2023's Home Stretch: What We Are Watching

Cohen

Economic

Stocks

Bond

Summary:

With the weight of elevated interest rates potentially cooling the appetite of the economic growth engine that is the U.S. consumer, Global Head of Multi-Asset Adam Hetts explains why investors should take a defensive stance by prioritizing quality companies and cross-asset diversification.

Along with the change of seasons in the northern hemisphere, global financial markets have decidedly cooled in recent months. We believe this reflects a widening range of economic outcomes as a much hoped-for soft landing becomes less of a sure thing. While it may appear that a resilient economy and steady corporate performance belie our growing sense of caution, we see a common thread among key indicators that reveals an environment that is potentially more fragile than many market participants realize.

Woe be the consumer?

As evidenced by blow-out third-quarter U.S. gross domestic product (GDP) data, the U.S. consumer continues to power the domestic economy. Consumption accounted for 2.69 percentage points of the aggregate 4.9% annualized quarterly growth rate. We don't know how much longer this pace can last. The bulge in personal savings owed to pandemic-era stimulus packages has largely run its course. Furthermore, consumption has more recently been powered by credit cards. With borrowing costs having reset to decade-plus highs, we question American households' desire – or ability – to keep racking up such purchases.

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Higher, longer, inevitable

Our reason for doubting consumption's durability is our long-held view that policy rates will remain elevated for longer – an assessment that is now largely accepted by the market. Compounding this risk is our belief that the U.S. economy – and others, for that matter – have yet to feel the full brunt of previous rate hikes. Relative to other tightening cycles, we are still in fairly early innings, meaning the curtailment of demand that is the intention of hawkish policy is still working its way through the system. Already business investment has slowed, with non-residential fixed investment contributing nothing to third-quarter GDP growth.

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Perhaps the most powerful signal that economic growth faces headwinds is the meteoric rise in real yields, with that of the 10-year Treasury at roughly 2.50%. This represents the highest cost of capital in inflation-adjusted terms in 15 years. Importantly, nominal yields have continued to climb even as inflation has subsided. We interpret this as the recognition of a potential regime change in rates. Consequently, corporate managers will likely become more selective when allocating capital, as returns on investments must meet a higher threshold.

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Markets: Staying invested, staying defensive

With both equities and bonds well beneath their mid-year highs, some investors may presume current prices adequately reflect the myriad risks posed by elevated rates. But we believe it's too early to sound the “all clear.” Within fixed income, mid- to longer-date Treasuries and mortgage-backed securities (MBS) have borne the brunt of the sell-off. Given our view that rates are likely nearing their peak in the U.S., these segments could merit consideration for investors seeking attractive yields.

This view, however, does not carry over to high-yield corporates, as the spread between their yields and those of their risk-free benchmarks remains below long-term averages. Our concerns for this segment are compounded by the risk of a harder-than-expected landing, which could stress some of these companies' leveraged business models.

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Similarly, we don't see risks dispersed evenly across the equities landscape. Over the course of 2023, mega-cap technology and Internet names have held up better than the broader market, and their valuations remain above their long-term averages. Yet unlike still-frothy high-yield credit, many of these business models, in our view, are well positioned to weather an economic downturn given their consistent cash flow generation, strong balance sheets, and exposure to durable secular themes. Value and more cyclically exposed names, on the other hand, could come under additional pressure in a slowing economy.

Despite gathering headwinds, earnings estimates for U.S. stocks have held up well during the sell-off, while estimates for ex-U.S. equities have proven softer. The resilience of tech's business models has likely played a role in U.S. estimates holding firm, but we are less confident in other sectors should the country's consumption engine lose steam.

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The merits of diversification

Lastly, a widening range of economic outcomes lends itself to increased market volatility. Uncertainty about the duration of elevated rates and rising geopolitical risks further clouds the situation.

