An optimist's guide to 2024's most important economic risks (Part 1)

While making money is fun, investing can be stressful at times. Think about all the risks and unresolved uncertainties the markets have faced just since March 2020. 

So when we read this list from Bloomberg entitled "A Pessimist's Guide to Global Economic Risks in 2024", we naturally felt a little down.

But we are a place full of optimists here at Livewire. So with that in mind, we've created the optimists' guide to macro investing - with the help of Yarra Capital Management's head of macro and strategy (and Signal or Noise alumni) Tim Toohey. Tim has already written two pieces, highlighting some of the reasons why Australian investors have more cause for optimism than those in many other markets - see here and here.

The Bloomberg list of pessimistic risks

In case you don't have access to the Bloomberg list, here it is reproduced:

• The Middle East is on the brink and Ukraine is at a tipping point
• The Federal Reserve could get burned (again) - Central banks could be left stunned by a resurgence in inflation.
• …While Europe feels the chill - Recessions are likely in Europe and the UK this year.
• China looks wobbly and Japan risks losing (yield curve) control
• Game-changing elections

Using this list as inspiration, I've crafted a list of questions for Tim that aims to extract the positive from an otherwise bleak outlook.

LW: How much of the EM recovery rests on the announcement of a major stimulus package in China?

Toohey: I was, and somewhat remain, surprised that even though emerging market economies have accelerated strongly from their cyclical trough in mid-2023, very few market participants have remarked on it. 

However, there are good reasons not to discount the recovery in emerging market growth.

1. This is typically what happens. EM led DM industrial production growth out of the 2001 global recession, they also led DM out of the GFC and they even led DM into the upswing that is now attributed to Trump’s 2016 election win. The most likely reason is that most of the EM economies are either commodity exporters or manufacturing-dominated economies that service global markets. They are at the pointy end of any shift in global liquidity and forward orders. 
2. The typical catalysts for an EM crisis failed to generate a material economic shock - namely a US Dollar spike, higher global interest rates, and weak global demand. The reason for the resilience is partly because EM countries have become more sophisticated and better at treasury risk management in particular combined with relatively low levels of debt due for maturity in 2023 and 2024.
3. EM supply chain duplication is acting as a growth catalyst. The spike in geopolitical tension between Western nations and China catalysed Western companies to seek to diversify supply chains from China. This duplication of supply lines is both resource-intensive and inflationary in the first instance with second-round growth benefits accumulating subsequently.
4. The final and perhaps the most under-recognised driver of the EM recovery is the capital spend required for decarbonisation. McKinsey estimates that the increase in annual investment spending is about $3.5 trillion per year, or 60%, more than is being spent today. And while there is a tendency to think of this spending as concentrated in the developed world, many countries in Africa, Asia, and Latin America are rich in the mineral resources that are essential to the transition. 

While investors are naturally cautious over mainland China’s prospects, one should be careful not to discount the rest of the EM space and the role they are providing in supporting and sustaining a global recovery in demand. Australia will continue to benefit from improving EM demand growth regardless of a major stimulus package delivered by China. 

LW: Why will the Federal Reserve be so keen to cut rates so quickly? 

Toohey: The main argument against [commencing an easing cycle] is simply that there has been little spare capacity released during the downswing in the economic cycle. And with evidence of improving leading indicators of growth, the rationale for easing interest rates is diminished as inflation pressures may re-emerge in time. 

However, we are not advocating for the Fed to return to an aggressively expansionary cycle. 

With the threat of excess inflation now resolved and productivity rebounding, the aim of policy should be to return interest rates to a level that is consistent with generating trend economic growth. We estimate it will take three to four rate cuts of 25 basis points each to return financial conditions to a level consistent with trend economic growth. 

The urgency to reduce interest rates has more to do with the credit cycle than the inflation trend. Broader measures of credit growth are contracting sharply at the moment. It’s easy to look at robust economic data and conclude the US economy is in good health at the moment, but maintaining an economic expansion is simply impossible if the credit channel is impaired. 

In our view, the Fed will also be forced to abandon [quantitative tightening] QT by May. Few things keep central bankers awake at night more than system-wide credit contraction. As the Fed concludes the inflation battle is over, its focus will soon shift to ensuring there is sufficient liquidity in the system. Quite simply, they can’t do that by keeping monetary policy unchanged. 

LW: Has the RBA being behind the curve been a good thing for Australia? (And has a lower terminal real rate been of benefit to Australian investors?)

Toohey: The reality is the RBA abandoned forward-looking policymaking in the post-COVID period in the belief that they could afford to wait to see “the whites of the eyes” of inflation as the then-governor said. However, this was the biggest error. 

By abandoning a perfectly good forward-looking framework for something untested, the RBA missed identifying the inflation shock and has now suffered such reputation damage and been dealt a series of ‘reforms’ foisted upon itself, which provide no guarantee that we have moved to a better model.

If we think about the terminal real rate, regardless of whether we are talking about market-implied terminal rates for the real cash rate or real 10-year bond yields, there was only really one year when a material shift lower in real interest rates occurred, and that was 2022-23.

As inflation fears have receded and cash rates have risen, real 10-year bond yields have risen back to pre-COVID levels. There has been no permanent downshift in real long-term rates other than a little over a one-year aberration. 

I would say the idea propagated by the RBA that interest rates would stay at very low levels compounded investment trends that were already in place and influenced positioning but didn’t necessarily drive excess returns. 

Sectors that exhibit low economic sensitivity such as technology and high sensitivity to duration such as healthcare, REITs and utilities should benefit during these periods. Yet, in the Australian experience at least, only utilities outperformed the ASX 200 during 2022-2023 when real long-term yields declined. 

If you adopted the central bankers' view of the world in 2022 of lower for longer, it ended up being a recipe for investment underperformance.

LW: You’ve written in the past that you expect geopolitical risks to die down over the next 12 months. Why is that?

Toohey: First of all, let me clarify that no one can predict geopolitical shock in advance of time with any degree of accuracy. Secondly, even once a shock eventuates you can’t always be sure that financial markets will a) care and b) respond in the expected direction. 

For instance, few would have expected that conflict in the Middle East would have been consistent with a material decline in global oil prices over recent months.

My view that geopolitical risk will fade as a market focus through 2024 is two-fold. 

Firstly, indices that attempt to gauge the level of geopolitical risk suggest that the starting point is historically high and these indices tend to exhibit mean reversion properties through time. 

Secondly, the further we move away from the point of the initial geopolitical shock the lower the probability that it will materially alter the course of financial markets in the year ahead.

Of the three key events that have caused the spike in tension, the Israel-Palestine conflict has yet to spillover into a broader regional conflict, the Taiwan election has largely resulted in the status quo rather than a spark for conflict, and the Russian invasion of Ukraine has devolved into a stalemate.

This ends Part 1 of our Optimists' Guide to Economic Risks series. 
We will return with Part 2, focusing on Tim's thoughts on the economic and market opportunities available in 2024.