PERSPECTIVES

OUR CENTRAL SCENARIO

ÉRIC BERTRAND
Deputy Chief Executive Officer,
Chief Investment Officer
OFI INVEST

With the exception of commodities and Chinese equities, the main asset classes fared very well in 2023, thus wiping clean most memories of 2022.

The main central banks said what they would do and then did what they said they would do – raise interest rates to a hawkish enough level to get inflation under control and then lower it to their 2% target. That target is now in sight and is likely be reached by late 2024 in the United States, and sometime in 2025 in the eurozone.

This was one of the main lessons of 2023. Contrary to some forecasts, economies did not sink into a deep recession, and growth was surprisingly resilient in the US throughout the year. However, growth is likely to slow in the first half of 2024, something worth keeping an eye on in getting a fix on the trajectory of short-term interest rates this year.

Central banks’ second accomplishment in 2023 was to have promptly and efficiently ensured financial stability on the markets during stressful phases, such as during the US banking crisis or the UK pension fund crisis. And this is a second lesson of 2023 – that the central bank “put” is still in play, which is no doubt the main reason for the vanishing of term premiums in yield curves’ long sections.

For 2024, we expect central banks to begin lowering their short-term rates late in the first half of the year – the Fed first, followed by the ECB – as they track inflation downward. We expect three or four rate cuts, believing that market expectations are still over done as the year gets underway.

The sudden and extensive bond rally late last year also looks a little overdone for the short term. Levels are now close to what we could have in the second half of 2024, once central banks have actually begun to lower their rates. The year’s bond returns are likely to be carry-like, but volatility is likely in the first quarter and could create opportunities for more bullish positioning.

Corporate bonds fared very well in 2023, as we expected. They are likely to fare less well in 2024, but still offer quality returns, no doubt comparable to carry. However, selectiveness will remain necessary in choosing issuers, given current monetary policy and the time it takes to transmit that policy to the real economy.

Equities also ended 2023 on a high note, with an impressive yearend rally that tracked interest rates. There were various factors behind equity markets’ strong performance. First of all, the solid resilience of companies that were able to hold onto their margins or even improve them amidst inflation and tighter credit conditions. This will probably be less the case in 2024. After punishing equities, shifts in interest rates provided a boost in the fourth quarter and, as with fixed income, no doubt in knee-jerk fashion. Here again, support is unlikely to be as strong in 2024.

All in all, we expect 2024 to play out in two stages on the equity markets: a volatile first half, driven mainly by a US economic slowdown, which should be an opportunity for taking on heavier exposure at levels lower than current ones; and a more positive second half, with central banks putting deeds to words with rate cuts.

One last point: the geopolitical context remained tense in 2023 (Ukraine, the Middle East, North Korea, and the South China Sea) but had rather little impact on the markets. International relations are likely to remain troubled in 2024, with major rebalancing and important elections, including the US presidential elections, and will affect the markets sooner or later. Best to keep a close eye on these events.

2024 OUTLOOK AS OF 09/01/2024

Opportunities in bonds, with a preference for corporates
Central bank interest rates rose in 2023, but not necessarily bond yields, with the Bund ending the year at about 2%, lower than when the year began. In 2024, key rates of the main central banks (Fed and ECB) are likely to head back down, as inflation returns gradually to the 2% target on both sides of the Atlantic. After an exceptional year on the bond markets in 2023 in terms of performance, we believe that the asset class could offer carry-like returns in the event of a soft landing in the economy. We are therefore overweighting the asset class, and in particular, corporate bonds and the money market.

Stay exposed to equity markets while keeping an eye on volatility
Traditionally, the equity markets closely track expectations of trajectories of bond yield trajectories and of earnings, and, of course, instantaneous valuations. On the bond front, we don’t expect any meaningful change this year. As for earnings, global growth, pegged at around 2.5%, is likely to leave equity markets close to their 2023 levels in Europe and up only slightly in the US. Current valuations don’t look stretched and are consistent with an inflation target of close to 2.5% by yearend. Against this backdrop, we forecast slight gains on the equity markets, albeit with episodes of steep volatility driven by the geopolitical context. We draw few geographical distinctions. True, European equities are priced lower than their US counterparts, but the latter possess a pool of tech stocks that could have further surprises in store, depending on trends in artificial intelligence. And, lastly, we believe that Asia ex China is one of the strong-growth regions not to be overlooked.