When this type of volatility and uncertainty causes asset classes to move in tandem – as they have occasionally done of late – investors can lose sight of the need for diversification. After years of it not being the case, bonds once again have the potential to act as ballast to riskier assets in a broad portfolio. Yields have risen to levels that offer both attractive income potential and possibly lower levels of volatility if rates stay within their current range. And should a rapidly weakening economy force central banks to pivot – not our base case – bonds' potential for capital appreciation could offset losses in more cyclically exposed asset classes.

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Source: Janus Henderson, Adam Hetts

To stay updated on all economic events of today, please check out our Economic calendar

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Goldman Sachs

Central Bank

Economic

For three decades, Japan's economy stayed stagnant, plagued by a combination of low growth, low inflation, and low interest rates. The term “Japanification” became shorthand for the country's prolonged economic plight and a warning to other advanced economies hoping to avoid the same fate. However, Japan's economy is experiencing a revival in 2023, spurred by domestic macroeconomic strength, a departure from deflation, and corporate governance reform.

This long-awaited resurgence and the possibility of a once-in-a-generation re-rating for Japanese assets has led to a meaningful shift in investor sentiment. The Tokyo Stock Price Index (TOPIX) hit its highest point since 1990 in mid-September and foreign investments into Japan continue to rise. The outlook for the world's third-largest economy looks more favorable than it has in many years. We believe long-term investment success in Japan requires a strategic approach; one that looks beyond near-term dynamics and considers a range of macroeconomic scenarios, domestic tailwinds, and secular trends. Active investing across public and private markets may prove rewarding if it's combined with on-the-ground expertise and an understanding of Japanese business practices.

A New Dawn in the Land of the Rising Sun?

Rising Prices and Wage Growth

Japan finds itself in a domestic demand recovery characterized by an unfamiliar yet desirable cycle of rising prices and wage growth. Inflation is hitting levels that have not been seen since the early 1980s and has even exceeded the Bank of Japan's (BoJ) 2% target; welcome news for an economy which has remained stagnant and faced deflation for a long time. Higher food and energy costs fueled the initial inflation ascent—consistent with global trends—but price increases have broadened out as 2023 has progressed.

Services prices, for instance, have accelerated sharply, reflecting the strong increase in hotel demand amid recent re-opening momentum and the recovery in travel-related consumption. Rail fares, delivery fees and restaurant prices have all climbed higher. Simultaneously, Japan's “Shunto” negotiations between labor unions and companies have resulted in negotiated wage hikes well above usual levels. Data suggest the base pay rise (+2.12%) agreed in spring is the largest since 1992 and headline wage growth (+3.58%) is the highest since 1993.1 The extent to which this wage growth will lift inflation is a key factor for monetary policy going forward.

Japan's Economic Revival and the Road Ahead_1

Rising Hopes of Japan Coming Out of Deflation

The BoJ has long viewed a virtuous cycle between wage growth and rising prices as essential for achieving its inflation target in a sustainable manner. It remains too early to tell whether the BoJ's desired virtuous cycle has been achieved. There has yet to be a fundamental reversal in the direction of monetary policy, which remains ultra-easy.

However, we believe strength in underlying inflation—as confirmed by July and August Tokyo core CPI inflation data—supports the case for a gradual normalization of policy over the coming year, including an exit from negative interest rates. That said, we think the risk of large upward or downward swings in inflation still warrant attention. The biggest upside risk is an uncontrolled wage-price spiral, a positive feedback loop between rising wages and prices.

On the other hand, extensions of government energy subsidies represent a downside risk to inflation. In August, Prime Minister Kishida announced plans to expand gasoline subsidies and extend them until the end of 2023.2 Longer term, Japan's shrinking and aging population may have the potential to cause either inflation or deflation in the years ahead. Until now, Japan has partially offset deteriorating demographics by raising labor force participation (higher female participation and higher elderly worker participation). But in the coming decade, the impact of a shrinking workforce may exert upward pressure on wages if the labor supply doesn't grow through immigration.

