Economic Commentary

2024 economic outlook – how might the consensus be wrong?

It is that time of year when it is traditional for investors to ponder what the next 12 months has in store. Last year did not exactly turn out as anticipated, with the US economy performing much more strongly than economists had generally expected, and China generally falling short of consensus expectations (see our commentary of December 2023).

However, this has not stopped the forecasting community from making their predictions for 2024. Precise forecasts vary, but there appears to be broad agreement in several key areas: the global economy will slow, but avoid a deep recession; inflation will fall; and interest rates in most developed economies (with the notable exception of Japan) will come down. With a focus on the US, the world’s largest and most influential economy, this month’s commentary looks at some of the thinking that underpins these consensus views and also considers how they might be wrong.

Slower growth, no deep recession

According to Bloomberg, the consensus amongst economists expects real GDP growth to slow to 1.3% in 2024 from an estimated 2.4% in 20241, as the lagged impact of monetary tightening cools activity and fiscal policy becomes somewhat less supportive. As regards the components of GDP, the outlook for household consumption, which accounts for nearly 70% of expenditure in the economy2, will remain key. In 2024, stronger real wage growth (as inflation falls faster than wage increases) is expected to play a bigger role in driving spending, given that the excess savings built up during the pandemic are likely to be exhausted.

Strong household balance sheets provide a basis for optimism going forward. Household leverage is not excessive (household debt to GDP stands at around 74%, down from nearly 100% prior to the great financial crisis3) and most homeowners locked in low long-term mortgage rates during the pandemic, with the result that debt servicing costs as a share of disposable income are still relatively low4. The fact that households in general have not overstretched themselves underpins hopes that an economic slowdown will not morph into a deep recession.

Government spending should also remain supportive in 2024. During the run-up to the US Presidential election in November, fiscal policy is likely to remain loose. However, estimates from the IMF suggest that the structural (or cyclically-adjusted) budget deficit will narrow from 8.7% of GDP in 2023 to 7.6% in 2024, indicating a somewhat less stimulative impact5.

What happens to the labour market will be key for economic performance in 2024. The consensus expectation for a ‘soft landing’ in 2024 (whereby the economy slows enough to further bring down inflation but does not slip into recession) hinges crucially on a benign rebalancing of the labour market, which has been seen as too tight to be consistent with the Fed’s 2% inflation target. Under such a scenario, the labour market cools via a reduction in job openings rather than an increase in redundancies that causes the unemployment rate to spike. This would mark a continuation of the labour market dynamics witnessed in 2023 (see our commentary of December 2023).

Downside, and upside, risks

However, it is possible that the downturn that failed to materialise in 2023 has merely been postponed. Indeed, several indicators continue to suggest an elevated risk of recession. For instance, the New York Fed’s recession probability model (which is based on the yield curve, the difference between the yields on 3-month and 10-year government bonds - see our commentary of April 20226) puts the probability of recession during the next 12 months at an uncomfortably high 63%7.

Other indicators that in the past have provided an early warning of recession are also flashing red. The Conference Board leading economic indicator has been in recession territory for a while now8. And although most indicators of the labour market remain strong, a decline in temporary jobs, as has been witnessed recently, has often preceded a slide into recession9.

Given the extraordinary nature of the 2020 pandemic recession and the subsequent recovery, there are good reasons why these indicators might be sending false signals. However, it is not difficult to imagine a turn of events whereby weaker nominal GDP growth, squeezed profit margins, and tight lending conditions10 prompt companies to cut back on investment and hiring, which in turn could hurt household incomes and lead to a rise in precautionary saving. Under such a scenario, a benign slowdown could tip over into a recession.

Conversely, one can also envisage circumstances where, like in 2023, the US economy once again surprises on the upside. As markets started to price in future interest rates cuts from the Federal Reserve (the Fed) during the final months of 2023, bond yields fell, credit spreads tightened, equity markets rallied, and the US dollar weakened.

This loosening in financial conditions (the fastest in history on some measures11) could in turn cause growth to reaccelerate12. Lower bond yields have translated into a reduction in mortgage rates and corporate borrowing costs13, potentially spurring activity. Rising equity markets and house prices could give rise to a positive wealth effect, making consumers more confident to go out and spend. In addition, there is also the possibility that the government will introduce new stimulus measures ahead of the November election.

Lower inflation

Clearly, much will depend on the path of interest rates going forward, which in turn hinges crucially on the outlook for inflation. Surveys suggest that most investors expect inflation to fall this year and, on average, policymakers at the Fed see their preferred gauge of inflation (the so-called personal consumption expenditure, or PCE, deflator) falling to 2.4% by the final quarter of 2024, down from 2.8% in Q4 of 202315.

