Rates and inflation are still issues but geopolitical shocks will feature highly this coming year

High inflation and surging interest rates dominated this year but geopolitics and economic fragility are likely to be the main concerns in 2024, says State Street Global Advisors.

People visit graves of Ukrainian soldiers on the Day of the Armed Forces of Ukraine, in the city of Lviv on Wednesday. Picture: AFP

High inflation and surging interest rates dominated in 2023, but geopolitical risks and a fragile economy appear to be the main concerns in 2024, according to State Street Global Advisors.

Rapid disinflation and decelerating growth make an elusive soft landing achievable.

However, with the full impact of rate hikes yet to be felt, central banks will need to manage a transition from policies built to lower inflation to policies that limit recession risks, State Street warns.

In addition, escalating geopolitical tensions and ongoing macroeconomic headwinds will continue to test economies, making 2024 a year in flux with many factors pressuring the path to global recovery.

State Street Global Advisors is the world’s fourth-largest asset manager with about $US3.69 trillion ($5.5 trillion) of funds under management. In its global market outlook, it says bonds are set to take centre stage next year and investors will need to be selective in their equities exposures.

Bond yields have fallen sharply in the past few weeks. However, the massive rise in yields since the pandemic has compressed equity risk premiums so much that investors are under less pressure to reach for riskier returns, until recently considered necessary to meet their portfolio objectives.

State Street says companies with more-resilient earnings and stronger balance sheets will be best placed to cope with interest rates, rising debt, and deteriorating consumer spending.

These “quality” stocks may allow investors to participate in expectations of stronger economic growth in coming years, while also offering downside protection in the event of drawdowns.

Positively, the normalisation of supply chains and moderating demand for goods after the Covid-19 pandemic speak to further disinflation despite recent volatility in energy prices.

“We see fixed income as a bright spot in 2024 given current yield levels, slowing growth, and continued disinflation,” says State Street Global Advisors global chief investment officer Lori Heinel.

But amid potentially heightened volatility and global fragility, State Street is cautious on risk assets like equities.

Emerging markets are expected to remain vulnerable given the global landscape, but the fund manager sees opportunities in emerging markets debt and some emerging market equities.

“In such challenging markets, it is critical to strike the appropriate balance, get portfolio implementation right, and retain flexibility to respond as clearer signals develop,” Ms Heinel says.

Global economies have been surprisingly resilient in the face of the sharpest tightening cycle experienced in decades, but the US and Europe are clearly slowing amid disinflation.

That economic resilience has now “largely exhausted itself”.

Global trade volumes are contracting, and industrial production is essentially flat.

Services demand has held up much better as post-pandemic pent-up demand was satisfied with a lag, but there are now signs of plateauing.

Past resilience does not equal immunity, especially when it is derived from unsustainable fiscal spending. Remarkably, the sharp disinflation over the past year hasn’t caused much visible damage to labour markets. “What was a hope a year ago has turned into reality,” says Heinel.

“Central banks, in their rate-hiking anti-inflation fight, have managed to restrict increased job openings without eradicating any jobs. That said, the ground becomes shakier from here.”

Moreover, she says the time has come for central banks to end their tightening cycle.

In the US, where disinflation is more advanced and where shelter inflation is bound to meaningfully moderate in coming months, she thinks the Fed should deliver at least double the 50 basis points worth of 2024 rate cuts envisioned in its September dot plot, consistent with market pricing.

Without such a recalibration lower in US interest rates, there would be a “high likelihood that the soft landing morphs into something harder”. Positively, disinflation has broadened and deepened, such that central banks should start cutting rates even sooner than the market expects. “Disinflation will not run forever, but it is not over yet,” Ms Heinel says.

Recent updates show an impressive retreat in eurozone inflation. In the UK, inflation has started to experience meaningful declines from excessively high levels. In Australia, the early indication for the December quarter is that inflation is slowing as expected.

Of course there’s a risk that a much larger spike in inflation could ensue because of hostilities in the Middle East widen, or in the event of oil infrastructure sabotage or other unforeseen events.

But unless oil prices were to soar from current levels and stay above $US110 a barrel for several months, disinflationary forces in motion should overwhelm their inflationary impulse.

Despite the Hamas-Israel war that erupted in October, Brent crude oil has plunged about 24 per cent from a high near $US97 a barrel in late September to levels below $US75 a barrel amid weakening economic growth and scepticism about so-called voluntary production cuts by OPEC+.

Increasingly volatile geopolitical conditions will warrant investors’ attention though. State Street says the coming year is “fraught with potential fracture points, particularly around territorial conflicts and geopolitically critical elections”.

“In total, we consider they pose enough risk to be more inflationary, thereby derailing the disinflation trajectory and disrupting terms of trade for large economies,” Ms Heinel says.

The concern is that geopolitical shocks could deliver stagflationary impulses as the number and intensification of armed conflicts and violence rise rapidly.

“This reflects an increasingly multipolar, unstable world, which suggests that interstate warfare is easier to imagine than in the past,” Ms Heinel says.

“Harder to capture is that these conflicts have gradually moved from the periphery toward the centre of the global economy. Most notably, Russia’s war in Ukraine delivered a global macroeconomic shock via the commodity supply channel.”