Tight monetary policy to hamper growth

Q Now we are now in a higher rates environment, are we at the end of the current financial cycle? What might it mean for the next cycle?

We have been through an exceptionally long cycle, which reached a crescendo after COVID with some of the speculative activity that took place. Policy now is notably tight in both the US and Europe, and as we look at major forces and trends across the next five to 10 years, I think we will see several things at play that will be quite different to the last 10 to 15 years.

For instance, we have elements of deglobalisation for national security reasons. We have efforts to decarbonise over the next decade and beyond and we have different demographic trends emerging, particularly within the US. All of this, we believe, points to a rising capex cycle and more resource intensity, whereas there was very little of that in the last 10 to 15 years. As a result, we could see very different behaviour in financial markets.

Q Economic growth in Europe appears to be stalling. What does this mean for European assets through 2024?

Europe has had some volatility and challenges since early 2022. Initially, the spike in gas and energy prices placed downward pressure on economies as it weighed on businesses and consumers. The big collapse in energy prices towards the end of 2022 and into 2023 generated considerable relief, which helped a lot of European assets.

Looking forward, we I think it is domestic factors that are at play. Monetary policies within the eurozone are now very tight and we are seeing monetary supply contracting, credit impulses slowing sharply, and higher frequency macro data that is looking weaker. Europe has a lot more variable debt, so those higher interest rates are passing through more quickly. We are also at the point within the eurozone where some of the peripheral economies have very high debt-to-GDP levels and, with interest costs this high, are flirting with unsustainability of debt stock. So, there are some challenges for the eurozone over the next 12 months.

Q Over in the US, economic resilience has been a feature in 2023. Will this continue?

US monetary policy has gone from very loose 18 months ago to quite tight in 2023, and this is beginning to feed through into monetary supply, into a notable slowdown in credit growth, and it is beginning to affect the lower income cohorts within the US. I would add that the lags within the US will be longer than in places like Europe because the US has a couple of benefits.

It has delevered materially across the economy, particularly within households, over the last decade. There is more fixed, longer-term debt so it takes longer to pass through those higher interest rates. There has also been the notable excess savings that are probably at the point now where they have washed off, and a lot of fiscal stimulus or stealth stimulus that has come this year, to the tune of about 3% of GDP.

At this point we think policy is tight, the laws of economics will work, the US will slow down, and we place a higher probability of a recession in the US over the next 12 months relative to quite a sanguine outlook that is currently being priced in by financial markets.

Q Turning to China, you have generally been more constructive than the consensus. How do you think the country will fare in 2024?

While US and European policy is currently tight, China is arguably experiencing the opposite, having tightened policy back in early 2021. The consequences of those tighter measures in China were evident over 2021 and 2022 but this year, we have seen much of that tighter policy in China unwind as policymakers moved to a looser setting. They began to unwind regulations, particularly macro prudential measures imposed on the real estate market and developers, and they have been clear that they would do what it takes to drive a recovery in the Chinese economy. While this is not a big booming V-shaped recovery, it is a recovery, nonetheless. So, we expect a more benign outcome in China, and we think policymakers can achieve that because they have a lot of control over what is essentially a command economy.

Q Considering all these elements, what are your primary areas of focus for asset allocation?

We like to allocate capital into asset classes and regions where there is a margin of safety, namely good valuation support, and where we see a prospective cyclical environment that should support those assets. If we split the world into three big blocks, starting with China, there is little value in defensive assets in China, which is what everyone has been invested in recently. We see more value in risky assets, particularly in equities, companies with longer-term thematic tailwinds behind them. Because policy is now restrictive in Europe and we are seeing signs of economic weakness, we currently see a lot of value in defensive European assets, so we are long government bonds and short the currency, with limited or little exposure to risk assets in Europe. It is the same story in the US. We are seeing value in various rates markets linked to US treasuries, but not US treasuries themselves, and we maintain a lower-than-average exposure to US risk assets.