The yen is expected to appreciate
Our scenario does not assume a collapse of the US economy or a sustained reacceleration of inflation in 2024, and we therefore do not expect a dollar rally this year. It should stay near its current level, reflecting the markets’ current rate-cut expectations. We remain constructive on the yen in 2024, based on the idea that Japanese monetary policy is likely to continue normalising, given the good domestic inflation trends at this stage.

MACROECONOMIC VIEW

THE INFLATION FIGHT AND A RESILIENT US ECONOMY

OMBRETTA SIGNORI
Head of Macroeconomic Research
and Strategy
OFI INVEST ASSET MANAGEMENT

2023 began with inflation fears, but, as expected, disinflation measures were effective, and inflation figures were a good surprise late in the year. Total inflation receded from 6.4% in January to 3.1% in November in the US and from 8.6% to 2.4% in the eurozone. The speed and extent of the decline are due to two factors: the favourable base effect of energy prices and disinflation in goods, as Covid-related supply chain issues were resolved. Very low inflation in China provided an additional boost to global disinflation. The stretch run towards the central banks’ 2% target is more closely linked to inflation in services, which is one of inflation’s most rigid components, due to wage inertia.

SURPRISINGLY STRONG US GROWTH…

The real surprise of 2023 was exuberant growth in the US despite the ongoing monetary tightening.

In January 2023, the consensus was forecasting 0.3% for US growth on annual average. And yet, economic activity figures showed no signs of slowdown and, throughout the year, growth forecasts were revised upward, ending in December 2 percentage points higher. How did this happen? The first factor was Bidenomics.

Covid cheques supported private consumption, and plans to promote the energy transition (Inflation Reduction Act) and semiconductors (Chips Act) boosted business investment and research & development spending. Second, US companies had very little need for refinancing in 2023 after having exploited zero rates in 2020 and 2021. Third, monetary policy remained highly accommodative until the end of 2022, due to the exceptionally low starting level of key rates. This resilience was why US bond yields began to rise so sharply during the summer, topping out at 5% in October in nominal terms and at 2.5% in real terms on 10-year maturities.

… IN CONTRAST WITH SLUGGISHNESS IN EUROPE

The divergence of the US economic cycle with the rest of the world, and in particular with the eurozone, was clear in the third quarter, when US GDP brushed up against 5% annualised growth, while eurozone GDP shrank by 0.1% (0.4% annualised). Last winter, Europe avoided gas rationing and, hence, a recession, thanks to the diversification of its gas supplies and weaker demand by households and businesses.

However, the eurozone economy has stagnated over the past year, and Germany is suffering the most of all from the impact of the energy crisis on its industrial fabric and from the sluggish post-Covid Chinese recovery. While monetary tightening did indeed undermine supply and demand of lending and investments in construction, and, more broadly, in real estate, consumption was the main reason for the gulf in economic performance between the United States and Europe. An ECB research note provides insight, among other factors, into weak European consumption. To wit: Covid-related surplus savings were distributed very unevenly (70% was held by the richest persons), and since 2021, they have been invested in highyielding financial assets and to a lesser extent in housing, and used to pay off loans rather than being consumed.

China achieved its 5% growth target, but its two main structural issues – real estate and demographics – are dragging down long-term growth prospects. Moreover, for the markets, the lack of an announcement of massive public aide speaks volumes. The Chinese government has sought to strike a balance – fiscal stimulus to prevent real-estate bankruptcies while keeping in place brakes on speculation in the sector. All in all, global growth in 2023 should come in just above 3%, driven by the US (and India), rather than China.

CENTRAL BANKS TACKLED INFLATION

The anti-inflation flight was central banks’ defining theme in 2023, and the monetary tightening cycle of 2022/2023 was one of the most extensive and rapid on record. The average (GDP-weighted) key rate rose from 0.10% in January 2022 to 4.5% at the end of 2023 in developed economies, and from 4.9% to 8.5% in emerging economies. The sole outlier was the People’s Bank of China (PBOC), which cut its rates, and the Bank of Japan (BoJ), which maintained a yield-controlcurve strategy but with greater flexibility on 10-year yields. Not until the second half of the year did the major central banks take their foot off the brake . In the US, key rates have stayed at 5.5%, since July, and in the eurozone the deposit rate has been 4.0% since September.

