by Marc Chandler
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The only thing that can be said with high confidence about the year ahead is that it will be different from 2023. Three broad forces will shape the business and investment climate in the year ahead.
First, the post-Covid tightening cycle in the high-income countries, leaving aside Japan, has ended. The question is when and how fast rate cuts will be delivered. Moderating price pressures and weaker growth impulses have seen the pendulum of market sentiment swing dramatically from the "higher for longer" mantra of most of last year to pricing in aggressive easing the Federal Reserve and European Central Bank. Several central banks from emerging markets, especially in Latam and central Europe, have already begun cutting rates.
The Federal Reserve's balance sheet shrank to a little less than 29% of GDP from almost 33.5% at the end of 2022. The impact through the reserves seems less than meets the eye as the reduction of the use of the Fed's reverse repo facility cushioned the impact. That will change, and we expect Quantitative Tightening to end around mid-2024. The ECB's balance sheet shrank to around 49% of monetary union's GDP, down from almost 60% at the end of 2022. It will slow and then stop the reinvestment of the maturing proceeds from the pandemic buying program in 2024. Before Covid, the ECB's balance sheet was about 39% of GDP compared with near 19% for the Federal Reserve. The Bank of England's balance sheet is around 30% of GDP, down from a little more than 37% at the end of 2022. It was slightly above 21% before Covid. The Bank of Japan's balance sheet expanded more than 129% of GDP from about 126.5% at the end of 2022. It was near 103% before Covid struck.
Second, the year ahead features electoral contests in countries that account for almost half of the world's population. Most of the contests will take place in the first half of 2024, and they begin quickly. Taiwan's election on January 13 kicks off the year's election. Although the US election is not until November, its shadow already looms large. The UK election has not been called, but many expect it in late 2024. However, there is a risk that it is called for May 2 to coincide with local elections. Japan does not need to go to the polls. Prime Minister Kishida has a high disapproval rating and is vulnerable to a leadership challenge from within the Liberal Democratic Party, which has dominated Japanese politics for almost as long as the Communists have been the sole party in China. The German coalition looks fragile.
Third, geopolitical developments will also shape the business and investment climate. Russia's war in Ukraine will extend into the third year, but the seemingly united opposition appears to be fraying. Polls show that around half of Americans think too much has been spent already, and the Republicans appear to be trying to turn it into a campaign issue. Support in Europe is also wavering. Hungary's Orban may have blocked the latest EU aid effort, but the earlier enthusiasm seems to be waning. At the same time, longer-range and more powerful weapons are being transferred to Ukraine, and the Biden administration appears to be more sympathetic to "re-purposing" the frozen Russian reserves to aid Ukraine.
Hamas's attack on Israel has reverberations well beyond the Middle East. It hardens the Beijing-Moscow-Tehran axis. It exposes a new fissure between the US/European elites who robustly defend Israel's right to defend itself and many people who draw parallels between Israel's punishing response to Russia's behavior in Ukraine (and America's actions in Afghanistan and Iran). Biden's support weakened, not so much because of the independent swing voters but because of defections from the Democratic Party's base.
There are many unresolved territorial disputes. Some see the US as preoccupied with Ukraine, the Middle East, and China, which may offer an opportunity to push for a resolution. In the Asia Pacific, China's aerial intimidation of Taiwan continues, but it is also bullying the Philippines, to which the US has a defense treaty (not the strategic ambiguity with Taiwan) and has indicated the disputed shoals are covered by it. Reports suggest China is also encroaching on Nepal and Bhutan. In a broader sense, deterrence has failed. It did not stop Russia from invading Ukraine. It did not prevent the attack by Hamas, or the rocket strikes by the Houthi, which has disrupted transit Red Sea and reignited supply chain challenges.
The US may escalate its efforts to slow China's technological development through denying it access to semiconductor fabrication technology, not just the advanced ones needed for AI, for example, but even previous generations. The US is also considering boosting the tariff on Chinese electric vehicles. The results of a three-year review by the Biden administration are expected in early 2024. Beijing recently imposed a ban on rare earth processing technology and some rare earth magnets. The International Energy Agency estimates that China accounts for 60% of the world's rare earth mining and 90% of its processing and refining capacity. This follows the previously announced restrictions on three other elements used in manufacture of chips.