Eventual outcomes may depend on Japan's ability to enact structural reforms to improve labor force participation, as well as the interaction of demographics with other structural forces like deglobalization, decarbonization and digitization. Yield curve control (YCC) measures continue to remain in place in Japan, having been introduced in 2016 to head off deflationary risks and to achieve an inflation target of 2%. This summer the BoJ—now under the leadership of Governor Kazuo Ueda—effectively relaxed its YCC policy by raising the rate for fixed-rate purchase operations from 0.5% to 1.0%. The rationale for the July adjustment was framed around ensuring bond market functioning, but also reflected an acknowledgement of firm inflation and rising inflation expectations. As expected, Japanese government bond (JGB) yields trended higher following the July meeting.

Investors should keep potential implications for global fixed income markets in mind. Higher local bond yields may lead Japanese institutional investors to repatriate capital invested overseas back to Japan. JGB yields remain lower than fixed income assets outside of Japan. But after taking into consideration currency hedging costs—as many Japanese institutional investors do—JGB yields appear attractive in a global context. This points to a shift in asset allocation ahead and we are mindful of the impact on US agency mortgage-backed securities, US Treasuries and Australian sovereign bonds, given the large footprint of Japanese investors in these markets. That said, the speed of repatriation of capital away from global fixed income back to JGBs remains uncertain.

Investors must weigh other potential currency implications of Japan's rising prices and wage growth, particularly in a market which has seen so little of either in the past 30 years. At present, Japanese companies with a high foreign exposure look to be in the most competitive position in decades with the yen trading at levels that have not been seen since the early 2000s. Domestic focused firms, such as consumer goods companies, retailers, and hotels, are also enjoying a long-awaited boost from increased tourism. The weaker yen makes Japan a more affordable travel destination for foreigners, notably Asian tourists. Now that yen movements have become more dramatic than in the past, foreign exchange (FX) sensitivity is an important parameter impacting corporate profitability and investment portfolios. In addition to FX hedging strategies, the key for investors may lie in finding companies with better cost structures, offshore manufacturing and market leading positions as these types of businesses tend to be resilient to exchange rate movements. Active investment managers can position themselves appropriately to ensure minimum impact from FX movements.

Japan's Economic Revival and the Road Ahead_2

Still Ample Scope for Recovery in the Number of Chinese Visitors to Japan

Unlocking Corporate Value

Arguably the most powerful game-changer for Japanese equities in recent years has been increased momentum of corporate governance reform. This is a key part of the “third arrow” of structural reforms first introduced when former Prime Minister Abe came into power for a second time in 2012. The Tokyo Stock Exchange (TSE) continues to focus on boosting corporate value to make Japanese stocks more compelling for investors who have long regarded Japan as a "value trap"—a market that appears attractively underpriced but fails to move toward value. One of the TSE's motivations for reform appears to be the key structural differences between the TSE Prime market and other developed stock market indices in terms of price-to-book value ratios and return on equity distributions. Japanese companies are becoming better stewards of capital and are committing excess cash to record levels of buybacks and dividends. This is attracting foreign investors back to Japan's public equity market.

The TSE is also encouraging more retail investor participation. Only 11% of Japanese household assets are invested in equities versus 20% in Europe, and almost 40% in the US.3 Going forward, further efforts to boost corporate valuations, combined with rising retail and foreign investor demand, could reinforce any upward trajectory of stock prices. Pressure on companies that do not comply with TSE guidelines has been steadily increasing. Insufficient disclosures and explanations about areas of non-compliance, or a lack of urgency about meeting listing requirements, are now being actively highlighted as areas of concern.

Companies are seeing not only pressure from the TSE, but also from investors, given increasing activist activity and investor engagement to improve management through stewardship. There is also a growing consensus about the negative implications inherent in cross-shareholdings ownership, or inter-corporate shareholding, which has been a common practice in Japan. From a capital efficiency and corporate governance standpoint, foreign investors have often emphasized that this is a key area where capital management should be improved. Taking action to avoid negative consequences can be a powerful motivator in any corporate culture, but this appears to be particularly true in the case of Japan.

