In its global investment outlook for the coming year, Fidelity International outlines why it is important to adopt a scenario based approach which takes into account the complexities of the current global economic and markets cycle. A soft landing set-up could stay for some time, but as 2024 progresses the probability of a cyclical recession rises sharply.
Andrew McCaffery, Global CIO, Fidelity International comments: “I have never managed money on the basis that I know for certain what’s going to happen in 12 months’ time. I may have a view, but good investing needs discipline, an open mind, and a preparedness to react to the facts as they change. That said, what a year we have ahead. There will be an exceptional run of elections across the world during 2024 coinciding with a renewed interest in fiscal policy alongside the future direction of restrictive monetary policy.
“The world is always uncertain. But this is one of those periods when it is not an exaggeration to use the phrase ‘regime change’. Investors will need to stay nimble in 2024, ready to navigate each twist and turn.
“Markets are currently lined up behind a ‘soft landing’ where the rate hikes and the tightening of the past two years will do just enough to gradually return the economy and labour market to equilibrium. We have a different view. We think a soft-landing set-up is going to be a significant influence into early 2024 as a range of our proprietary macro and bottom-up indicators show a mixed picture driven by the delayed effect of the extra-ordinary fiscal stimulus, run-down of excess savings and a still benign refinancing picture. However, as the year progresses, we think the transmission channel will strengthen leading to a cyclical recession outcome. Europe is already feeling the pain of the rate hikes (as growth has slowed sharply) but the macrocycle path in the US is likely to remain more complex into 2024 as well.”
“The global economy continues to deliver surprises, but we are confident of one thing: it is that US and other developed economy interest rates have most likely peaked. And against this backdrop, growth will moderate with a high risk of a moderate growth contraction developing later in 2024, with both the domestic and geo-political picture remaining in flux as major elections approach, especially in the US.
“Turning to China, we think we have firmly entered a phase of controlled stabilisation as a cyclical recovery takes hold with growth likely to range near 5% next year as well, contrary to consensus expectations. The range of policy shifts, which started in July, are starting to bear fruit as the policy changes are deployed to cut the left tail risk to growth. We think domestic macro stability is likely to re-emerge in 2024 and a number of opportunities will arise as a result for investors.
A recession is coming, but the soft-landing set-up will take time to dissipate
“Resilience driven by fiscally supported consumers and companies has been the biggest surprise of 2023 despite the very aggressive tightening in monetary policy. The buffer of savings built up by households in the pandemic is almost drained, fiscal support is stabilising, and the pick-up in refinancing needs at a time of ongoing credit tightening will start to change the macro picture. However, these buffers still have further to run and the peak rates narrative, given moderation in growth and inflation, taking place currently will keep the soft landing scenario top of mind as we enter 2024.
“Fundamentally, we continue to think there is simply a lag between policy tightening and the effects on the real economy. The transmission channel is delayed, not broken. A moderate recession is likely to be the final outcome of this cycle, driven by restrictive monetary policy as the effects of lagged fiscal support melt away in the developed world - a reality Europe is facing already.
Alternative endings
“We still see room for other possibilities. Alongside a cyclical recession, to which we give a probability of 60 per cent over a 12-month horizon, our 2024 outlook considers the investment implications of a more severe balance sheet recession (10 per cent probability) that prompts widespread cutbacks in spending by companies and consumers alike and judders through the economy, even into 2025, driven by a disruptive reaction to very high real rates. We consider the chances of the more benign soft landing scenario (20 per cent), whereby the current set-up extends well into 2024; and a case in which there is no landing in 2024 at all (10 per cent), in other words, where the economy holds at above trend level of growth and sticky inflation, provoking central banks into another, albeit incremental, round of policy rate rises.
This scenario-based navigation map, underpinned by a suite of proprietary macro and bottom-up indicators, is critical to our investment process, which is embracing the reality of faster cycles and the need for flexible tactical asset allocation, as the old regime of “Great Moderation” starts to firmly fade into history.
How to invest in shorter and faster cycles
“As the cyclical recession outcome takes hold later in 2024, there would still be good opportunities for investors who are discerning about sectors and geographies.
“Parts of the US equity universe would be especially well positioned. In particular, mid-cap stocks look attractive along with much of the S&P 500 that have not shared the incredible performance this year of the ‘Magnificent Seven’ stocks ( Alphabet , Amazon , Apple , Meta, Microsoft , Nvidia , and Tesla). Valuations look reasonable for these well-run companies with solid growth prospects. US small-caps would be more challenged in a slowdown or recession scenario given their greater debt refinancing needs. But for now, we think momentum in global equities is likely to remain positive as the scope and breadth of the ongoing rally broadens.
“The reduction in bond yields leading to above normal positive returns for government bonds is another area we are focussing on as the interconnected and interdependent nature of soft landing and cyclical recession scenarios mean lower yields as the Fed starts to change policy next year (the extent of which will depend on the nature and timing of the scenarios). Here, intermediate-maturity IG bonds and inflation linked bonds offer value especially, if we are right about the cyclical recession outcome being the end point of the cycle (leading to a fall in real rates).
“We would take long positions in certain emerging markets, given attractive valuations and idiosyncratic economic cycles, but our preferences change depending on which scenario emerges. That said, China offers value especially as the macro cycle stabilises and expectations of growth for 2024 rise from current depressed levels and our base case scenario of cyclical recovery/controlled stabilisation firmly takes hold in the coming weeks and months.
“Also in the emerging market space, India and Indonesia are markets with good defensive qualities that are less tied to the global cycle. We also favour some emerging market local currency bonds (potentially with exchange rate hedging) as global interest rates decline, but without any significant growth concerns impacting the creditworthiness of major emerging markets.”
“In conclusion, we acknowledge the resilience factors that have sustained growth and the interconnected and interdependent nature of the various scenarios we have laid-out. We do foresee a transition towards a cyclical recession, but the path here passes through soft landing which is the current set-up as we head into 2024. The expected policy pivot from the Federal Reserve, despite relatively sticky core inflation is a key element of this outlook reflecting the complex interplay between structural and cyclical factors, which are at play alongside a backdrop of a visible increase in political noise as key elections approach.”