Two macroeconomic developments, which characterized 2023, are unlikely to be repeated in 2024. First, the US economy outperformed expectations by a wide margin. In December 2022, the median forecast among Fed officials was that the US economy eke out 0.4% growth. The outlook steadily improved, even in the face of rising rates and in December 2023 stood at 2.6%, which is above the 1.8% pace that officials regard as the non-inflationary speed limit. The median Fed projection now is for a growth to slow to 1.4% in 2024.
The second development has been the sharp drop in inflation. It appears that the transitory element was larger than thought. As supply chains were repaired and food and energy prices receded from the 2022 highs, CPI has moderated. In the US headline CPI finished 2022 at 6.5% and was at 3.1% in November 2022. Eurozone CPI fell from 9.2% at the end of 2022 to 2.4%., while the UK's CPI moderated to 3.9% in November 2023 from 10.5%. Canada's CPI was halved from 6.3% to 3.1%. Japan's headline CPI was at 4.0% in December 2022 and slowed to 2.8% in November 2023. Further progress on inflation likely to be slow and haltingly. Nevertheless, the next easing cycle will likely begin before inflation, however measured, (the composition and weights vary), falls back to its targets.
In China, modest inflation (1.8% at the end of 2022) has slipped into deflationary territory (-0.5% in November 2023). Falling food prices, especially pork, has an inordinate influence. Excluding food and energy, China's CPI was 0.6% higher year-over-year October and November 2023. Conventional wisdom may under-appreciate Chinese consumption, which on a per capita basis has doubled in the past decade. In the year-through-November, Chinese retail sales have risen 7.2% from the same 2022 period. Investment ("fixed assets), which conventional wisdom says is over-emphasized, creating imbalances that foster protectionism elsewhere, rose 2.9% in the first 11 months of 2023 compared with the January-November period 2022.
The interest rate cycle has already turned in several emerging market economies in Latam and central Europe. This will continue in 2024, and more countries, including Mexico, India, South Africa, South Korea, and the Philippines will join. The benchmark that tracks the premium emerging market countries pay to borrow dollars over the US Treasury narrowed by more than 120 bp last in 2023. However, emerging market equities under-performed. Excluding China, which had a poor year, MSCI's emerging market equity index rose by about 16.5% in 2023, while the MSCI index of developed market equities gained a little more than 21%.
We expect the Bannockburn World Currency Index to appreciate in 2024 and snap a three-year decline. This is consistent with the deprecation of the US dollar as the economic outperformance and interest rate premium narrow. To signal a new phase, the BWCI can return 98.00-99.00 area that prevailed before Covid. According to the OECD's purchasing power parity model, the euro and yen are both around 50% undervalued and sterling is nearly 20% undervalued. These are extreme readings. The Bank for International Settlements model of real equilibrium exchange rates has the Chinese yuan, followed by the South Korean won as the most undervalued among the emerging market components. By the BIS calculations, the Mexican peso may be the richest in the basket after the US dollar.
U.S. Dollar: Many observers, including ourselves, were critical of the seemingly late end to the Covid-inspired QE and the beginning of the tightening cycle. However, subsequently, several times, the market anticipated the end of the hiking and the beginning of an easing cycle, well ahead of Fed signals. At the December 13 FOMC meeting, the median forecast was for three rates cuts in 2024. The derivatives market is pricing a little more than 150 bp of cuts in 2024, with the first cut near fully discounted by the end of Q1. These expectations have rippled through the capital markets, weighing on yields and the dollar, while boosting the attractiveness of risk-assets and non-interest generating financial assets, like gold and crypto. The market is at risk of getting ahead of itself. The nine-week rally in the S&P 500 is the longest in two decades. We expect Fed officials to continue to push against expectations and be helped by a still robust labor market (with demand implications) and above trend growth in Q4 23. Favorable base effect for CPI and the PCE deflator points to lower headline rates in early 2024, but the median forecast in Bloomberg's survey and among Fed officials is for the headline PCE to be at 2.4% at the end of 2024 and still above the 2% target at the end of 2025, albeit slightly. Meanwhile, the budget deficit is expected to be nearly unchanged from the 6.2% projected in FY23 to 6.1% in FY24 (CBO baseline). Temporary spending bills expire in two tranches, January 19, and February 2. Without a resolution, a partial government shutdown will result. The national election is not until November, but it is already a consideration. The possibility of tax cuts or more generous depreciation allowances may influence business investment decisions. Europe (and others) may need to be prepared for what has been dubbed a "dormant NATO." As expectations for rate cuts grew, some banks appeared to borrow from the Bank Term Funding Program (BTFP), launched during the bank pressures last spring, and lend back to the Federal Reserve locking in a handsome risk-free profit. Officials will discourage this and the BTFP facility (up to one-year loans in exchange for Treasury bonds at face value rather than market value) ends in early March. That banking stress was a function of managing risk in a higher interest rate environment. The next bout of stress may be stoked by the opposite. Lower interest rates are expected partly due to weaker growth prospects. And that could expose credit scores that had been inflated during Covid and the suspension of student loan servicing. Commercial real estate remains a concern. Yet, an index of large bank shares has risen by a third from the October lows, while an index of regional banks has risen slightly more. They finished the year near nine-month highs loo, but look stretched. The 2023 low for the Dollar Index was about 99.60 and finished the year near 101.25. We expect it to fall to the 93.00-95.00 area in 2024, even though in nine of the 12 elections years since floating exchange rates, the Dollar Index has risen and by an average of almost 6.80%. That the three declines took place in the last five election years seems to complicate the election year cycle.
