26 Jun 2024
Crucially, even if inflation is somewhat sticky in the region of 3% year-on-year, our judgement is that this will prove good enough for the West’s central banks.
We came into the year with markets expecting (1) an acceleration in global growth and corporate earnings, (2) declining inflation, and (3) massive central bank rate cuts. Adding in some artificial intelligence-related excitement, it was hoped that a new and enhanced version of ‘Goldilocks’ was back. In anticipation, bond and stock prices rallied strongly through the turn of the year.
The combination of all three of these expectations seemed to be too good to be true, and so it has proved. Growth has been resilient…but so too has inflation. This dynamic supported risk assets but challenged government bond markets as the prospect of large and imminent rate cuts has diminished.
Exhibit 1: Resilient growth and inflation has pleased equity markets more than fixed income
Source: Bloomberg, BofA, FTSE, ICE, LSEG Datastream, MSCI, S&P Global, TOPIX, J.P. Morgan Asset Management. Global government bonds: Bloomberg Global Aggregate – Government; Global IG: Bloomberg Global Aggregate – Corporate; Global HY: ICE BofA Global High Yield. Equity returns are in local currency, fixed income and commodity returns are in USD. Past performance is not a reliable indicator of current and future results. Data as of 31 May 2024.
Growth broadening
As we look to the next 12 months, we expect global growth to be robust, although its geographical composition is changing.
The US consumer is coming off its sugar high as the scale of direct fiscal support for households and pandemic savings have dwindled. Higher interest rates are not impacting existing homeowners given they fixed their mortgages at pre-pandemic lows, but the cost of unsecured lending is slowly starting to bite.
Some moderation in growth is welcome as the US was definitively overheating last year. However, economies have an unpleasant tendency to move from too hot to too cold. Soft landings are rare. As yet, there are few signs of impending trouble. Corporate balance sheets are strong, so a modest slowing in growth is unlikely to lead to job shedding allowing the labour market to continue underpinning US consumer strength.
The balance sheet that looks distinctly less healthy in the US is the government’s. Indeed, part of the US economy’s resilience is surely owed to the whopping 6% government deficit, something never before seen in a period of record low unemployment.
Exhibit 2: The US fiscal deficit is uncomfortably high for a booming economy
Source: BEA, BLS, CBO, Conference Board, LSEG Datastream, J.P. Morgan Asset Management. Budget balance forecast is CBO, assuming the provisions within the Tax Cuts and Jobs Act of 2017 that are currently due to expire at the end of 2025 are extended. Data as of 31 May 2024.
However, reducing government spending or raising taxes to tackle this deficit is notably absent from the political discussions taking place ahead of the US election. Indeed, if anything both candidates are talking about more spending and fewer taxes. As the source of the world’s reserve currency, the US has long been described as having an ‘exorbitant privilege’, allowing it to run deficits that others cannot. It certainly seems to be pushing that privilege to the limits, which is a risk factor for the coming year (see Scenarios and risks).
As momentum is weakening in the US, the opposite is true in Europe. The cost-of-living shock is fading and the European economy is entering a more favourable environment, with growth picking up meaningfully, albeit from very low levels. As real wages and consumer confidence rise, a recovery is evident in improving retail sales and services demand. Solid labour markets, a further expansion in real wages and a significant amount of pandemic-era savings that are yet to be spent have the potential to continue to support consumption.
Exhibit 3: While the US economy slows, Europe is starting to pick up
Source: Bloomberg, Citi, J.P. Morgan Asset Management. Data as of 31 May 2024.
The slow implementation of Recovery Fund investments (especially in Italy) should see public spending contribute further to this rebound. Although the European Commission has become increasingly vocal about a need to return to fiscal prudence, we doubt this will have much impact on spending plans.
The macro outlook for more industrial countries such as Germany should also be supported by a recovery in demand for manufactured goods. Weakness in manufacturing in the past two years likely reflects the more intense impact the cost shock had on this sector of the economy, as well as an overaccumulation of goods during the pandemic. However, this overhang appears to have normalised and demand for manufactured goods globally seems to be improving.
Overall, we are not looking for Europe to overtake the US, but a convergence in activity looks likely.
Inflation is sticky but bearable
The key question today is whether growth remaining firm in the US and recovering in Europe will be consistent with inflation returning quickly and sustainably to the 2% target.
Exhibit 4: US inflation has plateaued
Source: BLS, LSEG Datastream, J.P. Morgan Asset Management. Data as of 31 May 2024.
A large part of the drop in US inflation was thanks to food and energy prices stabilising. These favourable ‘base effects’ were slower to materialise in Europe, and are now helping headline inflation fall. But underlying inflation in the US is proving very sticky at around 3.5%. In the eurozone and UK, the underlying components, like services, also appear to be holding steady at around 4% and 6% year-on-year respectively.
Exhibit 5: Services inflation remains stubbornly elevated
Source: BLS, Eurostat, LSEG Datastream, ONS, J.P. Morgan Asset Management. Data as of 31 May 2024.
In our view, this stickiness in core inflation is likely to persist. Significantly, however, so long as US growth slows and Europe’s acceleration is modest, we don’t see a major reacceleration in inflation on the cards. The labour market is firm, but is no longer overheating. Workers are not tempted into new jobs with the promise of ever higher wages as they were a year ago. In Europe, the prevalence of indexation is likely to see lower headline inflation feed into modestly slower wage growth.