An economy slowing to a below-trend pace should naturally bring down inflation. Moreover, the quirks of how housing costs are incorporated into the consumer price index (CPI) should mean that the recent slowdown in rent inflation pulls down the pace of CPI increases, with a lag16. However, the disinflation process is showing signs of stalling – CPI inflation fell to a 2-yr low of 3% in June, but by the end of 2023 it had inched up to 3.4%17 – suggesting the ‘last mile’ of bringing down inflation to the Fed’s 2% target could be more difficult.

Several factors could work against the fall in US inflation that consensus expects this year. Rising house prices, bolstered by the recent fall in mortgage costs, could keep the shelter component of inflation elevated18. Strong wage growth could also work against a moderation in core services inflation. Although pay growth slowed markedly during the first nine months of 2023, annual wage inflation on the Atlanta Fed measure was unchanged at 5.2% y/y during Q419, as workers in sectors ranging from motor vehicles to healthcare flexed their muscles to secure large pay hikes20. Against this backdrop, it is perhaps not surprising that core services ex-housing inflation – an indicator closely followed by Fed Chair Jerome Powell – has remained sticky around the 4% y/y mark21.

Disruption to global supply chains as a result of attacks in the Red Sea and low water levels on the Panama Canal also threaten to reverse the decline in traded goods prices that was responsible for much of last year’s fall in inflation. Shipping rates are not nearly as high as during the pandemic, but have more than doubled since the end of November22. Estimates vary, but the IMF reckon that a doubling in freight rates, if sustained, could lift inflation by around 0.7 percentage points, with the effects peaking after a year and lasting up to 18 months23.

Conflict in the Middle East also heightens upside risks to inflation from higher oil prices. According to Fed estimates, every US$10 per barrel increase in the price of crude oil raises inflation by 0.2 percentage points and cuts economic growth by 0.1 points24. It is unclear how long the disruption to shipping routes will last, but if sustained, supply chain issues carry the potential to hamper the decline in inflation that both the Fed and consensus expect this year.

Alternatively, if these risks do not materialise, several developments could potentially cause inflation to surprise on the downside. A deeper-than-expected economic downturn could bear down on the pricing power of both businesses and workers. The continued easing of pandemic-related supply chain issues and falling prices for Chinese exports could lead to steeper falls in traded goods prices. And a sustained improvement in productivity growth, perhaps as a result of widespread adoption of artificial intelligence tools (see our commentary of August 202325), could reduce production costs and, by extension, prices.

Interest rate cuts

Surveys suggest investors expect interest rates to come down in 202426, and recent signaling from the Fed has bolstered such hopes. On average, policymakers at the Fed forecast that the central bank’s policy rate will fall 75 basis points (i.e. the equivalent of three quarter-point rate cuts) from its current 5.25-5.50% level27.

Although there is still a possibility of further rate hikes if there is a resurgence of price pressures, Fed officials have indicated that rate cuts could be warranted if inflation falls back in line with their forecasts, in order that inflation-adjusted interest rates do not become too restrictive. The Fed is clearly walking a fine line: if it keeps policy restrictive for too long, it could tip the economy into a recession; but if it cuts rates too soon, it risks reigniting inflation.

Markets currently take the view that interest rates will fall much more sharply in 2024 than the Fed anticipates. Interest rate futures are pricing in a drop of 170 basis points (i.e. the equivalent of nearly seven quarter-point rate cuts), with the first reduction coming as early as March 202428. In the absence of a recession or renewed financial turmoil, such expectations for early and deep rate cuts seem somewhat aggressive.

And yet, equity markets, at least, do not appear to be expecting an economic downturn. On the contrary, consensus forecasts indicate that profits and revenues of the 500 largest listed US companies will pick up in 2024, rising 11.8% and 5.5% respectively following growth of 0.5% and 2.2% respectively in 2023. In this regard, there is a sense of equity investors wanting to ‘have their cake and eat it’ i.e. steep interest rate cuts and double-digit gains in profits. This could prove optimistic.

Elevated uncertainty

The consensus view of a ‘soft landing’ for the US, and by extension, global economy suggests a benign macro backdrop for financial markets. The marked fall in inflation through last year, and the Fed’s preparedness to dial back its restrictive monetary policy has improved the chances of such an outcome. However, the experience of 2023 has provided a reminder that the consensus can get it wrong. Elevated geopolitical risks and pandemic-related distortions make for a high degree of uncertainty, and the mixed signals from economic and financial market data suggest there are risks to both the upside and the downside.

For investors, this underlines how important it is to construct a diversified portfolio across asset classes. And with the peak in inflation now probably behind us, and bond yields still trading at the upper end of their 15-year range29, this is an easier task now than it has been for quite a while.

16 January 2024