Three scenarios for a new era of high interest rates
After a year that surprised most investors by the strong performances of both the bond and equity markets the meeting considered the outlook for 2024. What will determine the progress of markets from here will be what happens to inflation. Last year was extraordinary in witnessing an almost painless return to low inflation. Despite monetary stimulus tripling, a huge fiscal stimulus, and a sharp rise in interest rates, by the end of the year markets were celebrating a goldilocks scenario. The expected recession never materialised, employment has remained strong, and with inflation falling markets are pricing an expectation of six interest rate cuts in the US in 2024. If markets are correct, and the US economy can get away with extraordinary fiscal profligacy without generating significant inflation, then this is immensely bullish. If what appeared to be reckless stimulus has no inflationary consequences that would suggest that assets should be rerated to much higher levels. However, if markets are wrong to be dismissing inflation, then the downside could be considerable. The argument of Gavekal is that markets have been too sanguine, and investors should be much more cautious of asset prices which are now assuming a return to a long-term inflation rate of 2%. This is especially true of bonds.
Broadly, there are three likely scenarios for the next year or so. The first is the ‘immaculate disinflation’ that markets are currently celebrating. The second is that the economy slips into recession. The third, which is Gavekal’s favoured view, is that inflation will be more persistent, and long-term interest rates stay at a structurally higher level than the last two decades. Instead of the trading range of US and European bonds having a ceiling of 2%, the range is more likely to be 3.5% to 5%, and the risk is that this trading range turns out to be too low. This would be similar to the period that existed before the Financial Crisis of 2008, and prevailed through much of the 1990’s. The reasons to be concerned that inflation may not behave as well as hoped is that many of the structural forces that created the disinflation environment of the last forty years are running out of steam or going into reverse. These include deglobalisation, the ageing of western populations, the shifting balance of power globally, and the ongoing use of fiscal and monetary policy; even in a growing economy the US fiscal deficit is enormous. Therefore, it seems premature to declare victory over inflation. Moreover the 2% inflation target is now seen as a floor not a ceiling. Tighter labour markets and higher energy prices are also putting upward pressure on prices. Even if inflation does settle at 2% the market should price a real rate above that, and this real rate is likely to be above what has been experienced for the last couple of decades. The dismal economic recovery post 2008, described by Larry Summers as the secular stagnation, meant that the world was awash with excess savings, and this excess liquidity kept interest rates low. Following this long period of lacklustre economic activity, the world needs an investment cycle, and this will be capital intensive. Areas such as transport, housing and infrastructure are obvious examples. The energy transition is another. In Emerging Markets ex-China, a boom similar to that experienced by China may be starting to take place. In India forests of high-rise housing developments are springing up, with all the transport and energy demands that accompany them. Indonesia is showing similar strong growth. The combination of this capital investment will soak up savings and thus raise the demand for capital and keep pressure on interest rates to stay higher.
The conclusion is that the risk for investors is that the benign scenario that has been priced into the market in the last two months fails to materialise. Markets have taken such a strong view that inflation has been conquered that if inflation figures surprise negatively, that will be a nasty shock. The bond market would fall, and long duration assets decline in line with it. The better opportunities appear to be in the cyclical areas of the market, particularly those areas exposed to energy transition and infrastructure. In currencies the US dollar appears expensive, and with its ability to protect against inflation, Anatole is recommending an allocation to gold for the first time in more than twenty years. Currencies that look attractive include the yen which is exceptionally cheap, and the Norwegian krona and Swedish krona. Finally, investors should not lose sight of the possibility that some things may improve in 2024. Geopolitical concerns have cast a dark shadow over the last few years, but there could be better news over the coming months. If the pro-China candidate wins in Taiwan that would remove the risk of a confrontation with China. The Ukraine situation may also move towards some sort of settlement, probably one which recognises the current areas of occupation. Greater clarity in these areas would improve sentiment, and in the case of Ukraine allow for plans for rebuilding the infrastructure destroyed by the war. That alone would be a substantial economic boost to all the companies that are involved.