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The hard part is over

The global economy has outperformed expectations in 2023. GDP growth is on track to beat consensus forecasts from a year ago by 1 percentage point (pp) globally and 2pp in the US. Core inflation has declined substantially across economies that saw post-pandemic price surges, falling from 6% in 2022 to 3% sequentially.

This positive performance came despite several unexpected negative shocks, including higher-than-expected interest rates, banking sector instability in the spring, and the Israel-Hamas war. However, the improvement in growth and employment, coupled with much lower inflation, represents even better news than initially apparent. Core inflation has fallen more than three-quarters of the way back to central bank targets across relevant economies since late 2022.

The disinflationary progress is widespread across price index components and economies. Goods disinflation still has further to run as the impact of normalized supply-demand balances filters through. Shelter inflation also has considerable room to decline, particularly in the Euro area and UK. Nominal wage growth is slowing meaningfully toward target-consistent levels, reducing the risk of second-round inflation effects.

On average, analysts expect core inflation across the relevant economies to cool to the 2-2.5% range broadly consistent with major central bank targets by the end of 2024. If anything, achieving target-consistent inflation may occur on the earlier side. The improvement in inflation outcomes and the sharp decline in headline rates means central banks have achieved their objectives without necessitating a recession.

Several factors support continued growth outperformance in 2024. Strong real household income growth should underpin consumption in the US and accelerate in Europe as the energy crisis fades. The biggest drags from monetary and fiscal policy are behind us. Manufacturing activity is poised to recover from a subdued 2023. Central banks are more willing to deliver “insurance cuts” if growth slows markedly as inflation normalizes.

Most major central banks have likely finished hiking rates, but our baseline sees no incentive for rate cuts until late 2024 absent a weaker-than-expected growth outcome. When policy rates ultimately settle, they will likely remain above central banks’ estimates of longer-run sustainable levels. The Bank of Japan will exit yield curve control in 2024H2 as inflation remains above target. Near-term Chinese growth should benefit from policy stimulus, but its multi-year slowdown will likely continue.

These baseline forecasts represent a supportive macro backdrop for asset markets. However, valuations on many risk assets are richer than normal, limiting potential outperformance versus cash. Government bond valuations have improved significantly with higher real yields. US rate volatility remains too high and is likely to fall in our central case, benefiting mortgage-backed securities.

We expect positive but modest returns in the mid-single to low-double digits for bonds, credit, and equities in 2024 as valuations constrain upside. Commodity prices should rise with supply constraints and steady demand growth, adding to returns. Outside potential supply disruptions, deeper oil price upside may be limited by production responses.

The transition to higher interest rates has been bumpy, but investors now face the prospect of much better real returns on fixed income assets than in the post-GFC era. Resilience looks surer for the US growth story than elsewhere, especially in Europe where sovereign stress could reemerge without diversions to US growth. Absent material upside surprises elsewhere, dollar strength is likely to persist.

While our baseline forecasts call for above-consensus GDP growth in 2024 across most economies, compressed risk premia and markets pricing our central case limit potential outperformance. Each asset offers protection against a different tail risk, so a balanced portfolio replacing 2023’s cash focus is preferable. For those assigning higher recession probabilities, a greater tilt toward bonds makes sense.

Elevated uncertainty persists. Downside risks surround our policy rate forecasts given convincing disinflation progress. Manufacturing weakness raises the possibility of a delayed recovery. Geopolitical escalations could disrupt trade. US resilience looks surer than elsewhere, especially Europe where higher rates endanger debt sustainability without offsetting US growth. The dollar is likely strong absent diversions to major economy growth.

In summary, 2024 should see the global economy escape the post-GFC environment of low inflation, zero rates and negative real yields. While risks remain, the transition to more normal monetary and economic conditions has opened the door to meaningfully positive real returns across asset classes for the first time in over a decade. Selective risk-taking against different tail risks within a balanced portfolio is preferable to an outright cash focus.