An optimist's guide to 2024's most important economic risks (Part 2)

The story so far in markets this year is one of disinflation. It seems the bulls are more interested in rate cuts than geopolitics and Chinese deflation. As long as it remains this way, risk assets will continue to rally and the pessimists will be kept at bay. 

With this spirit in mind, we're continuing our series looking at the most important macro and economic risks that investors should be watching closely in 2024. 

Last time, our guest Tim Toohey - Yarra Capital Management's Head of Macro and Strategy - shared his thoughts on why Australian investors should closely watch the recovery in emerging markets, why the Federal Reserve truly needs to be cutting rates soon, why Australia has increased rates less than some of our developed market peers, and why geopolitical risk may very well fade (rather than flare up) over the next 12 months.

If you missed that piece, you can check it out here.

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

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In this second and final part of the series, we will be applying Tim's optimistic view to asset allocation and markets. 

LW: What is one economic opportunity or optimistic economic data point that does not get discussed enough?

Toohey: The most under-appreciated data point that will impact financial markets through 2024 is the quits rate from the JOLTS survey in the US. 

The reason is that the Fed is currently waiting to be convinced that services inflation is moderating and that is a function of the outlook for wages. The quits rate has proven to be the single most effective leading indicator for wage growth in the post-COVID period.

It currently indicates that wage growth will be running close to 3% year-over-year in 6 months, which is well below the Federal Reserve’s expectations. If labour productivity continues around its current surprisingly strong pace in the US and wages slow to 3% year-over-year, then the Fed’s concerns over sticky services inflation will quickly disappear and financial markets can firmly concentrate on the pace and magnitude of the easing cycle.

LW: You’ve argued in recent times that Australian equities could rise by 10% in 2024. Can you please illustrate the hows and whys of this thesis?

Toohey: We are more optimistic about economic growth than the RBA and consensus, and ultimately, better-than-expected economic growth transitions into equity market out-performance. There are several things about this economic cycle that are different from typical economic cycles in Australia, which has seen economic growth prove more resilient. The four main factors are:

1. Commodities. Prior commodity price strength continued to underwrite double-digit nominal economic growth and profitability. 

2. Backlogs. Housing approvals and affordability are at very poor levels, yet the level of home building has barely declined at all. 

The backlog in work yet to be done is now peaking at a very high level, suggesting we shouldn’t be looking at the housing sector as a source of new economic growth. But equally, we shouldn’t be expecting a precipitous collapse in 2024. That may come in 2025 if interest rates remain at current levels, but that is not our expectation. 

Less has been made of the backlogs in non-residential construction (led by offices, warehouses, health, and transport), which equates to 7% of GDP and the backlog of engineering construction (led by roads, railways, electricity, and mining), which equates to 16% of GDP. 

This enormous backlog of work has kept upward pressure on the labour market and input prices at a time when a typical global slowdown would have seen investment tumble by 10% to 15%.

3. Buffers and asset prices. The rising trend in net household assets means that income from term deposits, financial assets, and investment property ownership have all risen over time and all produce an income stream that is still more than the rise in interest payments on the outstanding debt. This explains the bifurcated nature of spending growth. Older, asset-rich households are largely impervious to the rate hikes, whereas the cash flow of younger, more indebted households has turned negative and spending is being seriously challenged. 

4. Population pump priming. Net immigration has surged well past government projections. Population growth is close to 2.5% year-over-year growth in 2H23 alone. It is very hard to record a recession with that type of population growth at your back. 

We do expect net migration to slow in 2024 as the government seeks to tighten up some education programs and entitlements, but the risk remains that the flood of people entering Australia surprises on the upside until a more material rise in the unemployment rate is realised.

As we finished 2023, some additional factors that support a more positive outlook into 2024 were worth noting.

1. Commodity prices are exceeding expectations. A falling US Dollar and stronger global demand have seen commodity prices rising in Q4, which will provide a fillip for profits, tax revenue, and nominal economic growth.

2. Fiscal support and tax cuts. Despite the adjustments to Stage 3 income tax cuts, the cut is still equivalent to 1% of disposable income. With the Federal Budget in surplus, the RBA rate hiking cycle likely complete, and a federal election looming, 2025 is likely to see additional fiscal support announcements in 1H24 to support lower and middle-income households.

3. Inflation moderation to drive rate cuts. We expect inflation to move into the top of the RBA target band before the end of 2024, setting up the prospect of the RBA easing in August and again in November 2024. While we are expecting a relatively shallow rate easing cycle, it will likely come earlier than most expect. 

4. CAPEX intentions have lifted. We were pleasantly surprised to see that the ABS measure of investment intentions rose through 2H23. It now suggests that business investment will rise 10% in 2023-24 – well above the RBA’s 1-2% forecast. Indeed, not only has business investment been robust, but there are signs it is accelerating.

As a consequence, we think economic growth will accelerate sequentially through 2024 and average 2.25% - sufficient to drive earnings upgrades amongst the analyst community.

While better growth will drive better earnings, the more interesting thing is that as markets continue to remove fears of recession and embrace the prospect of a friendlier liquidity environment, equity markets tend to embrace the ‘hope’ phase of the cycle. P/E ratios expand on little new news other than a decreasing probability of negative tail risks (more on this below). 

LW: How does this more optimistic economic scenario inform Yarra’s asset allocation house view?

Toohey: We tend to back our macro views and valuation signals by taking much more active asset allocation decisions, vis-a-vis most other multi-asset funds in our peer group. This comes to the fore when we are near turning points in the economic cycle where we have historically added significant alpha.

Given our macro views, it probably won’t surprise you to learn that we are significantly underweight cash at present, overweight credit, and we have been progressively reducing our overweight fixed income positions to fund an overweight tilt to equities and real assets. 

As the cycle matures, we will likely be underweight fixed income. However, we intend to wait until central bankers make their case for the easing cycle and commence the easing process before making the switch to a significant underweight to fixed income. 

I would personally be underweight alternatives at this point of the cycle as macro hedge funds tend to do well in the hiking phase of the cycle and relatively poorly in a more normal operating environment. Market-neutral funds tend to lag during cyclical upswings. 

Given our global views where we see sooner and larger interest rate reductions offshore compared to Australia and rising commodity prices, we are Australian Dollar bulls and look for the Australian Dollar to finish 2024 around 74 cents. Thus, we favour hedging our global equities exposure. 

Tactically, we are conscious that the ‘hope’ phase for financial markets tends to reward equities the greatest. But these phases are notoriously short-lived, so we will continue to reassess asset class positioning continuously and adjust once we detect that markets have moved closer to embracing our macro views. At this stage, that doesn’t appear to be a decision we expect to have to make in 1H24.