Weekly Report (10th December,2023): Rearview 2023 and Crystal Ball 2024

(Part 1 -  Global Focus)

We started 2023 with Fed funds rate at 4.5% and inflation in US at 6.5%, not knowing how long it would take to tame inflation and where the rate hike cycle would end. We were into the 10th month of the Russia-Ukraine war and there were uncertainties around how China would reopen. 

Despite these uncertainties, risk assets have had a phenomenal year. In March we did see a glimpse of high rates causing turbulence as small US banks ran into difficulties. However, the Fed was quick to step in and prevented the situation from snowballing into a systemic crisis. Since then there have been very few hiccups. Even the Israel-Hamas war which broke out in October failed to puncture risk sentiment. 

In 2023, we have seen supply chains normalize or get rerouted. Russian crude has found its way into Europe through India and China and European goods have found their way into Russia through central Asian countries like Krygystan and Kazakhastan. We began the year with a lot of concerns around semi conductor/chip shortages but we did not see the problem manifest to the extent we feared at the onset of the year. All this meant that the risk premium that was embedded to account for input cost related uncertainties or supply driven inflation, gradually tapered off as the year progressed. 

On the other hand, labor markets continued to remain resilient and this has supported wages. Healthy wage growth and drawdown in savings continued to keep demand supported. Business fixed investment too has contributed to growth. 

Input cost normalization and robust consumption demand have enabled corporates mend their balance sheets. They have supported earnings and driven the rally in equities. This has more or less been the template for most of the developed markets. In case of Europe growth has been much weaker compared to US but it has benefitted tremendously from a drop in energy prices. 

As we head into 2024, the question is whether we will continue to see inflation moderate while growth remains steady and labor markets resilient. Can we get to a situation that existed before COVID where inflation was 1.6-1.8% in the US and unemployment rate was under 4%. While this would be a fairytale scenario and something everyone would be hoping for, there are two key questions:

1) Can the interest rates come down before it is time to refinance for the government and most corporates? It will be extremely burdensone for government as well as corporates if they were to issue greater chunk of long term debt at current levels.

2) Will OPEC+ be comfortable with crude between USD 70-85 per barrel? This is important because if crude remains above USD 85 per barrel, it would be difficult for headline inflation to come back to 2% and even if it does, it would be difficult for it to stay there. In that case we will see interest rates remain higher for longer and that increases the possibility of economic and financial  mishaps. 2024 is an election year and while the US would be keen to replenish its Strategic Petroleum Reserves, it will likely continue to pump crude at close to record levels through 2024 to ensure that global market is well balanced.

2024 is going to be a real test for the central banks, especially the Fed. They have to get the timing of rate cuts spot on. If they hesitate to cut rates after seeing inflation close to 2%, it could be extremely debilitating for the US economy and rest of the world. If the Fed is not in a position to start cutting rates by May'24, the probability that something breaks would drastically shoot up in our view.