Euro: The eurozone economy stagnated in 2023 and the outlook for 2024 is not much better. The ECB expects 0.8% growth in 2024 after 0.6% in 2023. Price pressures have moderated considerably, and this creates space for easier monetary policy. The year-over-year rise in CPI slowed to 2.4% in November 2023 from 9.2% at the end of 2022. This may overstate the case a bit, and modest acceleration is likely in the coming months. The details of the December agreement on the new fiscal rules have not been presented but the broad outlines suggest that the objectives of the Stability and Growth Pact (3% deficit cap and 60% debt ceiling) remain, while the adjustment process looks more flexible. The swaps market has nearly 75 bp if rate cuts discounted by the end of H1 24 and almost 165 bp of cuts by the end of the year. At the same time, the ECB expects to slow the pace of reinvestment of the maturing bonds bought under the Pandemic Emergency Purchase Progress and finish by the end of 2024. The European Parliamentary election is June 6-9, and a new European Council will be forged. Belgium assumes the rotating presidency of the European Council for H1 24. Hungary's turn in H2 24 may prove controversial given the numerous flash points, including Budapest's veto of aid to Ukraine. The euro recovered from the 20-year low set in September 2022 near $0.9535 to reach $1.1275 in mid-July 2023. Renewed divergence with the US pushed the euro back to about $1.0450 in early October before climbing back to $1.1140 by late December. We expect the euro to surpass the 2023 high and reach $1.17-$1.18 in 2024.
(As of December 29, indicative closing prices, previous in parentheses)
Spot: $1.1040 ($1.0885) Median Bloomberg One-month forecast: $1.0990 ($1.0860) One-month forward: $1.1055 ($1.0900) One-month implied vol: 6.9% (6.5%)
Japanese Yen: The yen appreciated against the dollar in Q4 23 by almost 6%. It was only the second quarterly gain since the end of 2020. Its recovery was fueled by two considerations. First, the broadly weaker dollar spurred by lower interest rates and expectations of Fed rate cuts. Second, the market expects the Bank of Japan to finally exit its negative interest rate policy by the end of April 2024, when the spring round of labor negotiations will be concluded and the government's extended subsidies for electricity and gas will end, which have taken an estimated 0.5% off headline CPI. Ironically, Japan's core inflation, which excludes fresh food, peaked in January 2022 at 4.2% and by November had fallen to 2.5%. Japanese investors returned to the global bond market in 2023, buying, according to the Ministry of Finance data about JPY400 bln (~$2.85 bln) a week, after selling about JPY420 bln a week in 2022, despite the higher yields available at home. At its peak in mid-October, the US 10-year premium was about 415 bp, the highest since 2001. The spread finished the year near 320 bp. Weak consumption and private investment in the middle two quarter of 2023 translated into a contraction in Q3. The BOJ expects the economy to expand by 1% in 2024. Public support for Prime Minister Kishida is poor, and although a general election is not required before the end of October 2025, an LDP leadership challenge looks likely in October 2024. We look for the dollar to fall back into the JPY130-JPY135 range in the year ahead.