Beginning in autumn, the Fed and ECB heads took note of the good news on inflation and signed off on a scenario in which key rates had probably peaked. Since then, the markets have gotten carried away with what they see as the next step – rate cuts.
Key rates have once again become the main tool of monetary policy, but monetary tightening has also been in the form of normalising central bank balance sheets. The ECB balance sheet shrank by about €2 trillion in 2023, mostly due to the repayment of targeted longer-term refinancing operations (TLTROs). Regarding bond-buying programmes, reinvestments under the traditional quantitative easing programme, the Asset Purchasing Programme (APP) were stopped completely in July 2023, while the Pandemic Emergency Purchase Programme (PEPP) will not be halted until 2024. As for the Fed, nonreinvestment of maturing securities had already begun in 2022 and went forth as scheduled in 2023 at a monthly pace of about $95 billion.

The normalisation of balance sheets seems to have had little impact on the fixed-income markets or the term premium of US rates.

A TWO-TRACK WORLD

We can’t end our look back at 2023 without speaking of geopolitics. The Hamas attacks of 7 October had no market impact, but the war in the Middle East showed us once again that we now live in a multi-polar world, with a more complex balance between the great powers. 2023 also showed us that populism is still very much alive. Javier Milei was elected president of Argentina, and the farright Geert Wilders won in legislative elections in the Netherlands. Was Donald Tusk’s victory in Poland an exception in Europe? The answer to come in 2024…

2024 OUTLOOK

DUE FOR A SOFT LANDING IN 2024?

TOWARDS A RETURN TO THE INFLATION TARGET IN THE US, THEN IN THE EUROZONE

In 2024, the main developed economies are expected to grow below their potential, with global growth a little above 2.5%, due to the effects of monetary tightening and the return of structural constraints on Chinese growth. Inflation is expected to continue to recede, which will allow central banks to gradually lower their key rates, although monetary policy is expected to remain hawkish.

Consumer spending, which was the real driver of US growth in 2023, is expected to slow, as a 4.1% savings rate looks unsustainable amidst moderation. In wage growth and in employment. We are already seeing the first signs of a slowdown, as the job market, while remaining tight, is gradually absorbing excess demand. Moderation of consumption does not mean collapse, however, as growth in real disposable income should stay in positive territory, given the weakening of inflation, not to mention the remaining surplus, rainy-day savings. Investment should naturally continue to be hemmed in by tighter financing conditions and nascent pressures on company margins. Available data suggest that the landing should not be too painful, and the US could achieve average annual growth of about 1.3%/1.4% in 2024, after 2.4% in 2023.

Global inflation has receded considerably, and a return to the target in 2024 in the US and in 2025 in the eurozone is still within reach. While good news is emerging in services on both sides of the Atlantic, it is still too early for the Fed and the ECB to sound the all-clear on inflation. We don’t expect any rate cuts in the first quarter, and the ECB will probably act after the Fed. For, inflation is likely to slow more gradually in the eurozone than in the US, and it is not certain that wages have peaked. We expect monetary policy to ease by about 75 basis points in the eurozone.
In the US, cuts amounting to 100 basis points are realistic, perhaps even more if the situation worsens significantly this winter and if inflation continues to surprise on the downside. And, lastly, central bank balance sheets are likely to continue moving back towards normal. In the eurozone, the last TLTROs will be repaid, and the Pandemic Emergency Purchase Programme (PEPP) will be halted. There are many uncertainties surrounding the US economy, and alternative scenarios of a hard landing or, on the contrary, of the lack of a slowdown in US economy are still within the realm of possibility. But there are other key factors to keep an eye on, such as geopolitics and a busy election agenda, including European Parliament elections on 6 June and US presidential elections on 5 November. Will this almost idyllic scenario of painless disinflation be put to the test?

