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.
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.
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.
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%.
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.
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).
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%.
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).
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.
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.
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,
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:-
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
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.
Long term inflation
Some commentators believe that Inflation may stabilize at a higher level given higher costs from :-
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.
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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By
Kristal Advisors
December 24, 2023
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We are licensed in Singapore, Hong Kong and India. Kristal Advisors (SG) Pte. Ltd. presently operates under the CMS license by the Monetary Authority of Singapore (MAS). Kristal Advisors (HK) Ltd is licensed and regulated by the Securities and Futures Commission (SFC) to carry out Type 4 and Type 9 regulated activities and is not involved in the discretionary management of any collective investment scheme. Kristal Advisors Private Ltd. presently operates as a Registered Investment Advisor under the jurisdiction of the Securities and Exchange Board of India (SEBI).
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Copyright © 2023 Kristal Advisors (SG) Pte. Ltd. UEN: 201711235E
WE ARE LICENSED IN SINGAPORE, HONG KONG, ABU DHABI, AND INDIA. KRISTAL ADVISORS (SG) PTE. LTD. PRESENTLY OPERATES UNDER THE CMS LICENSE BY THE MONETARY AUTHORITY OF SINGAPORE (MAS). KRISTAL ADVISORS (HK) LTD IS LICENSED AND REGULATED BY THE SECURITIES AND FUTURES COMMISSION (SFC) TO CARRY OUT TYPE 4 AND TYPE 9 REGULATED ACTIVITIES AND IS NOT INVOLVED IN THE DISCRETIONARY MANAGEMENT OF ANY COLLECTIVE INVESTMENT SCHEME. KRISTAL ADVISORS PRIVATE LTD. PRESENTLY OPERATES AS A REGISTERED INVESTMENT ADVISOR UNDER THE JURISDICTION OF THE SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI). KRISTAL.AI MIDDLE EAST LIMITED IS LICENSED AND REGULATED BY THE FINANCIAL SERVICES REGULATORY AUTHORITY (FSRA) FOR CAT 3 A LICENSE.
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