Can markets continue to confound the sceptics?

In the final quarter of the year, investment strategists often present charts showing how the cheery forecasts made at the start of the year have drifted lower in the intervening months. 2023 is shaping up differently. Nine months ago, most economists – including ours – were expecting a significant economic slowdown as interest rates reached the highest level in over a decade. But as the year has progressed, the outlook has steadily improved. This has come alongside a fall in inflation which should mean that central banks are very near the end of their rate hiking campaign. Throw in a dash of excitement about AI and the stage was set for an impressive rally in many equity markets.

Economists were too pessimistic at the start of the year

Consensus global GDP growth forecast for 2023 (%)

^{Source: Schroders Economics Group, Consensus Economics.}

The rally lost momentum in September, as investors started to worry about the impact of interest rates remaining at current high levels for some time before they start to fall – more like Table Mountain than the Matterhorn, as the Bank of England’s Chief Economist memorably put it. Even before this, the recovery in share prices was viewed somewhat suspiciously due to its very narrow “market leadership.” US – and indeed global – shares have been led higher by a small number of large technology companies. However, this does not necessarily mean the rally is unsustainable. More recently, we have seen other sectors delivering relatively stronger performance. And as my colleague Dominic Liversedge explores here, we have a constructive view on AI. The valuation of technology companies does not look extreme given their robust earnings and AI’s huge potential. We could also soon start to see its benefits spread beyond the technology sector.

As things stand at the start of the fourth quarter, global equities remain meaningfully than they were a year ago. Other asset classes are also reflecting a better growth outlook. Government bonds have been under pressure as yields rise (higher interest rates mean lower bond prices). And, despite problems in the Chinese economy, commodity prices have been moving higher, with a barrel of Brent crude hitting $95 for the first time this year.

Equities and bonds both reflect the better growth outlook

Performance of global equities and global government bonds in 2023 (rebased to 100)

^{Source: Refinitiv Datastream Total return basis. MSCI World Index is denominated in USD. FTSE World Government Bond Index comprises sovereign debt from over 20 countries, denominated in a variety of currencies.}

^{Past performance is not a guide to future performance and may not be repeated.}

Has a recession been avoided?

In the US, it looks increasingly likely that it has, at least for now. Some key indicators suggest that the economy is cooling, especially in the employment market. The number of non-farm, private sector jobs created each month has been falling since late 2021 (just before the Federal Reserve first started raising interest rates), but suggests that firms are still hiring. Some other indicators don’t suggest much of a slowdown at all. After dipping last year, US house prices have started rising again, despite higher interest rates making new mortgages much more expensive. Business surveys suggest that corporate confidence may be ticking higher.

Away from the US, however, big economies look more vulnerable to a slowdown. UK output is estimated to have contracted in July, putting a prompt end to any celebration of revised data showing that the country’s earlier economic performance was not as bad as feared. Europe is closer to recession, as businesses and consumers struggle with higher interest rates more than their American counterparts. The weakness in China is also a much greater drag on Europe than the US.

My colleague Josh Barber looks at the challenges that China faces in more detail here. I note that while Chinese equity markets have performed poorly, global markets do not currently appear too anxious about the country’s disappointing performance. Investors may be taking some comfort from the fact that, unlike many other governments, Beijing still has the fiscal headroom to undertake more substantial stimulus if and when it chooses. Many perhaps also view the transition to lower, but more sustainable, growth as a healthy development.

Not too hot, not too cold

In the near term, the strength of the US economy should be enough to keep global output expanding. This may continue to support markets. As ever, there are risks to this relatively benign outlook. The continued rise in interest rates means there is a risk of further shocks to the financial system, whether from the corporate or government sectors. It was almost exactly a year ago that the UK government found itself in a stand-off with the bond markets. As other economies slow, their leaders may also find themselves making choices that international creditors do not approve of.

Another worrying possibility is that the continued strength of the US economy, combined with recent rises in commodity prices, mean that inflation stages an unexpected rebound. This would come as an unwelcome shock to investors, who are now mostly assuming that interest rates are at, or very near, a peak.

^{Vladimir Putin and North Korean leader Kim Jong Un met in Russia’s Far East in September 2023.}

Looking at the world through a 3D lens

Our base case remains that inflation will continue to fall. However, several longer-term trends mean that it is likely to remain more of a challenge for policymakers than it was prior to the pandemic. We refer to these trends as the “3Ds” – deglobalisation, demographics and decarbonisation.

Evidence of the first has been very apparent in recent weeks. The EU wants to make it harder for China to sell electric vehicles in Europe, President Biden has been cosying up to China’s neighbours and, most worryingly of all, Kim Jong Un made a rare trip abroad to meet with President Putin. These all point to a very different geopolitical backdrop from what we have been used to. International tensions could well result in more tariffs and disrupted supply chains over the coming years, raising prices and depressing growth.

The inflationary impact of demographics and decarbonisation are also clear to see. Businesses have increasingly been struggling with a shortage of workers, driving up wages. Decarbonisation, while very necessary, will also raise the cost of doing business as companies invest and restructure to reduce emissions.

These trends will create opportunities as well as risks. For instance, a shift in supply chains away from China could mean new business for companies in other parts of the world. We must also consider the impact of another “d” – the disruptive impact of new technology. This may well have the opposite effect on inflation, as AI and automation increase efficiency and offset the impact of labour shortages. Given our view that we are still in the early stages of the “AI revolution” it will also open up new areas of investment.