By
Brett Lewthwaite
November 21, 2024
Sustained success and longevity in markets is seldom a function of luck, but rather the result of rigorous work,
unwavering principles, and a deep commitment to clients. The investing landscape is constantly changing due to
shifts in the global economic landscape, advancements in technology, or geopolitical changes. Likewise, a vital
component of our investment process is a focus on constant refinement, enhancement, and evolution. In line with
this, we have recently evolved our Strategic Forum, which will now be held twice a year, providing both an outlook for
the calendar year as well as a mid-year review.
Introduction
2024 started with debate about whether the aggressive policy tightening of 2022 would lead to a recession. However,
the narrative soon evolved to include speculation that interest rates would remain higher for longer amid a new
artificial intelligence (AI) technological revolution and era of fiscal dominance. This view essentially became uniform
market consensus right at the time almost all major global central banks started reducing interest rates – so much
for consensus thinking. In reality, 2024 saw modest growth for most major global economies, with the US being the
primary exception in terms of both economic growth and equity market performance. Indeed, the year appears to
be closing with another prevailing narrative: the US economy as the envy of the world – experiencing a period of
exceptional growth, coinciding with a potentially decisive general election.
US exceptionalism? For exceptional reasons
The US economy: The envy of the world? The prevailing market narrative suggests that the US may be experiencing
a period of exceptional growth. With equity markets hitting new highs and credit spreads reaching new tights,
financial markets are increasingly embracing the view of relentless US exceptionalism. Yet, upon closer examination,
what is genuinely exceptional is the ongoing, arguably excessive fiscal looseness that the US continues to pursue,
with US government deficits running higher than ~7% of GDP again throughout 2024. Through this lens it is little
wonder that economic growth remains resilient and continues to propel the perception of ‘it’s different this time.’ By
way of being exceptional, it is true that no other major economic region is running fiscal deficits close to that level.
Exceptional times? Or just exceptionally loose policy? This raises a key question about the sustainability of the US
fiscal deficit and whether fiscal looseness will continue post-election, into 2025 and beyond.
In our last Strategic Forum, we discussed the very real post-pandemic geopolitical shift from globalisation toward
a greater emphasis on national priorities, particularly in the US. This included 1) increased investment in national
security, 2) the dependable supply of essential needs, such as food, energy, and health; and 3) the paramount need
to stay ahead in the AI technological race and its influence on government sponsorship of all things infrastructure
related to support this goal. It is this geopolitical shift, executed via programs such as the Inflation Reduction Act
(IRA) and CHIPS and Science Act, that have contributed to the US fiscal deficit, culminating to form one of the first
genuine industrial policy programs in decades and adding weight to the idea that the era ahead will be characterised
by fiscal dominance. That being said, it is intriguing that the Institute for Supply Management (ISM) Manufacturing
Purchasing Managers’ Index (PMI®) indicates an ongoing contractionary environment for US manufacturers.
However, this is only half the story. The other half is the debt dynamics of the US. US debt levels continue to climb at
pace given the ongoing fiscal deficits, and increasingly due to the cost of servicing them, as seen in Figures 1 and 2.
Interest payments on debt are now the number one government expenditure item, and at the current level of official
interest rates, they are forecast to climb even higher. When combined with the reality that both political parties
appear indifferent and even additive to the current debt dynamics, many market commentators are increasingly
calling into question the sustainability of the current debt trajectory and its inevitable spillover into fixed income and
currency markets.
Figure 1: US federal debt and average interest rate
Figure 2: US federal debt interest payments
Source: Macrobond (November 2024).
Many are again asking who will buy all the bonds needed to fund this fiscal position, pressuring yields higher. This
concern is most visible in the recent movement in the price of gold, as seen in Figure 3. While we agree that US
debt dynamics do appear to be on an unsustainable path – and this is likely to cause episodic bouts of volatility
particularly in the long end of bond markets – we believe a more likely path forward is one where interest rates
are lowered materially, with the US Federal Reserve (Fed) returning to act as the buyer (or funder) of last resort,
ultimately supressing volatility and deferring the debt sustainability question even further into the future. That
may sound counterintuitive, but as we like to say, don’t focus on what should happen, prepare for what will
happen. In this case, prepare for lower rates and more liquidity, even as this further erodes the appeal of fiat
money and elevates the appeal of hard assets like gold.
Figure 3: Price of gold
Source: Bloomberg (November 2024).
