A tale of three probables Equity Outlook Year 2024

As they say, history doesn’t repeat itself but often rhymes. As we approach 2024 having seen high inflation followed by high interest rates globally over the last 2 years, we can look at 3 cycles of the US in the past, which may serve as a blueprint for the way ahead:

Cycle I - The 1994-95 cycle: Soft landing

This was a benign cycle where the Fed tightened preemptively, and the outcome was one of the few truly soft landings in US economic history. The unemployment rate had fallen since 1992, and GDP growth was reasonably healthy, between 2.5% and 4% in 1992-94. At the beginning of 1994, inflation was above 2.5%, and the Fed increased interest rates swiftly from 3% to 6% by March’95. Inflation was controlled, peaking at 3% in June’95, and GDP growth slowed down to 2.25% in Dec’95 with inflation at 2.5%. The improvement in macroeconomic conditions laid the base for an upcycle of more than 4% real GDP growth till 2000. The dollar weakened, with the US Dollar index falling from 97 in Jan’94 to 82 in Jun’95.

Cycle II - The 1973-79 cycle: Inflation strikes back

The US economy performed well during 197-73 with GDP growth crossing 5% in 1972. Due to tightness in oil markets and loose fiscal/monetary policy, inflation galloped to above 12% in 1974. Fed increased rates to 12% in mid-1974 but started cutting aggressively once inflation fell. Inflation bottomed out at the end of 1976 at 5%, with the Fed rate at 4.6%. Subsequently, due to the increase in commodity prices and GDP growth recovery, inflation rebounded, reaching a peak of 15% in 1980. Fed had to raise rates to 19% to get inflation down, causing recessionary conditions from 1980-82. The dollar was weak through this period of 1973-80.

Cycle III - The 1945-50 cycle: Negative real rates for deleveraging the government debt

During the early 1940’s due to World War II, the government sought to maintain price stability through the imposition of wage and price controls. After the war, as these controls were dismantled, the price level surged upward. Notably, consumer price inflation averaged 10% from 1946 to 1948. Also, the government debt-GDP had climbed to above 100% by 1946 from 40% before the war. Despite the high inflation, the Fed kept the yield on long-term bonds capped at 2.5% during 1945-1951, hence running high negative real rates. This helped the economy recover to 4% GDP growth in 1948, and government debt to GDP fell swiftly to 75% by 1950.

Our view of how 2024 may shape up in terms of the above cycles:

At this point, the current cycle most likely resembles 1994-95 Cycle, where inflation in the US has come down to 3% from a peak of 9% in Jun’22. Even as the Fed has increased rates to more than 5%, the GDP growth has remained strong, and unemployment is at a multi-decade low. If the Fed continues to keep real rates relatively high, then the US economy should slow down in 2024, with interest rates falling gradually. Given slowing global GDP growth as a headwind and lower interest rates as a tailwind for equity markets, it could be a neutral outcome.

The next likely outcome is that the Fed is more aggressive in cutting rates as the government debt to GDP is as high as in 1945-50 Cycle – if this occurs, equities could get a boost as this could help both the economy and valuations (through better liquidity). The downside risk is a resurgence in inflation like the 1973-79 Cycle – we believe the probability of this is low. Finally, there is a tail risk of the monetary tightening causing a big credit event or deep recession – as the tightening cycle is mature this risk has reduced over the last year. Overall, the chances of emerging markets outperforming developed markets are high in 2024 as interest rates in the latter start coming down.

Things are clearer on the domestic side. Noticeably, India remains a bright spot for global growth with long-term structural positives – strong demographics, political stability, stable macroeconomic indicators, etc. The reforms in the economy a few years back are now paying off through robust tax collections, improvement in the quality of government expenditure with a focus on infrastructure, boost to manufacturing through the PLI scheme and other measures, etc. Most other large emerging countries like China, Brazil, Taiwan, Saudi Arabia, etc. have issues around growth or geopolitics and this should help India garner a big share of global capital flows into emerging markets.

Indian markets have done well in 2023 in absolute terms and relative to the emerging markets index. The broader markets have significantly outperformed large cap indices. While the macro context looks supportive of equities it would be unrealistic to expect such high returns to continue in the broader market. However, for the patient investor who can look at equities from a long-term perspective the small and midcap space still deserves a healthy allocation in our view.

Source: Bloomberg



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