Since the financial crisis and especially since 2013/14, the ECB (and other western central banks) bought vast amounts of government bonds. The portfolio of bonds purchased in the Euro system amounted to over 5 trillion euros, most of which were paid in the same amount through the creation of central bank money. The consequences of this expansive monetary and financial policy will continue to shape the economy and capital markets in 2024. Following the outbreak of corona, central banks bought more bonds again, which enabled finance ministers to massively increase government spending. As a result of the increase in demand caused by the government and the shrinking supply of goods and services due to the coronavirus, inflation began to rise. Nevertheless, central banks remained fixated on the risks of deflation. For example, the ECB even amended its monetary policy framework in mid-2021 in order to be better prepared for future phases of deflation. At the time, central banks were almost unaware of the consequences. They only raised their interest rates in spring (Fed) and summer (ECB) 2022, after Russia's war of aggression in February 2022 had driven up energy prices and inflation had become visible to everyone. Central banks such as the US Federal Reserve (Fed) and the European Central Bank (ECB) could make their respective monetary policies somewhat looser overall. However, there is likely to be no return of key interest rates to the very low levels of the past even after 2024. The desired inflation rate of around 2 percent is not likely to be reached until the end of 2024.
The current dynamics of financial markets suggest that rising returns go hand in hand with falling share prices, and vice versa. Yields are expected to continue to decline over the next few months, which should have a positive effect on the overall market. However, this depends on inflation trends and the limited extent of a potential recession in the USA. As long as inflation falls and a recession is avoided, this could support the market. With regard to the European stock market, it is pointed out that a weak economy and high inflation are not conducive. The low valuation of the European equity market is unlikely to help unless there are signs of an economic recovery, which could potentially occur from 2024. Interestingly, despite numerous global stress factors, many emerging countries survived the crisis years relatively well. This is attributed to a reduction in budget and current account deficits, which in turn has reduced dependence on external financing. Overall, there are signs that some emerging markets are taking a robust position in the changing economic landscape.
Small and medium-sized companies on the equity markets have reported disappointing results in recent years. In 2023, the German DAX saw an increase of 15% by November 23, while the MDAX only posted a 4% profit. Small caps are often particularly affected by rising interest rates, as these companies generally have higher debt ratios. Small companies are also more reliant on short-term bank loans, while long-term refinancing through corporate bonds plays a lesser role. Small-cap stocks, however, are expected to get a boost in 2024 as interest rates are expected to fall over the year. At the same time, the outlook for the global economy is expected to improve from the second half of 2024. Historically speaking, small cap stocks have posted above-average gains when the economy recovers after a recession.
Key interest rates appear to have already been reached. The US Federal Reserve Fed is expected to cut its key interest rates from the middle of the year, particularly if economic performance in the US weakens and the Fed regards progress towards the inflation target as sufficient. This is likely to result in a significant fall in government bond yields, with this trend likely to gain momentum, particularly in the first half of 2024. The yield on 10-year US Treasuries could well fall to 3.5% in the coming year. At the same time, the yield on 10-year federal bonds is expected to fall below 2%, although the decline may be more moderate.
The performance of equities and funds in the renewable energy sector has often been disappointing recently. ESG investments depend on many of the same factors as non-ESG investments, and in some cases, the headwinds for ESG investments may be even stronger temporarily. A macroeconomic perspective should be taken when considering ESG investments. In the long term, market development in the area of fossil fuels continues to point to a declining sector. Renewable energy and other ESG investments should always be viewed in the context of a sustainable transition. Investing exclusively in non-hydrocarbon-based business models may hinder this transition process rather than promote it. It could make more environmental and financial sense to invest in existing companies that do not have ESG investments but are committed to driving environmental improvements and carbon reduction. If you would like to find out more about Bavest's ESG offering, you can find information here: https://www.bavest.co/de/solutions/esg-climate-solutions
The economic outlook for the coming months and quarters paints a pessimistic picture. It can be argued that the euro area could already be stuck in recession, and there is a possibility that the US will follow this trend in 2024. Despite an expected decline in inflation rates, they are likely to remain above the target of two percent set by central banks at the end of 2024. This implies that headwinds for the stock market and other cyclically-sensitive investments are to be expected at the start of 2024. Due to persistently high inflation, central banks' room for manoeuvre to lower interest rates is limited. At the start of the year, this is likely to result in a difficult environment for the equity market and other cyclical investments such as commodities. In these circumstances, a balanced asset allocation should be aimed at minimizing losses in value without losing sight of opportunities. Stable yield sources such as (government) bonds could therefore play an important role in every portfolio at the beginning of the year, while a certain restraint is required when it comes to equities and commodities. In an environment with low economic growth, investors should look specifically for sectors that offer above-average potential, with appropriate risk management being important. In particular, stocks in the areas of technology, non-basic consumer goods and communications services could be an attractive option. The bond market, in particular good-credit corporate securities from Europe and the USA, is making a comeback in terms of returns. Alternative investments such as real estate and infrastructure investments are also interesting, but are more susceptible to fluctuation.
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