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European Macro – 2024 Outlook
Euro area: There’s likely to be confirmation that the euro area economy is in a mild recession next week, but the broader picture is one of stagnation rather than crisis. Survey evidence has stabilised somewhat and we expect growth conditions will gradually improve through the year. Despite a blip in the December HICP data we think that the disinflation process is set to continue, boosting households’ real incomes, and monetary easing should also spur a pick-up in activity in H2. All in, we are slightly above consensus on euro area growth in 2024 and expect quarterly rates to improve towards potential by the end of the year.
United Kingdom: It’s a similar story in the UK. The UK economy is also likely to slip into recession, although it’s a closer call than in the euro area. Stronger survey momentum suggests that the outlook is slightly brighter at the start of 2024. Pre-election tax cuts are set to combine with recovering household incomes to boost overall consumption growth. Monetary policy easing will likely provide further support. As with the euro area, we are a little above consensus on the UK this year and expect growth to pick up in H2.
US Fixed Income: Summary of our 2024 Views
Macro View: We continue to get mixed messages from tier one versus tier two data. The most recent US labour data is the best example (see below for factors that suggest there are cracks forming in the US labour) but we are also seeing it in the underlying trends for various inflation metrics and growth measures too. We continue to view this period as a potential inflection point to much weaker activity (after a major boost to growth in 2023 from fiscal spending and consumers drawing down their savings).
Although the December NFP initial jobs report data showed over 200k jobs were added, overall the US labour data ended 2023 with the longest string of monthly revisions for a non-recessionary period (given this trend it’s likely that the December also gets revised lower, in our view). The headline establishment report continues to diverge from the household (HH) survey data (where HH was very weak). The labour force participation rate decline was the main reason that the unemployment rate (U/R) remains under 4% (and why the trend upwards in the U/R hasn’t broken the SAHM rule yet). If it had not declined, we would have seen a near 0.3% rise up in the U/R. Employers are cutting back hours versus cutting back employment as seen by the reduced weekly hours worked. Meanwhile most of the job growth in the back half of 2023 came from non-cyclical employment (government, healthcare and education) as private job growth has virtually stalled. Nearly all states in the US are seeing a rise in unemployment (once this trend goes national it usually continues until a recession eventually unfolds). Lastly US continuing claims data remains elevated as the recently unemployed are having a hard to finding work once let go.
Fed and US Rates View: We now expect 175bps in cuts (previous range was 150-200bps in cuts for 2024 since we had that call from mid-summer). To make it straight forward, this assumes 25bp cuts at every meeting starting in March. It’s a version of “measured” Fed policy in reverse. This would take the Fed Funds median range to 3.625%, which would still be 75-100bps more restrictive than the long-run neutral rate. Slow and steady rate reductions would allow the Fed time to assess the economy’s reaction. It would also allow the Fed to keep QT in place into late 2024.
That said, in the latest FOMC minutes, the Fed is preparing the public on when it will end its balance-sheet roll-off. It’s possible that the tapering of QT takes place closer to the first cut (or at the same time) and would see QT phase out by 4Q24. The March cut is the most contentious and challenged piece of our Fed call. However, as we have seen in the last few months narratives can change as can the data and market performance. We were one of the first to suggest March as the first cut because of our concerns around the banking system and financial conditions more broadly. If there are no financial flare-ups before March, the first cut may come instead in either May or June, if they skip March.
After weakening sharply at the end of last year, the USD has since rebounded strongly at the start of 2024. The price action fits with our view that USD weakness overshot fundamentals at the end of last year. In our Annual FX Outlook report (click here) we outlined our forecasts for the USD to rebound in Q1. The USD rebound has been encouraged both by further evidence that the US economy is still proving resilient to higher rates and by weaker growth outside of the US especially in China and Europe. It has prompted the US rate market to scale back expectations for an earlier Fed rate cut. The probability of the first 25bps rate cut being delivered as soon as at the March FOMC meeting has dropped back to around 50%. At the same time, European economies may have fallen into technical recession in 2H of last year while China’s economy lost upward momentum in Q4 despite policy stimulus. We expect the challenging global growth outlook to remain supportive for the USD in the near-term. Yet the USD ‘s ability to stage a bigger rally should be curtailed by: i) slowing US inflation, ii) the ECB’s plans not to cut rates until the summer, and iii) the BoJ’s increased confidence that their inflation target will be met.
KEY RISK FACTORS IN THE MONTH AHEAD
- The main upside risk for USD/JPY would be if US yields and the USD continued to strengthen, and Japanese policymakers did not express much concerns over further JPY weakness. Potential triggers could include a further flare up in Middle geopolitical tensions that pushes back against expectations for lower inflation and Fed rate cuts. Evidence of a significant pick-up in demand for foreign securities by Japanese households in response to changes to the Japan’s NISA tax-free investment scheme could pose downside risks for the JPY as well at the start of this year.
- The main upside risk for EUR/USD would be if wage growth in the euro-zone continues to remain uncomfortably strong at the start of this year discouraging the ECB from beginning to lower rates. Any signs of an improvement in the growth outlook after such a weak end to last year could also offer more support for the EUR. The broader USD performance could tun on whether the Fed is judged as more or less likely to cut rates at their next meeting in March. A weak NFP report could trigger the biggest negative USD reaction by not only brining forward Fed rate cut expectations but also casting doubt on building optimism over a softer landing for the US economy and gradual rate cuts.
- The upside risk for USD/CNY is that China has not yet stabilized the domestic property market and deflationary concerns could further weaken market sentiment towards China’s economic outlook and asset markets. On the other hand, the CNY could be boosted by the rolling of a series of effective stimulus measures to help stabilize the stock market and housing market and in turn boost domestic demand, and in turn boost domestic demand.
After an early January re-pricing credit markets recovered well in recent weeks with spreads close to the late December tights. Overall yields have declined significantly since Central banks from ECB to the FED have halted rate hikes on the back of lower inflation prints. The credit market is still very much driven by rates direction and rates volatility. The benign economic backdrop also remains very supportive for IG credit. The recent oil prices have been at lower end of a band at around USD74 and other risk indicators such as Bund-BTP spread has now rallied to 2 year tights of 153bp,from 205bp in October 23.
We maintain our view that IG credit continues to be an attractive area for investors, given the mixture of strong underlying fundamentals of the bulk of the members of the index and overall still attractive yield levels, albeit less than in October or November 2023. Credit spreads have rallied significantly into year-end 23 and got ahead of themselves, leading to a re-pricing in early January. In recent weeks the spreads have, nevertheless seen a return to tightening and have recovered most of what was given up in early January.
The geopolitical situation remains complicated with the conflicts in Ukraine and Gaza as well as the security in the Red Sea and potential volatility in tensions in Taiwan and North Korea. Despite no signs of appeasement these remain a cause of uncertainty, albeit the market has grown used to it. China’s domestic economic uncertainties, and weakness in the real estate market there, add to the overall volatility in risk sentiment. But also here overall sentiment has remained stable.
As a result, post the early January wobble credit spreads have rallied significantly with synthetic indices not showing any signs of respite. Since end October the XO tightened almost 23bps to 322bps (from a March 23 515bps wide and a Dec 23 tight of 314bp). Pre-invasion of Ukraine XO was in the 320 area. Main is also 6bps tighter at 59bps from the January, which compares to October wides of 90bps.