodes – such as the 1960s and 1970s – there were “second waves” of inflation after the initial threat had been seen off. Further rises in stock and bond prices, which monetary policymakers regard as an easing of “financial conditions,” could make this more likely.
Inflation may have fallen more quickly than expected in 2023, but the real surprise was the resilience of the US economy in the face of a 5% rise in interest rates over two years. It wrong-footed investors and economists alike. In almost all previous economic cycles, significant increases in rates have led to recessions, or at least significant slowdowns.
Why haven’t they this time round? It comes down to the incredibly unusual circumstances of the past few years. US consumers came out of the pandemic with a big stock of excess savings. As this money has been spent on domestic services, it has had a “multiplier” effect as it circulates through the economy. Meanwhile, the risks associated with higher interest rates have taken longer to materialise than anticipated. Businesses have taken advantage of long-term, low-cost financing, insulating many of them to higher borrowing costs. Households also have some protection through the long-term nature of the US mortgage market. New mortgages are much more expensive, but many homeowners locked in long-term mortgages at low rates and have been reluctant to sell, limiting supply and mobility and supporting prices.
Having said this, the US has not been immune to higher rates – and it is possible it goes into recession at some point in 2024. The US unemployment rate has ticked up to 4%, from a low of 3.4%. Weaker companies experienced a default rate of 4.1% in the year to November 2023, based on S&P’s data on speculative-grade corporate defaults. This measure was below 2% in late 2021. While neither figure is alarming, they do suggest that the US is slowing down. In fact, Schroders’ economists expect the US to grow by just 1.3% over the course of 2024, down from 2.5% for the whole of 2023.
Is big tech too big, or are other markets undervalued?
We talk a lot about the US because it is still by far the largest financial market in the world and has a huge influence on what happens elsewhere. However, America’s economic experience over the past year is far from universal. European economies and China have been struggling, while Japan is enjoying something of a renaissance. This degree of divergence is unusual and may create tactical opportunities going forward.
We discussed China’s challenges in more detail last quarter. In short, the slowdown in its property sector remains a major headwind. Geopolitical tensions may also be contributing to the slowdown, as international companies adjust their supply chains and restrictions on technology sales start to bite. The weakness in China has had knock-on effects in Europe, which is a major exporter to the country. Higher interest rates are also taking a greater toll on consumer spending in the eurozone and UK than in the US.
The challenging growth outlook, combined with a lack of investor enthusiasm, has left stock market valuations in Europe and China at a significant discount to the US, and to long-term historic averages. Even Japan, which has much more attractive growth prospects, trades at a meaningful discount to the US and long-term average. Investors appear to view the US stock market as “reassuringly expensive” given the strength and growth prospects of its biggest companies.
The biggest US technology companies are now worth more than many stock markets
Weight in MSCI All Countries World Index (%)
Past performance in not a guide to future performance and may not be repeated. Data as of 30 November 2023. Source: Refinitiv, Schroders. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell.
This has led to a very unusual situation where the biggest US technology companies (often dubbed “the magnificent seven”) are now worth more than the entire stock markets of the UK, France, China and Japan combined! It is possible that this is an accurate reflection of today’s economic reality. It is perhaps more likely that the biggest US tech firms are overvalued or markets outside the US undervalued. We would tend towards the latter explanation, which suggests that global markets may rise in value relative to the US.
Technology has again been the star performer in 2023
Global sector returns in USD, % change to 30 November
Political and geopolitical risks rise
For the first time since 1992, the US and UK will be holding elections in the same year (assuming the UK government does not hold out for an election in January 2025). Along with India’s election, these will be the first major votes held in the age of AI. Politicians, regulators and investors will all be closely monitoring its impact.
The UK election probably won’t alter the trajectory of global markets, but it will have significant implications for UK financial markets and could usher in changes to personal taxation. A new government’s room for manoeuvre looks severely limited. The recent Autumn Statement made much of the UK’s “fiscal headroom” – and used it to fund two large tax cuts. However, it was far less frank about the fact that this headroom assumes minimal increases in public spending over the coming years. Given the state of many of the UK’s public services, this is likely to lead to further battles over tax and spending – and potentially further volatility in UK markets.
In the US, it currently looks as if Joe Biden and Donald Trump will once again be competing for the presidency. Bear in mind, however, that the candidates are not finalised for many months and there have been surprises in the past.
I would note that investors will be very focused on what the outcome could mean for America’s debt trajectory. We have already seen concerns over the supply of US government debt leading to significant volatility in bond markets and this could well continue as the campaigns kick off. We could see more expansionary fiscal policies (and even higher debt) if one party gains control of both the White House and Congress. The election will also have a significant bearing on geopolitics. A Trump presidency could take a very different approach to China, as well as conflicts in Ukraine and the Middle East.
Back in 2016, few were optimistic about markets under a Trump presidency. Indeed, as the election results started to come in, markets initially reacted badly. However, they quickly reversed course and rallied sharply over the following weeks. Investors who went into the election with very fixed views of how the market would respond missed out. A pragmatic approach, and the ability to quickly take advantage of tactical opportunities, will be important in 2024.