Markets start 2024 with inconsistent rate expectations

The year 2023 ended positively for practically all assets, with the exception of Chinese equities. Despite this, the year began with a very negative tone due to the more-than-expected recession (which ultimately did not materialize) and inflation that managed to be subdued. In March, the US banking crisis and the Credit Suisse episode in Europe raised fears of a systemic crisis, which was partly remedied by the rapid intervention of central banks (especially the US Federal Reserve) injecting liquidity into the system.

Around the same time, artificial intelligence sparked huge rallies for a few companies (the Magnificent Seven) that led the market for the rest of the year. Then in the final quarter, the transition from October’s “higher for longer” stance to the Fed’s “pivot” in December had a positive impact on both equity and fixed-income returns. This concluded a year in which the majority of indices recorded their highest returns of the past decade.

Now, as the year begins, many investors are wondering what to expect in 2024 after a magnificent 2023. While it may be logical to think that after such a good year, a bad one will follow, there are compelling reasons to remain positive about the next 12 months. The market continues to swing back and forth, which is exciting for some and dangerous for others.

The opportune moment to enter the market is when the fluctuations between extremes are less volatile. However, it’s important to acknowledge that these extremes will persist (which is precisely part of the market’s allure) and adapting to them is crucial. With proper management, they can present highly attractive opportunities for profitability. One of the lessons learned in 2023 is that the key is not necessarily being right but generating returns. To achieve this, it’s best to remain invested at all times.

Where are we now?

The year kicked off with some moderation after two spectacular months in terms of returns. Stock markets remain relatively stable as they await the results of companies for the last quarter and their outlook for the entirety of 2024. Meanwhile, fixed income has seen a bit more movement.

On the one hand, following the clearly accommodating message from the Fed in the final meeting of December, several regional Fed presidents have attempted to qualify Jerome Powell’s words, although for now, the message has been rather ambiguous.

In Europe, the first few days of the year saw an avalanche of debt issues (more than €120 billion), more than half of which came from public issuers. As a result (albeit for different reasons), interest rates have risen slightly at the beginning of the year, although the market continues to anticipate around five interest rate cuts throughout the year.

This is where we find the first inconsistency that the market will have to confront in the coming months: anticipating cuts exceeding 100 basis points would be logical only if the market foresaw a recession. However, the consensus still leans towards expecting inflation to persist on its trajectory towards the 2% target and growth to remain resilient.

Growth and Inflation

Although a recent report by the World Bank warned that global growth for the first half of this decade is on track to be the lowest in 30 years, growth expectations have barely moved over the last twelve months, albeit with nuances. In the United States, growth is consistently being revised upward, whereas in Europe, the trend is the opposite.

This divergence would neutralize the impact on global growth were it not for the fact that growth forecasts for China have been improving due to the expectation of new fiscal and monetary stimuli to help the country return to above-target growth. Despite the divergence and possible future trends, we should not lose sight of the fact that the figures in all cases (United States, Eurozone, China, and World) are positive, meaning economists do not expect a recession this year either, as we mentioned earlier.

Inflation expectations face practically the same situation, given that the levels expected at the beginning of 2024 are very similar to those we expected a year ago. The potential that inflation may not decrease as much as anticipated poses a significant risk for the upcoming year, as its trajectory strongly impacts the correlation between equities and fixed income.

Furthermore, the consensus scenario of a smooth economic landing is not entirely aligned with the notion of inflation continuing to decline at its current rate, especially considering the robust employment markets in both Europe and the United States.

Financial conditions: real rates and liquidity

With virtually no interest rate cuts yet, the various indicators of financial conditions point to an easing similar to what was observed during the post-pandemic period. It has been enough to wait for interest rates to lower sooner rather than later for financial conditions to erase at once all the monetary tightening caused by the abrupt and rapid rise in interest rates instituted by various central banks in the last year and a half. This move again undoubtedly clashes with the expectation of steep interest rate cuts — one of the risks we foresee at least during the first quarter.

Another factor partly explaining the change in financial conditions has been real interest rates: the fall in nominal interest rates of more than 100 basis points over the last two months has led to a significant decline in real interest rates (calculated as the difference between the 10-year IRR and 10-year inflation expectations).

Last but not least, liquidity reverted to neutral territory after a few months during which central banks significantly reduced the monetary base. This is quite positive for risky assets, although if central banks delay rate cuts, liquidity could contract again.

Conclusion

The situation is nearly identical to the end of November, except that with the start of the new year, the indicators reset to zero due to the “calendar effect.” Despite some moderation in the first days of January, market expectations remain somewhat inconsistent: on the one hand, the anticipated rate cuts are the product of an optimism that seems excessive and would only take place with the unequivocal support of central banks for the market. In no case would such rate cuts be justified at this time from the point of view of inflation and growth, so one of the three elements would have to correct.

The market movement will depend on how this correction occurs, but, as in other years, this new scenario will come to light in the first quarter, which could result in a highly volatile first few months of the year. In addition to the above, there is a substantial number of upcoming electoral processes in the coming months. While it doesn’t make sense to make investment decisions based on their potential outcomes, they will introduce an additional element of noise in the market.