A key focus in the first half of this year will be on where policy rates will peak. They have not peaked yet. The risks are that monetary policy is tightened too much, or equally that rates rise further than markets expect as core inflation proves more stubborn and global geopolitical pressures prove more unpredictable and damaging.
But if rates peak by this summer, as markets expect, and inflation decelerates as predicted, then economic sentiment may turn more positive than is expected now, as we move towards the second half of this year.
The issue for markets
However, the big issue for markets remains the end of cheap money. Japan’s policy tightening is a clear indication of this and raises questions about the yen no longer being seen as a funding currency in the way it has recently – only last autumn, the market was viewing the yen as a weak currency against the backdrop of previous Bank of Japan policy. That has now changed.
Also, the end of cheap money – particularly in economies like the UK – may raise questions about the property market. And, in terms of the markets, the end of cheap money raises the issue as to whether we should think in terms of rates reaching a plateau as opposed to a peak this year – but this is not where the market or policy debate is.
‘The good, the bad and the uncertain’ is how I described prospects in surveys at the end of last year and the start of this:
- The good being that inflation will decelerate and this will allow economic prospects to improve as the year progresses.
- The bad is that growth will be weak, especially in the first half of the year, before recovering.
- The uncertain is where inflation will settle, how high interest rates will rise, and how leveraged sectors including property as well as economies will cope with the ending of cheap money.
The state of the world economy
Confidence and sentiment are key drivers of markets. And how things start the new year can always set the tone. In this respect, the last few weeks are interesting as they may signal a shift in sentiment towards a more positive mood.
Overwhelmingly, the year ahead surveys are downbeat. For instance, a survey of CEOs globally, released to coincide with Davos, was described as the most pessimistic ever. It mirrors the downbeat surveys of economists at the start of the year in the FT and The Times – although their focus was on the UK.
Despite this, the mood appears to be shifting towards being less pessimistic, and while it would be premature to describe it as more upbeat, it appears more constructive. I would suggest there are three key factors here:
- The markets had already discounted much pessimistic news about the growth outlook.
- Greater belief that inflation has peaked and will fall. Even though inflation looked like it had peaked a few months ago, and this was being talked about, the belief has only recently emerged that this is indeed the case.
- Newer news has been positive: this includes China’s abrupt decision to open up, plus some slightly better than expected economic indicators, such as US jobs and UK GDP.
There are reports that major US investment banks are revising higher their forecasts for US and global growth. Also, it was noticeable that the IMF chief kept stressing recession and that one-third of countries would be in recession at the end of last year, but recently, based on the same growth forecasts, she was emphasising growth would bottom this year and pick up in 2024. The IMF is forecasting global growth slowing from 6% in 2021 to 3.2% last year and 2.7% this, with one third of countries in recession.
In global surveys of economists, the positive factors that are quoted include: the strength of household balance sheets, resilience of labour markets, inflation peaking, the opening-up of China, the resilience of emerging market economies, plus other specific issues such as diversification of supply-chains away from China.
The green agenda is also cited as a positive for global growth, but one might view this as a structural, and less of a cyclical, issue.
Despite a likely global recession, there is a sense that the backdrop for emerging markets has improved, with monetary policy tightening across emerging economies having run its course – as inflation has peaked, and the external environment has shifted; as the dollar is no longer expected to keep appreciating and is off its highs; as US policy tightening is near its end and China, and with it world trade, is expected to recover as the year progresses.
Of course, caveats are needed when viewing present sentiment:
- Even if the data may have been better than expected, it is still consistent with a weak global economy and growth this year will be lower than last.
- While inflation (in western economies) is decelerating it is still high – being higher than wage growth in most countries, including the UK, and it is still way above policy rates. The latter reflects the extent to which central banks (including the US Federal Reserve and Bank of England) were slow to anticipate the rise in inflation, even though monetary policy has been tightened over the last year. Thus, it is still likely that monetary policy – including in the US and UK – will be tightened further.
- Although the markets are expecting further rate hikes, the improving sentiment about inflation is leading to hopes that rates will not peak any higher than previously feared and also in the US to a belief that softer growth will trigger US rates to fall next year. This anticipated lag between rates peaking and then subsequently falling seems remarkably short. I think it is premature for markets to believe that rates will peak this year and to then fall next.
Please note, the value of your investments can go down as well as up.
