Investment Insights

Insight Q1 2024 - Soft landing?

OVERVIEW

We share the generally benign consensus outlook for the world economy in 2024: a continued decline in inflation and a soft landing for economic growth. In the longer-term there are important cross currents affecting prospects.

2024: benign outlook

Across the major advanced economies, inflation rates are retreating. The trend is clear in six-month annualised rates of change (see Figure 1) which have already dropped below 1% in the UK and eurozone.

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1. Inflation retreating

As 2024 progresses, there may well be bumps along the way as inflation retreats. Supply chain pressures have re-emerged in some areas (because of sea freight disruption, for example). But by the end of 2024 there are good grounds for thinking that inflation rates (measured in the conventional way, as 12-month changes) will be close to central banks’ 2% targets. This disinflation has been achieved without any major recession – notably in the US, where it was widely expected to occur in 2023. Indeed, from the summer of 2023, expectations for growth in the major advanced and emerging economies have trended higher (see Figure 2).

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2. Forecast 2024 GDP growth: advanced and emerging economies

Around the base case of a ‘soft landing’ remain two risks. First, of a recession, notably in the US. We would put around a 25% chance on such an outcome. Leading economic indicators, yield curve inversion and the collapse in broad money growth all indicate the possibility. A coincident indicator of recession – based on the unemployment rate – does not yet signal such a downturn but will be closely watched. A mild recession could still, however, be consistent with current consensus expectations of US growth above 1% year-on-year. The second risk, to which we ascribe a 10% chance, is one in which US growth carries on at a rate close to 2% supported, in particular, by a strong labour market, the continued run-down of household savings and the easing of (particularly mortgage) interest rates.

Longer-term developments

Although John Maynard Keynes famously stated that “in the long run we are all dead”, it is increasingly important to consider longer-run prospects now that the volatile performance during and after the pandemic has receded into the distance. These will condition the environment for financial markets in the years to come. We consider three factors as of the greatest importance.

Generating growth

First, how much real economic growth can be generated. This is determined by demographic trends (population growth and the proportion the population that are participating in the economy) and productivity growth. These determinants are shown in Figure 3 for the major economies. For the US, they point to longer-run growth of around 2% p.a. (around 0.5% population growth, little change in the participation rate and 1.5% productivity growth). In Europe, the rate is lower (due to a shrinking workforce and lower productivity). In China the population is set to shrink over the next 15 years, a trend which deteriorates further as the horizon is extended. An ageing population will mean the proportion of the population working is likely to decline – meaning all of China’s growth will depend on productivity gains. India and Indonesia look set to be the strongest-growing economies, as productivity improvements are complemented by demographics.

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3. Major economies: longer-term growth drivers

Globally, we are optimistic that the productivity trend can improve. That is one of the key themes of our 2024 Outlook. The effects of generative artificial intelligence (AI) are already being seen and could boost US labour productivity by 0.1% to 0.6% p.a. up to 2040, according to one estimate. In the rest of the world, trade restrictions, in areas such as high-technology products, could impede productivity gains for some economies although ‘frugal innovation’ is a key theme in many emerging economies.

One important factor driving productivity gains and growth will be investment in the new clean energy infrastructure. By the 2030s, this is estimated to require annual investment of over USD 4 trillion per year (see Figure 4).

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4. Investment required for Net Zero

Public versus private sector financing How to finance that spending is the second main longer-term theme. Raising more in tax revenues to finance new spending is constrained by the fact that government tax revenues are already high – close to historic highs – in most advanced economies (see Figure 5). The appetite for tax increases is low. More tax could be raised in developing and emerging economies, a major theme of the IMF’s recent recommendations. They claim there is ‘low hanging fruit’ that can be harvested – notably by removing fossil fuel subsidies. The scope is large. Globally, fossil fuel subsidies were USD 7 trillion in 2022 and are expected to be USD 8 trillion by 20305 – twice the anticipated clean energy infrastructure investment. Again, however, the appetite for phasing out such subsidies is low.

Pressure on real interest rates

Realistically, therefore, much of the financing for the clean energy infrastructure will need to come from the private sector.

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5. Government revenues

That is one reason why real interest rates have been under upward pressure recently. 10-year real yields in the US have risen to around 2%, from significantly negative levels two years ago. Interestingly, that is well above the 0.5% real longer-term Fed funds rate implied by US Fed policymakers (see Figure 6).

Longer-term real rates are normally higher than short-term rates: the yield curve is upward sloping. Our assessment is that a 1% real Fed Funds rate and a 1.5-2% real 10-year rate are broadly appropriate. Assuming inflation credibly and sustainably returns to 2%, that would translate into an equilibrium Fed funds nominal rate of 3% and an equilibrium nominal 10-year bond yield of around 3.5% to 4%. The bond market is close to that level already. The futures markets suggest the Fed funds rate will get to a 3% level by early 2026. It could well reach that level sooner if inflation falls quickly or the chance of a recession is seen as higher. The Fed will likely remain data dependent.

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6. Longer-term real interest rate expectations

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