Spot: JPY141.05 (JPY146.80) Median Bloomberg One-month forecast: JPY142.05 (JPY146.30) One-month forward: JPY140.35 (JPY146.15) One-month implied vol: 10.7% (8.8%)
British Pound: The UK economy has not grown since the 0.3% expansion in Q1 23. It was flat in Q2 and contracted by 0.1% in Q3. The fourth quarter began off poorly with a 0.3% contraction in output in October. After a slow start, price pressures eased sharply as the 2023 progressed, with CPI falling from 10.1% at the end of Q1 to 3.9% in November. However, the core rate remains sticky at 5.1% (November), down from 6.3% a year ago and average weekly earnings rose by more than 7% in the three-months through October on a year-over-year basis. Three of the nine members of the Bank of England's Monetary Policy Committee favored hiking rates at the mid-December meeting. The market is convinced that the weak economy and moderating price pressures will push the central bank into cutting rates. The swaps market has the first cut fully discounted in early May and almost 175 bp in cuts are priced in for 2024. The government is expected to call for elections in late 2024. The Conservatives have consistently trailed Labour, but the two main parties are drawing only around two-thirds of the voters, according to recent polls, suggesting a coalition government may be a likely outcome. Sterling was the second strongest G10 currency last year, appreciating by about 5.5% against the US dollar and about 2.2% against the euro. After setting a record low against the greenback in 2022 near $1.0350, sterling recovered to around $1.3140 in mid-July 2023. Amid widening growth and rate differentials, sterling was sold back to almost $1.2035 by early October. The recovery in November and December took sterling back to about $1.2825. If the market reconsiders the timing and magnitude US rates cuts, sterling could pull back toward $1.2400-$1.2500, but we look for sterling to exceed the 2023 high, with potential into the $1.33-$1.35 area.
Spot: $1.2730 ($1.2710) Median Bloomberg One-month forecast: $1.2650 ($1.2600) One-month forward: $1.2735 ($1.2715) One-month implied vol: 7.2% (7.1%)
Canadian Dollar: The Canadian economy stagnated after a strong start to 2023. Headline CPI slowed to 3.1% in October and November after finishing 2022 at 6.3%. The Bank of Canada hiked rates is January and held steady until June and July when it hiked by a total of 50 bp to 5.0%, where its overnight lending target remains. The swaps market has the first cut discounted for April, and for the central bank to deliver slightly more than 150bp of cuts in the year ahead. The Bank of Canada expects growth to slow to less than 1% in 2024 and headline CPI to moderate to 3%. The Trudeau government will implement at 3% digital services tax at the start of 2024 (retroactive to January 1, 2022) on revenue earned in Canada regardless of the company's headquarters. The tax applies to companies with overall revenue of about $795 mln and Canadian sales of more than C$20 mln. The US is opposed and claims it singles out US companies. Washington threatens to retaliate. The US dollar recorded the year's high near CAD1.39 in early November but fell below CAD1.32 in late December. On the year, the Canadian dollar appreciated by about 2.6%, making it the best among the dollar-bloc currencies. Momentum indicators are stretched, favoring a recovery in the greenback that could extend into the CAD1.3400 area early in the New Year. Still, we expect the 2023, low slightly below CAD1.3100, will be taken out, and target the CAD1.28-CAD1.29 area.
Spot: CAD1.3245 (CAD 1.35000) Median Bloomberg One-month forecast: CAD1.3300 (CAD1.3500) One-month forward: CAD1.3235 (CAD1.3490) One-month implied vol: 5.7% (5.6%)
Australian Dollar: The Reserve Bank of Australia lifted the overnight cash target rate by 125 bp in 2023 to 4.35% and but trailed most of the other G10 countries in tightening. Inflation is a bit stickier than elsewhere at 4.9% year-over-year in October. As a consequence, the RBA is seen lagging others in rate cuts. The swaps market has about 60 bp of cuts discounted for 2024. The central bank forecasts lower inflation (3.3% vs. 4.5% in 2023), higher unemployment (4.5% vs. 4.0%) but stronger growth (1.8% vs. 1.3%). The IMF is less sanguine, forecast 1.2% growth, 4.0% inflation in 2024, and 4.3% unemployment. The Australian dollar rose by about 7.9% in November and December to finish the year almost flat against the US dollar. The Aussie peaked last February near $0.7160 and recorded the low for the year in the year in late October near $0.6270. The November-December rally lifted it to $0.6870. Speculators in the futures market covered about half of the net short Aussie position in Q4 but have not been net long since mid-2021. The exchange rate seems most sensitive to the broad movement in the US dollar and the general risk environment. We are concerned that the markets have moved too aggressively about US rate cuts, which has weighed on the greenback. The Australian dollar appreciated in nine of the last 11 weeks in 2023, leaving momentum indicators stretched. A correction could see a pullback toward $0.6650 in early 2024 but we expect the Aussie will challenge the $0.7000-$0.7200 area later in the year.