INTEREST RATES

YIELD IS BACK

GEOFFROY LENOIR
Co-CIO, Mutual Funds
OFI INVEST ASSET MANAGEMENT

2023 was a big year on the bond markets. While the main central banks continued to raise their key rates, both government and corporate bonds offered higher-than-expected returns. How did that happen, given that bond prices are supposed to fall when interest rates rise? Simply because, while short-term rates did rise, bonds maturing in more than two years ended 2023 below their levels of the start of the year. Moreover, credit spreads narrowed sharply, particularly in the fourth quarter. But let’s take a closer look at 2023 for a fuller explanation of what happened.

One year ago, Europe and the US were exiting an especially challenging year in 2022, marked by a spike in inflation - 10.6% in Europe - and a bond market crash that will go down in economic history books as a backlash of the Covid crisis and the war in Ukraine.

In early 2023, the markets were pricing in further disinflation, paired with slower growth in Europe and the US or even a shallow recession. This optimistic view suggested that central bank plans were going to go off without a hitch and that the markets could rise above the fray. And, well, in retrospect, the markets were right to be optimistic!

RATES CONTINUED TO BE RAISED BEFORE A PAUSE

In the first half of the year, central banks were still busy fighting inflationary pressures with more hawkish monetary policies. To do so, they had to continue raising rates, as they had since 2022, with the goal of lowering inflation towards their 2% targets. The year was thus paced by central bank announcements and expectations of terminal rates, which were revised upward on a regular basis.

After raising its key rates to 4.25% in 2022, the US Federal Reserve raised them gradually to 5.50% by July 2023 before taking a break. The European Central Bank (ECB) raised its deposit rate from 2% to 4% before pausing in September. In this context, central bank decisions and the inflation trajectory were well priced in, and bond markets held up very well.

Nevertheless, 2023 was no a walk in the park. Among the events that drove market activity, let’s first mention the risks to US growth. Then, in March came the collapse of SVB* and fears surrounding US regional banks, as well as the Crédit Suisse episode* with the emergency rescue by UBS. Fortunately, the crisis was quickly circumscribed. As the year began, it seemed that China, not the US, would fare best. As it had at last exited its draconian zero-Covid posture, China was expected to see consumption take off again and its growth support other countries, including in Europe. This optimism was short-lived and the Chinese economy was hit by structural issues, among other things, in its real-estate sector and its regional governments’ debt burdens.

In May, the excitement around artificial intelligence took over. The US returned to the spotlight, with consumer spending more robust than expected and growth forecasts constantly revised upward throughout the second half of the year. In late summer, investors began to price in a “higher-for-longer” scenario before new geopolitical risks emerged with Hamas’s attack against Israël in October. Quite unexpectedly, the markets shrugged all this off, and wave of yearend optimism even triggered a massive rally by all asset classes, with investors increasingly hopeful for a soft landing in the US.

The long-awaited Fed pivot was announced late in the year by its chairman, Jerome Powell and widely cheered by investors, spurring the markets on to a strong finish to the year.

HIGH YIELD BONDS STEAL THE SHOW

Against this backdrop, the 10-year German yield rose gradually until October, from a low of 2.00% in January to a high of 2.97%, before pulling back sharply late in the year to 2.00%. Even the 2-year yield ended the year lower than it started it, moving from 2.76% to 2.41%. These shifts were one main reason for the performance of the bond markets but the narrowing of credit spreads also played an important role. Upward revisions of inflation and growth forecasts allowed companies to achieve good results with refinancing capacities remaining solid.

In these conditions, high yield stole the show, with returns near 13% on the year (based on the Bloomberg Barclays European High Yield index). Other European fixed-income assets also fared well, with gains of more than 8% by investment grade (IG) corporate bonds, 7% by sovereign bonds, and about 3.3% by moneymarket assets. Corporate bond performances were driven most of all by high carry in the first three quarters, and then by a rather pronounced narrowing of yields and credit spreads late in the year. Note that the quest for yield was once again the main driver in 2023, which explains the outperformance of BBB rated issues in the investment grade universe and B rated ones in high yield. Unlike previous years, political risks in Europe and government debt burdens were not the main concern.