The structural inflation debate remains
Against this backdrop of growing debt and deficits, it is understandable that the debate surrounding the potential for
a new era of structurally higher inflation continues to persist. The inflation discussion also garnered significant focus
in our Strategic Forum. Our analysis suggests that an approach focussed separately on the shorter-term cyclical
inflation pulse and the longer-term structural trajectory is sensible. Our previous research indicating inflation would
continue to fall throughout 2024 fared well. A detailed review of the evidence in October reaffirms our conviction
that the near-term influences of inflation continue to point to a further cyclical softening of inflation as we head into
the first half of 2025, as demonstrated in Figures 4 and 5.
Figure 4: US core inflation returning to target
Figure 5: US CPI ex-shelter below 2% target
Source: Macrobond (November 2024). FOMC: Federal Open Market Committee.
The longer-term structural environment deserves much more debate, leading to lower conviction. Particularly given
the re-election of President Trump and the associated ongoing fiscal looseness, with the potential to ignite the
structural narrative around higher inflation. The re-emergence of heightened concern in this regard could quickly
influence financial markets, especially the longer end of the US yield curve. With that said, it is worthwhile revisiting
both sides of the structural outlook for inflation.
In brief, the case for operating in a structurally higher inflation environment hinges on a few key narratives:
- The recency bias of the fading, yet severe, inflation episode and the lingering effects in the global economy,
resulting in heightened sensitivity to any further spikes in inflation. The adage that ‘once the inflation genie is out
of the bottle, it is very difficult to put back in’ remains front of mind.
- The seemingly broad acceptance of prolonged excessive fiscal looseness, instigated by the ‘break-in-case-ofemergency’ situation the pandemic represented. This led to a greater willingness and comfort among elected
governments to utilise ongoing fiscal looseness, which has been sustained by the shift in national priorities toward
domestic needs and security. When viewed alongside the commencement of global central bank easing, many may
conclude this risks overheating economies and thereby fanning the flames of inflation.
- Some commentators point to ongoing geopolitical friction and deglobalisation, with the associated onshoring and
friendshoring, as structural inflation forces. Likewise, inflationary fears are also attached to the energy transition
and associated ‘green-flation.’
- Lastly, the outcome of the preceding monetary policy era and globalisation era was widespread inequality, which
suggests that that underlying societal influences are shifting and will likely influence policymakers to once again
engage in policies that are more tilted towards inflation.
On the other hand, several drivers are likely to exert disinflationary influences on the global economy:
- Debt is now much greater than in 2007/2008. High debt (public or private) does not and cannot thrive in a higher
inflation world, with the ensuing higher cost of capital quickly impacting the indebted components of economies.
- Digitalisation is accelerating at an exponential pace. AI is effectively the discovery of an unlimited new workforce
and is a powerful, albeit less-discussed, deflationary force.
- Demographics remain the same. Aging populations tend to be disinflationary (as seen in Japan) and not to
mention the infinite supply of new AI/bot colleagues.
Ultimately, this debate could evolve in either direction. Our approach is to favour following the cyclical direction
of inflation while keeping an eye on policymakers and their potential to fuel the flames of the structurally higher
inflation narrative. On balance, we think the outlook for inflation is unlikely to be a structurally higher. The powerful
forces of both digitalisation and debt dynamics are individually deflationary. In combination, they have the potential
for significant societal changes, and herein lies the potential trigger that could indeed lead to a higher inflation
environment.
Structurally, the contained environment continues – at least for now
For years, we have written about the concept of the ‘contained environment’ with policymakers being forced to act
to alleviate crises, time and time again. We had thought that inflation would break the cycle, although as 2024 ends,
this increasingly appears not to have occurred.
The pattern of the ‘containment’ of risk or volatility first emerged via the trend of lower and lower interest rates,
then zero rates, and then unthinkable levels of quantitative easing (QE) and liquidity. Now, it seems to remain intact
by a shift towards fiscal policy and potentially endless government spending (fiscal dominance). Thus, the overarching
approach of supressing volatility in financial markets continues. While this sounds overly simple, an approach that
supresses volatility or risk in financial markets does not resolve it; it simply transfers the instability elsewhere.
This can be seen in the unintended consequences of widespread societal inequality, concentrated narrow financial
markets with a few big winners (e.g. the Magnificent seven), and increasing geopolitical tension.
In this light, narratives like ‘higher for longer’ are not supported by simple financial maths, unless an event
triggers the transferred risk or instability to erupt in conflict – whether that be internal social inter-generational
or external geopolitical - both of which are non-zero probabilities and are rising gradually. Recall that in 2007,
5.25% interest rates created the great financial crisis, and now in 2024 we have debt levels that are much higher,
with interest rates that are again around 5%. And yet, market pricing suggests everyone believes there is no
possibility that high debt levels amid high interest rates could lead to a recession. Further, the longer higher
rates persist, the more this dynamic will accelerate the concerns relating to debt sustainability. While it could be
argued that this should happen, it is more likely that higher rates do matter, and as such the opposite will happen
– there could be a notable shift to lower interest rates and more liquidity to ‘contain’ the associated volatility.
