KRISTAL IC’S 2024 OUTLOOK

In 2024, US and European stock and bond markets will be driven by the type of anti-inflationary measures that the Fed and ECB take going forward. Wrong measures will likely lead to a hard landing, the right ones could result in a soft or even to a ‘no landing’ scenario. We first discuss the causes of the Great Covid Inflation and then describe the ‘right’ and ‘wrong’ anti-inflationary measures that the Fed and ECB can take in 2024.

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What, relatively, was more important in causing the Great Covid Inflation, - demand or supply-side factors?

Covid put the global economy through some very strange contortions. In the 2-year period from March 2020 to March 2022, the US government put USD 6 trillion into the hands of the individuals (see chart below), while the Eurozone injected about EUR 3 trillion. To give context, the US’s GDP is only USD 27 trillion.

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The production of goods and services decreased due to lockdowns and supply chain disruptions. The increase in demand (cash infusion) and reduction in the supply of goods and services resulted in explosive inflation (light purple line above). Some of the largesse found its way into stock markets (blue line up till end 2021) with ‘work-from-home’ punters goosing up meme stocks while riding Peloton bikes.

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Economists debated fiercely whether inflation was transitory (supply-driven) or structural (demand-driven). Leading economists on the demand side felt that the only way to cut inflation was by increasing interest rates and inducing a recession. After backing the ‘transitory’ school through 2021, the Fed capitulated in early 2022 and in a series of unprecedented hikes took the Fed funds mid rate from 0.25% to 5.375%.

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Inflation fell steadily in 2023, but against the expectations of all economists, not only was there no recession but in fact, the US and global economy (barring China) grew at a robust pace.

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How did inflation fall without a recession?

With the benefit of hindsight, it is becoming clear that while monetary stimulus (demand-side factor) did abet inflation, supply-side reasons were relatively the more important cause of inflation. As lockdowns were rolled back, manufacturing capacity came back online, supply chain constraints eased and pent-up demand was met. Inflationary pressures eased first in goods and then services. There were many speed bumps along the way, including the war in Ukraine, but every component of the CPI basket, including fuel and wage growth, trended down in 2023, except housing (rent).

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The rent index used in US CPI and PCE calculations (blue line in chart below) takes the average of all outstanding lease rentals, many of which were signed more than a year ago. However, current rent indices like Zillow (black line) that show the average of all leases signed in a particular month, have fallen sharply. If the CPI rent index, currently at 6.86%, falls to the Zillow index level of 3.23% then overall CPI would be very close to the Fed’s target level of 2.0%.

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What anti-inflation measures will the FED take in 2024?

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If the Fed believes that demand-side factors were the primary cause for inflation then it may persist with its ‘higher-for-longer’ rates as well as ‘Quantitative Tightening’. But such a path could result in prescribing an overly strong medicine for an inflation problem that appears to have been dealt with. Real interest rates (Fed funds rate minus inflation) are already rising to recession-inducing levels as inflation falls (see chart below).

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The sharp rises in interest rates are already beginning to bite smaller corporate and lower-income strata of the population. Continued unemployment claims are going up as are credit card delinquencies.

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The overall US economy is still robust but sustained high real interest rates could upend the economy. Much of corporate America raised debt in the zero-interest era but that debt will all start coming due for refinancing over the next few years putting added pressure on corporate earnings and equity prices.

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Thus a tighter rates environment would induce an unnecessary recession and a Hard Landing. Once the recession bites, the Fed would be forced to cut rates at a later point in time. In this scenario,

Equity markets, high-yield debt and Commodities are likely to suffer
Investment grade bonds, after the cuts in rates, would do well

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On the other hand, the Fed is well aware of the delicate balance between demand and supply-side dynamics. The following are grounds for optimism for a Soft Landing; the latest FOMC meetings recognised the following:-

The results of rate changes take about 12-18 months to start showing. The Fed knows that the real slowdown in the economy may just be beginning.
The Fed has a dual legal mandate, to control inflation and to maintain growth.
As mentioned before, every component of inflation is falling.
The Fed Chairman has suggested that a mistake was made in being too late in raising rates and they don’t want to repeat the mistake be being too slow in cutting them, especially, in a very very crucial election year.

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If the Fed were to begin cutting rates, even if only at a pace proportionate with the fall in inflation (so that real rates remain stable) then

Equities, high-yield debt and commodities would rally nicely
IG bonds would do well but not as well as the above.

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Other regions

Eurozone: The eurozone has seen a sharper slowdown in inflation and may see cuts sooner because its economy is in a more delicate state.

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China: Ruchir Sharma, chair of Rockefeller International, wrote in the FT that for the first time in 40 years, China’s share of the world economy shrank as per the Chinese government’s own figures. The two-year drop of 1.4% is the largest since the 1960s. The world economy is expected to grow by USD 8 trillion in 2022 and 2023 to USD 105 trillion. China will account for none of that gain, the US will account for 45%, and other emerging nations for 50%. Half the gain for emerging nations will come from just five of these countries: India, Indonesia, Mexico, Brazil, and Poland. That is a striking sign of possible shifts to come.

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EM, like Brazil and Mexico, increased interest rates, before the US, when they foresaw inflation. They are likely to begin cutting rates soon. Their asset markets are likely to do corres

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India appears to be poised for a good run given its good macro and ‘friend-shoring’. It is an election year but the incumbent appears to be well positioned to retain power.

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Other Factors

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Black Swans
The wars in Ukraine and the Middle East are exacting a heart-rending humanitarian toll. But they have not had any long-lasting impact on the global economy. However, any conflict over Taiwan or in the South China Sea would have a very significant impact on markets.

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Long term inflation
Some commentators believe that Inflation may stabilize at a higher level given higher costs from :-

Deglobalisation
Smaller workforce as the population ages (higher labour costs) and;
Climate Change costs

However, AI may increase productivity at lower costs. And perhaps the increasing frequency of natural disasters will finally drive us to our senses to take concrete action to save our planet, with a helping hand from lower costs of renewables and improvements in technology including in carbon capture and geo-engineering.

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Conclusion

The prospects for 2024 look quite good but one must remember that in December 2022 100% of the economists surveyed by Bloomberg predicted a recession in 2023. With luck the global economy will pull through. Our approach to investing, as always, will be to follow Deng Xiaoping’s advice - “cross the river by feeling the stones.”

Happy investing in 2024!

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Final Kristal Investment Committee’s View For 2024

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Disclaimer: The recommendations contained herein are for the exclusive use of the investors and prohibits any form of disclosure or reproduction. The content cannot be relied upon by any other person for any other purpose. The recommendations are information provided to the investors and are subject to risks. Any recommendations including financial advice provided by Kristal.AI or its affiliates shall be subject to contractual understanding, necessary documentation, applicable laws, approvals and regulations. Though the recommendations are based on information obtained from reliable source and are provided in good faith, they may be valid only on the date and time the recommendations are provided and shall be subject to change without notice. Kristal.AI or its affiliates, does not make any representation, undertaking, warranty, guarantee, or other assurance as to the timelines, completeness, correctness, reliability, or accuracy of the recommendations herein. The investments made by the investors may suffer losses and the investor shall bear all the losses in connection with an investment. Kristal.AI and its affiliates accept no liability or responsibility whatsoever for any direct or consequential loss and/or damages arising out of or in relation to any use of opinions, forecasts, materials and data contained herein or otherwise arising in connection therewith.

Kristal Advisors

December 24, 2023

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