For proof, look no further than the 10-year Italy/Germany spread, which narrowed from 210 to 165 basis points. Meanwhile, inflation expectations looked well anchored late in the year with real rates and inflation break-even points lower than at the start of the year. The 5-year euro inflation swap thus ended the year at 2%. Lastly, yield curves remained inverted throughout the year. Although the worst appears to have been avoided, this atypical situation – which often precedes recessions – is still worth keeping an eye on in the coming quarters.

To sum up, 2023 was an outstanding year on bond markets. Key rate hikes and a normalisation of market conditions have made bond markets attractive once again for yield and diversification.

2024 OUTLOOK

OPPORTUNITIES IN FIXED INCOME WITH A PREFERENCE FOR CORPORATES

WE FORECAST RATE CUTS FROM THE END OF THE SECOND QUARTER

Driven by rising key-rate hikes in 2022 and 2023, the bond markets were quite volatile but did return to favour. Rising yields had the benefit of restoring prospects to the entire asset class – money market, government bonds and corporate bonds. Bonds thus once again became a true alternative to equities and a source of diversification.

As the new year begins, the markets are expecting central banks – the Fed and the ECB – to stick to the status quo on key rates for another few months before beginning to lower them gradually until 2025.

Almost 1.5% of rate cuts are expected in 2024, which would send the Fed Funds rate to about 4.0% and the ECB’s deposit rate to about 2.5%. Initial cuts are being partly priced in for March 2024. Assuming a slowdown in the US in the first half and stagnation in Europe, followed by a recovery in the second half of the year, we believe the market is overestimating rate cuts in both their extent and their timing. With inflation still close to, or above 2%, we expect rate cuts late in the second quarter and be close to 75/100 basis points on the year. In our view, only a more negative scenario would push the central banks into lowering their rates further and faster than the markets are currently pricing in.

In light of the steep pullback in 10-year yields llate in the year on both sides of the Atlantic, we have assumed in our baseline scenario that they will rebound a little in 2024. We also expect yield curves to steepen, and the 2-year vs. 10-year could move back into positive territory. We also expect the Italy/Germany spread to hover around 160 basis points.

As 2024 begins, we are bullish on bonds with preference for corporates. We expect money-market assets to return 2.5% to 3% this year.

Sovereign bonds could compete with money-market assets and serve as a safe haven, but carry on corporate bonds should make it possible to target better returns. In our baseline scenario, we are assuming that investment grade corporate bonds could achieve an objective of almost 4%. They could once again be outperformed by high yield bonds, which could offer between 5% and 6%, if idiosyncratic risks are closely controlled. We will be paying especially close attention to the primary market in high yield in the first half of 2024, as companies exploit the yearend 2023 exuberance to refinance debt maturing in 2025 and 2026 (the famous debt wall in this asset class).

EQUITIES

WIDE DIVERGENCES BUT A VERY STRONG SHOWING ON THE WHOLE BY EQUITIES

ÉRIC TURJEMAN
Co-CIO, Mutual Funds
OFI INVEST ASSET MANAGEMENT

Divergence. That’s probably the best way to describe the equity markets in 2023. Divergence, first of all, between central banks, which had to tighten the screws on excessive inflation, and then on fiscal policies that were still just as accommodative, marked by yawning deficits in developed economies. Secondly, economic divergence, with Europe flirting with recession and with the US holding up admirably well, thanks to unstoppable consumer spending; and Asia, which was caught between hopes for a Japanese recovery and disappointment over the Chinese economy’s failure to launch. And, thirdly, divergence of performances, especially among developed markets. Tech large caps outperformed small industrial stocks by far. There are several reasons for this, but they do show just how extreme last year was.

The year in equities ultimately reflected the shift in consensus forecasts on interest rates and inflation. The first quarter was marked by Europe’s outperformance vs. the US. Monetary policy was already more hawkish in the US; the risks of slowdown were more marked. But, most of all, equity markets were still trading at close to cyclepeak valuations. The first warning sign came from the US banking system, squeezed between unrealised capital losses on their balance sheets and deposits under pressure as households dipped into their savings.