Where does it all end? Well, that is for a future discussion. To offer a hint, the answer is either in conflict – internal
societal or external, between nations – or in massive structural reform of areas such as exceptionally profitable ‘big
tech’. Such reform would likely benefit society greatly, though it may not be favourable for the very high valuations
of the mega-tech sector, which play a significant (currently upwardly) influential role in most global indices. However,
we have not reached that point yet. The pattern of increasing frequency of shocks and widening fault lines, although
contained for at least the foreseeable future, remains intact. Countries like Japan have been following this playbook
for nearly three decades. Understanding rapid technological advancement and the policy response to it is key to
understanding how long the ongoing ‘contained environment’ will continue. When it comes to technology and all
things AI, the value of knowledge is falling towards zero. With an apparently unlimited new workforce coming online,
none of us quite know what that means, good or bad. Exceptional times indeed.
Investment implications
As monetary policy is currently restrictive with real rates notably positive, interest rates should continue to fall.
Greater fiscal looseness likely results in increased volatility in long maturity bonds, and this will need to be supressed.
Putting those two together, our analysis favours owning solid levels of duration in portfolios and adding on moves
higher in yield. We remain cautious on credit and risk assets, primarily due to current heightened valuations, although
we seek to add on the inevitable volatility episodes given our view that policymakers continue to exhibit a keenness
to contain the environment and support it when needed.
To summarise – interest rates and bond yields are likely to move lower, and abundant liquidity conditions will likely
remain or be afforded as needed, encouraging a mindset of ‘buying dips’ in higher-risk assets. Meanwhile, it appears
increasingly sensible to hold real assets, including property, infrastructure, and yes, gold.
- Rates: Following clear signals from central bank officials that further easing is likely, bond markets have moved
to price in historically aggressive easing cycles by most major central banks in the coming quarters (with the
notable exception of the Bank of Japan, for which further hikes are priced). While this pricing may limit the extent
to which bond markets can ultimately rally, the fact that central banks have only recently commenced easing
cycles should limit the extent of any selloffs. We therefore expect higher yields to represent a buying opportunity,
while Fed easing and potential supply should pressure yield curves steeper. With superior relative valuations and
fundamentals in European and Australian markets, we expect these fixed income securities to perform better than
those in other developed world geographies.
- Credit: While spreads are already tight, a number of positive factors are expected to see credit trade in a relatively
narrow range in the medium-term. With monetary and fiscal policy set to provide more support to the growth
outlook than was earlier expected, fundamentals should be supported. Moreover, while spreads are tight, all-in
yields remain high relative to history, and expectations of positive total returns should drive demand. We have a
favourable view on sectors such as critical infrastructure, including electric, energy, and domestic banks. We prefer
BBB-rated credit over A-rated credit given event risk, with our BBB exposure being in relatively defensive sectors.
- Structured securities: Lower interest rates and a stable economic outlook is expected to be supportive of
structured securities fundamentals. Mortgage-backed securities spreads have been range-bound
year-to-date, but remain at attractive levels over investment grade corporates. On the commercial side, the
prevailing ‘no landing’ narrative is helping to avoid the worst-case scenario for the sector. We see potential
opportunities in high credit quality tranches at relatively wide spreads. Collateralised loan obligation
fundamentals are also benefitting from lower interest rates and valuations are screening attractive to investment
grade corporates.
- Emerging markets (EM) debt: EMs have continued their strong post-pandemic economic run. GDP growth
remains above that of developed markets, and the disinflationary trajectory remains intact. Outside of China, EM
government balance sheets are also looking healthy compared to their developed market counterparts, which is
exemplified by a large proportion of positive ratings outlooks. Given this resilience, we view the structural spread
pick-up in EM as currently offering fair value and remain strategically neutral, though we continue to watch
supportive technicals and opportunities in EM local currency bonds.
- Currency: Our view is that US dollar weakness will continue, driven by the Fed easing cycle and fading global
recession fears (with the market having less demand for a safe haven currency), though political outcomes in the
US pose a risk to this view. Conversely, we see pro cyclical currencies benefitting the most from this weakness –
such as the Australian dollar, which is supported by a lagging monetary policy easing cycle and increasing Chinese
stimulus measures. Elsewhere we are also positive on the Japanese yen as rate differentials continue to normalise.
We have less conviction on other major currencies (notably the euro and British pound), as their central banks are
increasingly easing rates in lockstep with the Fed.
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