Crucially, even if inflation is somewhat sticky in the region of 3% year-on-year, our judgment is that this will prove good enough for the West’s central banks. Communication from these central banks over the last six months has, in our view, revealed a lot about their reaction function and the growth risks they are willing to tolerate to bring inflation back to 2%. In this heightened political environment, it seems that central banks will tolerate a continued overshoot in inflation as a price worth paying to ensure unemployment remains low.
We therefore expect all major Western central banks to begin cutting rates before the end of the year, which they will present as normalising policy from restrictive levels rather than easing. In the absence of a shock that upsets growth, we do not see much more than 100 basis points of cuts over the next 12 months, so rates will stay much higher than in the pre-pandemic era.
While the recent move from low to ‘normal’ interest rates has been a painful journey for bond investors, we should remind ourselves that the outlook now for fixed income is positive. Bonds are back doing what they should, which is providing us with decent income and diversification from growth shocks (see Higher for longer is good for fixed income). Importantly, despite interest rates staying relatively high, we think there are better places for investors to find durable income than in cash.
Resilient growth and sticky inflation is, all other things being equal, good news for corporate earnings. While overall this backdrop should provide support for risk asset valuations, we expect the earnings recovery to become more evenly spread between sectors and regions over the coming 18 months (see Shifting gears in equity leadership).
China still lacking a growth engine, but elsewhere in emerging markets activity is improving
Over in Asia, there are few signs yet that China is on a meaningful upswing. Consumers are reluctant to spend given the recent fall in wealth following a large equity market rout and the slow but continual decline in property prices. Beijing has announced further stimulus measures over the first half of 2024, including scrapping the floor for mortgage rates, reducing downpayment requirements and, most significantly, a new fund which will allow local governments to acquire excess housing supply and convert it to affordable housing. Yet given the scale of the property problem, these steps look more likely to prevent the situation deteriorating further, rather than provide the catalyst for a meaningful recovery.
The difficulty for Beijing is that in the absence of a consumer upswing, there is no obvious engine for a strong growth recovery. The lack of domestic demand is leading Chinese companies to focus on exports, which had sent a disinflationary impulse through the global economy. However, this is starting to upset Western leaders and we appear to be on the cusp of a new trade war.
One of the questions we are often asked is whether broader emerging markets (EM) can perform if Chinese markets stay lacklustre. In the short term, the usual routes by which Chinese growth tends to support the broader complex – such as commodity demand and tourism – will remain challenged. But there are cyclical and structural supports that could build over time to support activity elsewhere in EM.
Many EM economies were much faster to respond to the emergence of post-pandemic price pressures, and therefore have controlled inflation with high real rates. Ahead of the game on the way up, they have scope to take rates down as soon as it is absolutely clear that the next move from the Federal Reserve is down.
In addition, some of China’s woes are benefitting other EM countries. There is now compelling evidence that companies are shifting their supply chains to other economies, perhaps ‘friend-shoring’ to protect themselves from the potential for further geopolitical conflict. In 2015, before relations between the US and China started to deteriorate, China accounted for 21% of US imports. That has now fallen to 14%. In contrast, South Korea, Vietnam, Taiwan and ASEAN have seen their share rise from 11% to 17% of US imports. Mexico is another key beneficiary, with its share of US imports rising from 13% to 16%.
Political risk is prevalent but hard to position for
Do conflicts and elections – particularly in the US – have the potential to upset this relatively benign macro backdrop?
Despite the harrowing continual loss of life from the ongoing conflicts, we do not foresee significant economic or market ramifications. Western economic links to Russia are now entirely severed, and Europe has enough liquefied natural gas storage in train for us to stop worrying about major gas price spikes over the winter. In the Middle East, our judgment is that Saudi Arabia has both ample oil production capacity to prevent an oil price spike and the incentive to do so, even if Iranian supply were affected (see our recent On the Minds of Investors publication).
European Parliament elections resulted in a move in favour of right-wing parties, at the expense of support for the Green Party. While this is unlikely to affect any near-term policy decisions, it is reflective of the broader shift we are seeing across the West of countries both ‘turning inward’ – focusing on their national interests at the expense of trade and the free flow of migration – and becoming more hesitant about climate change policies as the short-term impact of internalising the cost of carbon becomes more apparent.
The UK election is unlikely to be a major global market mover. Polls point to a shift in power from the Conservatives to the Labour Party. But the Labour Party has become more centrist in recent years and both parties live in the shadow of the Liz Truss’s mini-budget crisis, so are both focused on a narrative of fiscal prudence and economic stability (see our recent On the Minds of Investors publication).
With regards to the US election, we have to be very humble about our conviction on how this will affect the US and global markets. At this stage we do not know for sure who will win, or whether they will have full control of Congress and therefore the ability to enact their full agenda (see our US election hub).
If former president Trump does regain the White House we should be cautious about expecting a repeat of the policies that were supportive for the US stock market. Tax cuts, alongside measures to quickly curb migration and raise tariffs on imports, could all ignite inflation concerns and bond volatility. Tariffs and disputes about partnership in global defence could also challenge relations between the US and Europe. However, in the past we have tended to see that an external threat in fact galvanises Europe towards greater internal cooperation.
Overall, we caution against ‘trading the election’, aside from avoiding large overweights in positions that might be vulnerable.
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