2024 | The turn in interest rates

Our CIO Robert Alster, and Investment Officer Isabel Albarran, pause to look back and consider what the future holds.

After a rollercoaster 2022, many UK investors were understandably tentative about what 2023 might bring. As we look back over the last 12 months, it’s clear that we haven’t had as bumpy a ride as was expected. In spite of a challenging backdrop, the economy has performed better than anticipated. Higher interest rates, the hangover from high inflation and a slowing Chinese economy have all taken their toll on global economic growth, but this has been offset by greater resilience from the US economy.

In the UK, interest rates climbed steadily from a 15-year high of 3.5% in December 2022 to 5.25% in August 2023. The Bank Rate has since plateaued, and the UK, as well as Europe, appears to have skirted recession - for now at least.

Globally, asset markets have performed stronger than expected, especially equities, which have been boosted by the very strong performance of US tech stocks – the so-called Magnificent 7 (comprising Apple, Amazon, Nvidia, Tesla, Microsoft, Meta, Google). This leadership pattern is a sign that markets are now pricing in interest rate cuts for 2024, and there is less pressure on assets with high valuations to hold up as a result.

All eyes will remain on central banks over the year ahead, and asset class returns will be heavily influenced by the timing and magnitude of interest rate cuts. In the US, Federal Open Markets Committee (FOMC) Chair Jerome Powell has stressed that rates will stay “higher for longer”, but at the December Fed meeting, he acknowledged that the timing of cuts “begins to be the next question.” Recent data suggests that US inflation is cooling quicker than expected and the labour market is clearly weakening. With economic activity expected to slow further in the first quarter of 2024, we could well see a 25 basis point rate cut by the summer.

It is not just the timing of interest rate cuts that matters. When central bankers raise interest rates they tend to raise them gradually, interest rate cuts, however, often happen in larger increments as they respond to an unwanted slowing of economic data. We therefore expect that in 2024, the pace of monetary easing will depend on whether we see a modest or accelerated slowdown in economic growth. This is the crucial question that investors will be grappling with in the first half of the year.

Market reaction to these scenarios will depend on the economic tempo. In a moderate economic environment, for example, modest cuts may disappoint investors but the more favourable growth backdrop will support equities in the longer term. In contrast, rapid cuts in the face of an accelerating economic downturn can boost equities at first, but this will typically be relatively short lived as investors worry that the economic slowdown will feed through to company earnings and undercut valuations adversely affecting share prices. We are going to see a balancing act between the magnitude of the economic slowdown, interest rate cuts and corporate earnings.

Many factors beyond central bank activity could impact economic growth, including China. Having enjoyed a reopening bounce following the eventual easing of Covid-19 restrictions, China’s services sector has lost momentum, and its real estate market is weak and troubled. The much-anticipated July Politburo meeting garnered limited policy support, and vital concrete measures were only announced at the end of August. However, further help may be in train: an additional RMB1trn issuance of government bonds was announced at the National People’s Congress in October, the first mid-year budget increase since the 1990s. Early data signs have so far been encouraging.

The markets may have been largely unruffled by consistently high levels of geopolitical risk of late, but the conflict in the Middle East could cause further notable moves in energy markets, especially if Iran becomes more involved. And Russia’s war in Ukraine remains a continued risk. In addition elections in the US and UK may lead to governments stimulating economies either via tax cuts or increased spend in order to woo voters. Statistically election years are good news for markets.

Equities and bonds will benefit from the anticipated interest rate cuts (as bond prices move inversely to interest rates), but the potential combination of soft economic growth and falling inflation could knock company earnings, and then the wider equity landscape.

A shift away from further monetary tightening should support bonds, but any disconnect between market expectations of central bank policy and actual bank rates could drive further volatility. Bonds offer more attractive yields than in recent years, though these have pulled back in recent months. Thus, investments must be given due consideration on the quality of underlying credit, given the weak outlook for growth, and longer duration assets are likely to remain extremely volatile.

All things considered investors should be cautious entering 2024 but there are still opportunities within the market. Some of the more favourable moves within certain segments have increased demand and inflated valuations, but other areas still offer attractive yields. Monetary policy is at a standstill, and until it eases we favour staying close to benchmark at an overall asset class level, and making the most of selective opportunities in sectors and stocks as attractive valuations and value emerge. Also in this era of relatively high (but falling) inflation compared to recent decades alternative investments offering genuine diversification and inflation protection will always have a place in portfolios.

 

Important information

Our ‘Investment Insights’ series is published four times a year and is available on our website.

The information contained in this document is believed to be correct but cannot be guaranteed. Past performance is not a reliable indicator of future results. The value of investments and the income from them may fall as well as rise and is not guaranteed. An investor may not get back the original amount invested. Opinions constitute our judgment as at the date shown and are subject to change without notice. This document is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation. Where links to third party websites are provided, Close Brothers Asset Management accepts no responsibility for the content of such websites nor the services, products or items offered through such websites. Close Brothers Asset Management is a trading name of Close Asset Management Limited (Registered number: 01644127) and Close Asset Management (UK) Limited (Registered number: 02998803). Both companies are part of the Close Brothers Group plc group of companies, are registered in England and Wales and are authorised and regulated by the Financial Conduct Authority. Registered office: 10 Crown Place, London EC2A 4FT. VAT registration number: 245 5013 86.