Outlook Overview: Headline Inflation Slowing, Core Inflation and Policy Rates in Focus

  •We continue to feel that most central banks are underestimating the strength of tightening on credit/economy and then inflation and the effects of cumulative rate hikes since the start of 2021 (Figure 2).  DM central banks are placing too much weight on current core inflation, rather than the forecast trajectory into 2024 and 2025. Economic recovery will start to appear by H2 2024, but it will be below trend.  A downside scenario exists that the adverse effects are more powerful than our baseline (Figure 1), which leads to a mild U.S. recession and modest recession in EZ/UK.  In Japan, we see a further 25bps increase in the 10yr JGB cap to 0.75%, but the BOJ is highly unlikely to abandon QE with yield curve control.  

•China 2023 growth pace has moderated but should be reasonable, as the reopening effects broaden in the economy and we still forecast 5.5% GDP growth.  However, in 2024, structural headwinds will kick in, with peak labor force hurting employment/income and consumption momentum, while the burden of debt and property overhang being a drag on the economy. Risks for growth are skewed to the downside for China and we have brought forward our forecast of 3% growth trend to 2026-28.  Though India has growth momentum it does not yet have the same benefit to global GDP as China.   

•Across most large EM countries, inflation rates are returning back towards target quicker than DM countries, as labor market slack (excluding Mexico) has meant less second round effects. EM Asia ex China and Latam will see reasonable growth rates closer to their trend growth rates.  Modest interest rates cuts in Asia will likely be delivered in 2024, while Brazil and Mexico will ease restrictive policy.  Weaker EM and Frontier countries remain more problematic, due to their greater exposure to USD debt and associated refinancing risks.  Select Frontier countries (such as Sri Lanka) will see restructuring into 2024.   

•Geopolitics will remain a focus as well.  We see the Ukraine war becoming a stalemate, but the prospects for a credible peace deal/surge in Russian commodity exports are low (here) and this will see a bottom to commodities in H2 given demand/supply balances.  China disinformation in the January 2024 Taiwan election will likely be seen, similar to what they have done in 2020. However, the risks of an invasion of Taiwan in the next 5 years remains low (here).  Presidents Biden and Xi are scheduled to meet at the September G20 and November APEC meetings and will look to put a more cooperative tone on the U.S./China relationship, especially on climate change initiatives.  However, multi-year strategic competition between the U.S. and China will curtail a wider thawing of relations or easing of tariffs/restrictions.  

•For financial markets, the economic/inflation and policy picture is tricky, with inverted yield curves in government bond markets discounting some success on getting inflation back towards target amid slow growth expectations, but equity markets not discounting a hit to corporate earnings.  We see scope for a modest dip in equity markets in H2, but not much further decline in 10yr government bond yields as core inflation takes time to come down.  2024 should see a good rally in global equity markets (Figure 3) helped by hopes of H2 economic recovery; core inflation  continuing to converge towards target and easing from DM central banks.  10yr government bond yields will likely remain elevated, as growth picks up and 2020 real yields are higher than the post GFC period (supply issues and Fed/ECB QT continues).  The USD is set to decline multi-year against DM currencies, both due to the current overvaluation and as the Fed pivots to 2024 easing.        

Risks: DM central bank tightening could be more powerful than our baseline (Figure 1), which causes a mild recession in the U.S. and modest/moderate recession in EZ/UK. This could also help core inflation come down, but would hurt riskier assets.  Separately, China growth risks are skewed to the downside, as the structural headwinds are catching up with China.   

Figure 1: Economic Scenarios

Source: Continuum Economics

Figure 2: Policy rate and 10yr Yield Changes Since Start of 2021 

  Source: Continuum Economics, latest June 21

Market Implications

•Government bonds: 10yr U.S. government bond yields are discounted ultra-low growth/a borderline recession and will likely not fall much further. 2024 will likely see a rise in 10yr yields, as the focus switch to economic recovery and given traditional yield curve steepening forces. 2yr yields will trend down once the Fed starts delivering rate cuts (we look for 75bps in 2024). Bunds/Gilts are set to follow a similar pattern.  

•Equities: Tactical downside risks exist as U.S. valuations are modestly overdone relative to equity metrics and also against 10yr real bond yields.  We can see 4000 on the S&P500 in H2 on corporate earnings/economic worries, before a rebound to 4200 for end 2023.  We maintain the forecast of 4700 by end 2024, as rate cuts and economic recovery helps U.S. equities.  EZ equities will likely modestly outperform the U.S., as equity-bond valuations are more favorable than the U.S. UK and Japan equities can modestly outperform the U.S. by end 2024 on cheap valuations and low interest rates respectively. EM equities can outperform the U.S. helped by easing, reasonable valuations and growth/inflation mix.  China can outperform in 2023 but is a cyclical play, as the structural headwinds means we prefer EM Asia ex China and India especially on a 1-5yr view.  Brazil equities can perform strongly helped by rates being cut to 8.5% by end 2024.  

•FX: The USD is clearly overvalued on most measures and USD declines are forecast to resume, as Fed rate peaks.  Losses will be modest, except against the JPY in 2023. 2024 will likely see a further modest decline in the USD (e.g. 1.18 EUR/USD end 2024), as the Fed moves to cut interest rates.  In EM FX, we see the Chinese Yuan weaken further to 7.30 versus the USD, both as further PBOC rate cuts arrive to boost the economy and China authorities accept moderate Yuan weakness.    

Commodities: Oil physical backdrop is better than the pessimism in financial markets, with below average inventories and a demand/supply balance that is consistent with $85 and $90 end 2023 and end 2024 respectively.  Gold will be supported by ongoing EM central bank reserve diversification from the USD, which will offset the effects from positive real 10yr U.S. Treasury yields and we see $1950 by end 2024.  

Figure 3: Asset Allocation for 18 Months to end-2024

Source: Continuum Economics. Note: Asset views in absolute total returns from levels on June 21 (e.g., 0 = -5 to +5%, +1 = 5-10%, +2 = 10% plus).

The chapters can be accessed by clicking on the relevant links. 

U.S. Outlook: No Recession, but Subdued Growth Will Help to Reduce Inflation (here)

LatAm Outlook: Lower Inflation and Growth above Expectations (here)

China Outlook: Recovery To Fade Into 2024 (here)

Japan Outlook: Trend Inflation To Remain Below 2% (here)

Asia/Pacific (ex-China/Japan) Outlook: Defying Global Headwinds (here)

Eurozone Outlook: Import(ant) Downside Risks (here)

Western Europe Outlook: Consumer Fragilities Persist (here)

EMEA Outlook: Domestic Factors Dominant (here)

DM Rates Outlook: Yield Curve Inversion to Ebb (here)

DM FX Outlook: Slow USD decline to continue but JPY and GBP could be volatile (here)

Equities Outlook: Tactically Difficult/Strategically Bullish (here)

EM FX Outlook: USD Strength Peaking (here)

Commodities Outlook: Navigating Uncertainty (here)

Technical Analysis Quarterly Chartbook (here) 

Figure 4: Key Events and Critical Uncertainties