The failure of Silicon Valley Bank woke the spectre of the 2008 crisis. Equity markets consolidated and volatility spiked. Savers drew their own conclusions in massively withdrawing their deposits from regional banks and depositing them with financial institutions they felt were more solid. A massive intervention by the Fed and the deposit guarantee system to calm things down and organise a return to normal.

But caution was still the byword, as everyone waited to see whether household consumption would suffer from the end of surplus savings accumulated during the Covid period.

Companies themselves had a hard time providing full-year guidance, given how much pressure there was on volumes. It was not unheard of for first-half results to report higher revenues but with volumes down and price effects still up sharply – the symbol of tenacious inflation. Company margins were highly resilient but were nonetheless looked at warily by investors. With volumes under pressure, the consensus began to believe that they could shrink. And didn’t the PMI manufacturing indices reflect some pessimism from industrial companies, probably one step ahead of service companies, but which would also end up slowing down?

CONSUMPTION AND TECHNOLOGY HAVE DRIVEN THE TREND

But it was the opposite that occurred in the second quarter, and a new scenario took hold the rest of the year. Contrary to the most pessimistic expectations, household consumption showed no sign of running out of steam. Of course, households got a boost from very low unemployment, which continued to push wages upward. Consumer purchasing power, especially in the US, thus remained in positive territory, as reflected in retail sales. Only the lowest-income households seemed to be in difficulty. Consumer staple companies have accordingly begun to experience a slowdown, and a series of profitwarnings have been issued by companies exposed to the least rich quintile of the population. The same goes for the banking system, where provisions spiked on credit card debt of the lowestincome households. In contrast, for the richest households, the wealth effect played out in full. The markets spiked, raising asset valuations. Current savings earning interest not seen in more than 10 years, supporting consumption of services (restaurants, leisure and tourism). This trend lasted throughout the year.

But it was indeed in late April that the upward trend took hold, despite the worsening in the geopolitical situation in the Middle East. The advent of generative artificial intelligence, revealed by the ChatGPT app, propelled the entire ecosystem upward, sending the Nasdaq to a new series of records. Nvidia*, the uncontested leader of GPU chips, thus joined the Magnificent 7 (Alphabet*, Amazon*, Apple*, Meta*, Microsoft*, Nvidia* and Tesla*), which alone account for 30% of the market cap of the S&P 500, and accounted for two thirds of its performance in 2023. The Magnificent 7 allowed the index to eke out slightly positive earnings growth; without them, it would have been down by almost 6%.

PERFORMANCES HAVE DIVERGED WIDELY BY SECTOR, STYLE AND MARKET CAP

In 2023, performance dichotomies hit record levels. True, small and mid caps did rally in November but remained far behind large caps on the year as a whole. The same goes for value stocks, whose discount widened even more, particularly after the pullback in bond yields during the last weeks of the year. Industrial cyclicals continued to be bogged down in inventory drawdown issues and squeezed by leading indicators that remain sluggish. Meanwhile, the Chinese economy’s failure to take off kept pressure on industrial sectors, mainly in Europe.

While the Chinese market was the big loser on the year, 2023 was ultimately an exceptional year for most equity markets worldwide, as several of them set records… including the French index!

2024 OUTLOOK

KEEP A CLOSE EYE ON MARGINS AND MONEY MARKETS

STAY EXPOSED TO THE EQUITY MARKETS WHILE WATCHING OUT FOR VOLATILITY

After a brusque shift in the monetary environment in 2023, 2024 is looking like relatively clear sailing. For one thing, the much hoped-for soft landing is now being achieved in the US, and recession fears are fading. In Europe, not so much, but it appears to have bottomed out, particularly in industry, where inventories and order books have now returned to normal. Most importantly, the receding of inflationary tensions is coming at a good time and should at last allow central banks to adjust their monetary policies downward. And it’s probably best for events to unfold like this, given the markets’ great expectations on interest rates in 2024!

Apart from monetary policy trends, in 2024 the markets will focus mainly on companies’ margins, which managed to get through the past year while remaining at record levels. In some sectors, revenue growth was achieved through price hikes and in some cases, despite weaker volumes. Keeping margins that high in 2024 will require volume growth. Otherwise, companies may be tempted to get tough with competitors by giving consumers a break on prices. This would put 2024 consensus forecasts on earnings at risk and would mean a return of volatility.

