The turnround of the US economy, starting last year, has been the most dramatic, while the UK and European economies stagnated. Yet inflation has fallen throughout the developed world and wage inflation is following suit, though there has been no rise of unemployment, even during the ‘technical recession’ in the UK.
Low unemployment has removed the pressure on central banks to make urgent cuts. However, we already see clear signs that wage inflation is on track to fall into line with central banks’ inflation targets. Therefore, we expect that interest rates will be cut more than currently discounted by investors.
Elections are an important consideration for investors this year. With the race for US President and Senate too close to call, the radical agenda of the Trump 2025 project contrasts with the more familiar prospect of a second Biden term. In the UK election, Labour is the clear favourite, but also has a surprisingly radical agenda.
Falling inflation and lower interest rates will support returns from both bonds and equities. Equities will also gain from the economic boost from those same interest rate cuts. However relative valuations are in favour of bonds.
UK moves ahead on economic surveys
Figure 1: Composite Purchasing Manager's Indices
Source: Columbia Threadneedle Investments and Bloomberg as at 26 February 2024
The US economy loses momentum, but remains on track.
Last year the US economy was the biggest upside surprise to growth. This year we expect it to be a mild disappointment.
The US consumer has spent down their ‘Covid piggy bank’ and so future spending growth is likely to lag growth in earnings as savings are rebuilt. US inflation, having fallen sharply, may be slower to fall further as the tight rental market represents a huge proportion of the consumer price index versus the smaller (and more realistic) weighting for the UK and euro zone.
That loss of momentum of the US economy does help to push down hiring and wage inflation and should be sufficient to persuade the Federal Reserve (Fed) that it can start cutting interest rates.
We see little risk of a recession as wage rises are still running ahead of falling consumer inflation, providing US consumers with real income gains. Financial conditions have eased, and interest rates cuts should further support confidence.
Figure 2: US business hiring plans are tumbling
Source: Columbia Threadneedle Investments, Bloomberg and Macrobond as of 19/03/2024
The consensus on the UK economy remains too pessimistic.
A solid, if unspectacular, UK recovery is my largest out-of-consensus call, but the one in which I have most confidence.
UK wage growth is currently rapid on a year-on-year basis and the 9.8% hike in the minimum wage is imminent. That is a potential problem for inflation and the Bank of England. However, consumer price inflation is set to move down to the Bank of England’s target and remain there for the next 12 months. Indeed, it is likely to fall significantly below the 2% target in the next few months.
Wages outstripping falling inflation will deliver a much-needed boost to real incomes. But UK consumers could easily increase spending even more if they cut back their level of savings from current peak levels.
We can already see the impact of these positive factors in the dramatic turn round of the UK housing market. I had originally forecast a 10% fall in house prices, peak to trough. However, the market only fell 5% and I now expect those losses to have been reversed by the end of the year.
Figure 3: Housing set to recover
Source: Columbia Threadneedle Investments and Bloomberg as at 19 March 2024. RICS = Royal Institution of Chartered Surveyors
Falling inflation to boost real wages and allow for interest rate cuts in Europe as well
You get a misleading impression of the strength of the European economy if you look at the slump in Germany, particularly German manufacturing. Elsewhere, such as Spain, the consumer has been more positive.
Wage growth is currently far too high. However, the spring wage round is likely to produce a sharp reduction that will put the European Central Bank (ECB) in a position to cut interest rates at its June meeting.
Those wage increases, especially by comparison with falling inflation and energy bills, will deliver a recovery in real incomes after a tough period for the consumer. Consumer spending could easily anticipate further gains in purchasing power if rising confidence allows consumers to spend some of their accumulated savings.
Figure 3: Euro Area, indicator of negotiated wages %yoy
Source: Columbia Threadneedle Investments and Macrobond as at 19/03/2024
Lower interest rates make bonds and equities attractive; gold to shine.
Continued growth, falling inflation and interest rate cuts provide a positive background for investment returns. We like both equities and bonds, though relative valuations make us prefer bonds.
Valuations suggest that equities are expensive, and they could become more so over the next 12 months. That valuation gap for US equities is largely the result of the ‘Magnificent Seven’ which have driven margin and profits growth while the remainder of the S&P 500 has seen a net decline. However not all of the Magnificent Seven appear equally magnificent, we prefer the strong profits growth from the developing AI market.
A valuation gap has also appeared for gold. The gold price has risen in defiance of higher interest rates that would normally reduce its attractiveness. We see a fundamental shift in demand after the freezing of Russian foreign currency reserves and some 2000 related individuals and entities. The recent decision to apply the interest from some accounts to the reconstruction of Ukraine confirms the shifting nature of ‘safe haven’ assets and that is likely to favour gold.
Figure 4: Gold up by 31% since Feb '22 despite adverse fundamentals
Source: Columbia Threadneedle Investments, Bloomberg and Macrobond as of 19/03/2024