Spot: $0.6810 ($0.6675) Median Bloomberg One-month forecast: $0.6775 ($0.6655) One-month forward: $0.6820 ($0.66850) One-month implied vol: 9.4% (9.0%)
Mexican Peso: For the second consecutive year, the Mexican peso was the second-best performing emerging market currency. In 2022, it was bested by Brazil (5.5% vs.5.0%) and in 2023, the Colombian peso did better (~25.9% vs. 15.2%). Colombia joined Brazil, Chile, and Peru in beginning the easing cycle. Mexico has not. The central bank has modified its rhetoric, and the swaps market has nearly priced in a quarter-point cut in the 11.25% overnight target rate by the end of Q1 24. A little more than two cuts are anticipated by the June 2 national elections. AMLO's hand-picked successor, Claudia Sheinbaum, the former mayor of Mexico City, is running well ahead in the polls. Mexico's headline CPI moderated from 7.82% at the end of 2022 to 4.32% in November 2023. The core rate fell from 8.35% in December 2022 to 5.30%. The high real rates may contribute to the slowing of the Mexican economy to around 2% in 2024 from almost 3.5% in 2023. China has increased its direct investment in Mexico, and this becoming more worrisome for the US. Under the USMCA, production in Mexico can enter the US duty-free. In other parts of Latam, Chinese direct investment is mostly in infrastructure and raw materials. In Mexico, it is in services and manufacturing (including cars, home appliances, and electronics. Chinese brands count for about one-in-five cars sold in Mexico. Mexico's bilateral trade surplus with the US jumped from about $7.1 bln in the first ten months of 2022 to almost $37 bln in January-October 2023 period. Policy uncertainty in both Mexico (and the US after the November election) suggests that the peso's strength, which could see a re-test of the dollar's 2023 low near MXN16.62, may fade in the second half of 2024.
Spot: MXN16.97 (MXN17.1950) Median Bloomberg One-Month forecast: MXN17.20 (MXN17.39) One-month forward: MXN17.06 (MXN17.28) One-month implied vol: 11.2% (11.9%)
Chinese Yuan: The dollar peaked near CNY7.35 in early September and retreated to six-month lows in December slightly below CNY7.09. The exchange rate is closely managed but seems largely to track the dollar's broad movement. If the yuan continues to lag against other major currencies, as a trade-weighted measure finished 2023 near three-month lows, we still expect the dollar to move below CNY7.0 in 2024. The US 10-year premium over China peaked in mid-October a little more than 225 bp. It fell by around 100 bp before the end of the year. In late December, large Chinese banks cut deposit rates, which fanned expectations of easier PBOC policy in early 2024. While foreign investors bought bonds of large Chinese banks in November, they continue to avoid mainland shares. The CSI 300 is among the worst performer among large bourses in 2023, losing nearly 12%. A little before the end of the year, Chinese regulators announced new rules aimed at the videogame sector and limiting time played, though quickly approved more than 100 new games. Still, the action highlights the policy risks. Foreign companies seem reluctant to keep retained earnings in China as cyclical factors and the geopolitical environment make for a poor backdrop. And despite, the Biden-Xi meeting, the bilateral relationship continues to deteriorate. As 2023 wound down, reports indicated the US is considering increasing the tariff on Chinese electric vehicles from the current 25% and broadening its restrictions to include legacy (older technology) for semiconductor chips. The Biden administration's three-year review of the so-called Trump tariffs expected to be completed in early 2024. Beijing moved to ban rare-earth processing technology and rare-earth magnets on top of its restrictions on gallium, germanium, and graphite. Economists may be underestimating Beijing's determination to support the economy. The IMF's 4.2% GDP forecast for 2024 seems too low, and we expect the actual performance to be closer to 5%.
Spot: CNY7.10
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