Although some risks remain, we believe uncertainty is lower as 2024 begins than it was one year ago, and that’s why we have taken on a neutral stance on equities. The US markets do not seem to offer any discount.

Their performances were driven in 2023 by tech stocks. The rotation that began in early November is thus likely to continue and favour value stocks, but the pace of Fed rate cuts could decide otherwise. In Europe, the discount is too high to be ignored. Many stocks are trading below their historical averages and could rally as the recovery progresses.

In short, while we would have trouble justifying a double-digit gain by the equity markets, especially in Europe and the US, in the coming year, competition of the corporate bond markets is weaker after their remarkable performance. This suggests not sitting out this asset class, while nonetheless taking care with volatility that will subsist.

EMERGING MARKETS

CHINESE EQUITIES MISSED OUT ON THE 2023 MARKET RALLY

JEAN-MARIE MERCADAL
Chief Executive Officer
SYNCICAP ASSET MANAGEMENT

The Chinese equity markets ended 2023 in the red. This was all the more disappointing given the high hopes arising from China’s post- Covid reopening. The MSCI China is off its February 2021 highs by almost 58%. It fell by more than 14% in 2023, its third consecutive year of declines, something that had not happened since 2002. Never have there been four consecutive down years in the index’s history. Other Asian equity and emerging debt markets, however, performed very well.

A VICIOUS CIRCLE SEEMS TO HAVE TAKEN HOLD IN CHINA

Business and consumer confidence have been hit hard by the regulatory crackdown that began in 2021. Among other things, this helped burst the real-estate bubble and, more broadly, brought on broad wariness by businesses. Internationally, China’s general attitude stoked a tense environment, especially with the US. This led to a collapse in foreign direct investment in China, with a deficit of 11.8 billion dollars in the third quarter, the lowest level on record since this indicator was started in 1998.

THE TWO MAIN HISTORIC DRIVERS OF THE CHINESE ECONOMY - REAL ESTATE AND EXPORTS - HAVE STALLED

The real-estate sector has fallen sharply, due to lower prices, fewer transactions, and other factors. But this crisis doesn’t look to be systemic in nature. China’s total real-estate debt is estimated at 8,400 billion dollars, equivalent to almost 54% of its GDP, of which 34% in mortgages and 20% in developer debt. Individual mortgage loans would not appear to be a major concern, as leverage is low, given that a large downpayment is required to buy a home. The risk is, rather, with property developer debt, which consists of bank loans and bonds.

75% of this debt is held by Chinese banks. At major banks, this is estimated to account for about 3% of their total assets, vs. 5% at smaller banks. So major Chinese banks would appear to have the resources to absorb losses on these loans. Keep in mind, however, that almost all of these debts are held in China. The government could thus find an “in-house” solution to the problem. Exports naturally shrank due to the geopolitical context and the economic slowdown in Europe and the US. Even so, China’s trade surplus did not shrink (as imports were also down) and is expected to approach this year the impressive sum of 860 billion dollars. Meanwhile, China is developing strategic partnerships with other countries to offset the decline of its historic markets of the US and Europe. President Xi Jinping’s trip to Johannesburg for the recent BRICS summit is a good illustration of this. Likewise, the new partnership with Saudi Arabia is noteworthy. Saudi Arabia knows that oil is doomed and that it must therefore diversify into other fields, such as tourism and renewable energy. China is naturally wellplaced in exchanging its solar and infrastructure skills for oil, which is still needed, pending a full transition.

SEEKING A THIRD DRIVER…

China now wants to focus on its “Common Prosperity” plan and rely more on its domestic economy. The government has announced a series of support measures since last summer, including an easing of rules on property purchases, monetary easing, fiscal support, and guarantees on local government debt.

But these measures have had little effect thus far. The authorities still appear to be torn between the determination to regulate some excesses that emerged during the Chinese economic boom (corruption, a wealth gap, accessibility to housing, the birthrate etc.) and the need to address short-term growth issues. At the most recent annual economic conference, held in mid-December, President Xi Jinping reiterated a dual objective: quality growth and a high level of security, which are certainly praiseworthy long-term goals. Will this strategy shift in response to growing discontent of a portion of the population, facing, all at once, a decline in the value of their assets, wage cuts decided unilaterally by companies who have no other choice, layoffs in manufacturing and unemployment of young graduates? Meanwhile, private investment is down and is not being offset even by the 6.5% increase in public investment. In short: long-term strategy or shortterm tactics? This is one of the challenges facing China in 2024.

