Macroeconomics, Geopolitics, and Strategy - January 2024

Core services remain pivotal to the disinflationary process

Recent Q4 2023 inflation data in the Euro Area, UK and US, on net have surprised on the downside, with year-over-year (YoY) rates of headline inflation now standing at 2.9%, 3.9%, 3.4% respectively, prompting expectations of a faster than expected reversion to target.

A rapid disinflationary trend, more dramatic in headline than in core, has been at work across Developed Markets (DM), helped by very favourable base effects on energy prices which are now set to progressively fade and become less prominent, if not marginally adverse. The expiry of the special measures implemented by national governments, particularly in Europe, to reduce the impact of the energy shock back in 2022 may temporarily lift the energy contribution to headline inflation and add to nearterm volatility. Thus, while the general disinflationary process is poised to continue (we expect goods prices to continue falling in 2024), we also believe that the “easier part” of the disinflationary process is past and that the path to bring core inflation back to target will require a substantial moderation in demand and growth. Though core CPI remains above target in all three regions – US (3.9%), UK (5.1%) and Euro Area (3.4%) – macroeconomic policy settings, especially monetary policy, are sufficiently restrictive to deliver this growth slowdown.

Normalised supply chains, expected sub-par economic growth and a shift in domestic demand from goods to services point to a continued price moderation across core goods in 2024, as part of a global phenomenon which should similarly impact the US, UK and Euro Area.

For core service prices, though, the dynamics remain more complex: while economic growth has been moderating progressively, demand for services remains resilient, supported by ongoing healthy wage growth, thus keeping pricing power and price levels elevated in the service sector. As such, we think that a significant moderation in labour market tightness and wage dynamics will be key to keeping inflation stable once it is around central bank target levels. The weak growth we expect for 2024 should help on this front.

China: Housing turnaround ahead?

India: Easing activity in December

Broad industrial and manufacturing indicators still outline robust economic momentum early in the quarter, despite December’s PMI softening across the board (54.9 from 56). Domestic demand leads external demand with new orders at 57.3 and export orders at 53.2. Food prices, the most erratic and relevant component, drove overall inflation up to 5.6% YoY in November from 4.9% YoY, by contributing 3.7%. The December Inflation reading is expected to reach 6% YoY.

More and more CBs approaching the pivot

2024 a year of bigger downside risks

For those wanting a binary assessment of risk: our base case (around 60%+) across the board is that the big geopolitical hotspots should not boil over next year. However, it is important to note that 2024 will seem like 2023 with even higher risks (rather than be like 2018). This means we will likely see downside surprises given the amount of risk in the system and the appetite by some powers to exploit vulnerabilities to weaken the US and its allies. We have revised up the downside risks to many of our geopolitical scenarios for this year. In many instances, this risk is as high as 40%, meaning it is best to be prepared and think through the implications of what could occur should such a risk play out.

In Israel, while the base case that the conflict stays ‘local’ remains, current developments are a reminder that the risk of broader regional escalation remains acute. While Iran is unlikely to directly involve itself, there is a growing likelihood that Israel may decide to strike Iran.

With regard to relations between China and Taiwan: we expect a more China-hawkish government to be in place after the January election, so tensions with China will likely rise. Even if the more China-friendly opposition wins, while relations between Taiwan and China would improve, they would likely deteriorate between the US and Taiwan and therefore between the US and China.

For Russia/Ukraine, continued fighting is the most likely scenario for most of 2024, with Russia likely going on an offensive ahead of the US elections.

Eurozone: mind public debt divergences

Fiscal consolidation is essential. Persistent upward pressure on spending and higher interest charges are complicating governments' tasks. The 2024 budgets allow for a reduction in public deficits, thanks to the removal of temporary measures and an expected return to growth. But official GDP growth forecasts are too optimistic.
The debt of certain countries (France, Italy and Belgium) will hardly stabilise. This means that ambitious countercyclical fiscal policies are a thing of the past.

In Germany, the debt-brake rule imposes a form of fiscal consolidation that is difficult to reconcile with Germany's structural weaknesses and risks being counterproductive in a period of recession. This consolidation is likely to harm potential growth, particularly if investment plans are scaled back.

In France, the savings made by cutting energy-related supportive measures are offset by increased spending in other priority areas. The government expects the deficit to return to 3% of GDP, but not before 2027.

In Italy, the debt burden continues to hamper the fiscal outlook. Reductions in public spending are limited to a gradual reduction of the temporary spending related to Covid and the energy crisis. This reduction is likely to be offset by an increase in debt servicing. Rather than raising taxes, the government plans to stimulate growth through a €250bn national stimulus programme.

In short, the Eurozone lacks ambition. This could come at a high price.

Central and alternative scenarios

Risks to central scenario

Cross Asset Sentinels Threshold (CAST)

What is the model about?

• The rationale: CAST is Amundi Investment Institute’s (AII) model to assess the extent to which financial conditions pass through to corporate fundamentals and valuations. As market risk perception tends to be correlated with financial conditions, a deterioration in the latter would point to an increasingly defensive asset allocation.
• Model setup: CAST consists of five selected sentinels, which aim to generate the probability of markets being in risk-off mode. An alert threshold is estimated for each sentinel and represents the level beyond which the sentinel has historically flagged an episode of elevated market stress and heightened risk aversion. Indeed, thresholds can be seen as signposts of excessive market complacency for investors and signal a possible turning point for risky assets.
• Model output: as the sentinels move towards their threshold levels, market risk perception increases and the probability of a risk-off phase rises exponentially if such a level is exceeded.
   

Equities in charts

Bonds in charts

Modest oil upside still ahead

Higher non-Opec supply and a loosening of Opec+ discipline were key caps for oil prices. US output surprised on the upside in 2023, thanks to improved drilling techniques while tapping into the reserves of wells near completion. The well inventory now needs to be rebuilt and the price incentive for shale producers is less attractive, which would limit future surprises from US output. Also, OPEC+ is yet to deliver on its recent cut commitments, even though compliance on quotas will be harder to achieve.

The fall of the USD and the “early cycle signal”

The USD sold off aggressively in Q4 2023, with no exceptions across G10. While the negative December USD seasonality certainly played a role, the main drivers of the move were a combination of weak US economic data and a dovish Fed meeting in December. The FX reaction seems consistent with the positive performance of both bonds and stocks during that time, yet we feel the rapid USD catch-up to its fair valuation seems premature and implies caution when chasing the market from here.