OTHER ASIAN EQUITY MARKETS FARED MUCH BETTER

The EM Asia ex-China index gained 14% in USD (+12% in euros), with a special mention for Taiwanese (+24.6%) and Indian (+18%) equities. These two countries sum up rather well the features of this asset class: India is lagging behind in development and its growth rate is high, expected at 6.5% in 2024. Taiwan is more advanced and features one of the world’s top expertises in semiconductors. Meanwhile, while Asian countries are naturally correlated to the Chinese business cycle, they are also well integrated into global economic circuits and are likely to be made more so by strategies to bypass China by both Western and… Chinese companies!
Several Asian countries are wellplaced to receive these investments, for either political reasons (India, the world’s largest democracy) or for competitiveness reasons in terms of labour costs, including Vietnam, Indonesia and others. In another area, note also the strong performance of emerging sovereign bonds issued in local currencies. The J.P. Morgan GBI-EM index rose by 10.2% (in euros) in 2023, driven by a combination of two major factors:

• Carry, with the asset class yielding a little over 7% early this year;
• A price effect, due to the lower yields in some countries, particularly in Latin America, where 10-year yields fell by almost 2.7% in Brazil and Colombia. Note also the fall in bond yields of 3.8% in Hungary and 2.0% in Poland.

The currency effect, meanwhile, was minimal in 2023.

FIGURE OF THE YEAR

3

The number of consecutive years the MSCI China index has fallen.

MSCI CHINA INDEX VS MSCI EM ASIA EX CHINA

2024 OUTLOOK

VALUE PLAY, GARP AND BOND DIVERSIFICATION

EMERGING BONDS DENOMINATED IN LOCAL CURRENCIES OFFER DIVERSIFICATION THAT SHOULD ONCE AGAIN BE ATTRACTIVE IN 2024

After three years of losses, China now looks like a value play. The 2024 P/E of the MSCI China index is now below 10x, with earnings now expected to rise by about 10% in 2024, in an economic environment that seems to be stabilising with consensus forecasts of Chinese growth at about 4.5%. We now see little downside risk, but to absorb this discount, a catalyst will be needed. As is often the case in China, the catalyst could be political in nature.

For, in highly centralised countries, things can go very fast. The government could respond to growing broad miscontent with a massive fiscal splurge, or even by pushing institutions to support the market in order to restore confidence. If that happens, a prompt recovery could occur, driven by investors who have fled this market and who would return to avoid getting left behind by the indices.

In our view, the most attractive sectors fall into several categories: 1/ those favoured by the government, such as the green economy; “self-reliance” sectors, such as semiconductors; technology, etc.; and 2/ domestic consumption with the boom in local brands in sectors, where the government has few reasons to get involved, as they are not the highly sensitive: food, cosmetics, healthcare, leisure, services, etc.

The rest of Asia seems more “consensual” and is a GARP story, i.e., ”growth at a reasonable price” (with a 12-month P/E of 14.8). Asia ex China is currently receiving positive investment inflows. Assuming a broad stabilisation of interest rates and a moderate slowdown in the US and Europe, Asian economies are likely to achieve decent growth.

Earnings growth forecasts of 15% for 2024 therefore look within reach and could trigger market gains of an equivalent extent.

On emerging debt markets, there is probably less chance of capital gains from rate cuts, but the overall yield of more than 6% looks competitive. Meanwhile, the currency component could be positive in 2024. On the whole, emerging market currencies have been penalised in recent years by being hit by inflation earlier than in Western countries and, most of all, by the strength of the dollar. But the trend has reversed itself in recent months, and they are once again outperforming. This recovery could pick up speed under the very likely assumption of an easing in US monetary policy in mid-2024. Historically, phases of relative weakness in the dollar have been rather favourable to emerging currencies.

Document completed on 09/01/2024