Data suggests more listed companies are following TSE guidelines by presenting cost of capital calculations and outlining initiatives to boost corporate value; those that did fared particularly well during 1Q 2023 earnings season.4 Looking further ahead, corporate transformation in Japan will create winners and losers, with some management teams proactively seeking to use governance reforms as a channel to achieve sustainable growth, while others fail to keep up. As active, long-term investors in Japan's public equity market, we see the next few years as an interesting time to potentially benefit from this meaningful differentiation and continue to focus on identifying strong management teams with shareholder friendly track records.

Corporate governance reform momentum is also fueling activity in Japan's private equity (PE) market, which has grown significantly in recent years with approximately $20 billion in deal value annually, driven by larger transactions. Dealmaking by private equity funds in Japan roughly doubled in the first six months of 2023 compared with a decline of roughly 40% in the Americas and 65% in Europe, albeit from a smaller base. Approximately half of Japan's public equity market continues to trade at book value despite the TOPIX's surge.

As a result, take-privates and carveouts are being circled by general partners (GPs); the $14-billion take-private deal for Toshiba early this year could prove to be a harbinger.5 Japanese corporations often have a less-focused portfolio than their global counterparts, suggesting certain businesses have the potential to thrive more under independent management. The momentum behind divestitures may continue given the ongoing improvements in corporate governance and transparency.

Capturing Long-Term Alpha

Active Exposure to Secular Growth Trends

Japan is not home to an abundance of high-growth innovators and disruptors. But it has several unique technology companies with vital roles in automation, digitization, semiconductors, electronics supply chains and advanced healthcare. Many are not well-represented by Japanese indices which continue to have significant aggregate exposure to cyclical and low growth areas such as auto manufacturers, banks, commodities, transportation, and telecom companies. These top industries make up more than 70% of the TOPIX by weight.7 Some of these sectors were prominent a few decades ago, but these are no longer the areas with the highest future growth potential. Just below this top tier in terms of size, we see many high-quality, long-term growth opportunities. This contrasts with other developed markets like the US, where the indices and markets tend to be led by the faster growing areas of the market.

Japanese equities have shown one of the lowest degrees of long-term correlations with both developed and emerging market indices, driven by the uniqueness of domestic economy and corporate landscape. In our view, the key to investing in Japan will lie in identifying companies that are underrepresented within indices but that are aligned to structural growth trends, and capable of outperforming over the long-term. We believe that active managers in Japan can provide a better forward-looking exposure while limiting allocation to legacy low-growth sectors.

Japan's Economic Revival and the Road Ahead_3

Japanese Equities Remain Under Researched by Sell Side Analysts When Compared to Counterparts

Japan's Economic Revival and the Road Ahead_4

Active Managers Have Significantly Outperformed the TOPIX Over Longer Periods

Despite being home to one of the largest stock exchanges in the world, Japanese equities have largely been out of favor for many investors and under-researched, with no analysts covering 45% of the TOPIX. By comparison, only 3% of the Russell 3000 Index (a proxy for the US equity market) lacks analyst coverage. For investors with strong research capabilities, a local presence and deep understanding of accounting standards and cultural factors—including cultural conservatism, deeper and longer-term corporate business relationships—we see Japan as fertile ground for alpha generation through active management. In contrast to many other markets, the investment landscape in Japan has historically boded well for active equity managers over time with the minimum annualized alpha for top-quartile players amounting to +472 bps and +193 bps over trailing 3- and trailing 5-year periods.8 In today's highly uncertain world, the impact of strong, consistent alpha generation is likely to be more pronounced than ever before.

Supply Chain Shifts and Geopolitics

Delivering strong and consistent returns also requires investors to identify regional and global geopolitical risks and embrace potential opportunities where they can be found. With conflicts between countries and competition for national interests becoming more pronounced, Prime Minister Kishida has committed to reinforce Japan's defense capabilities, noting cybersecurity and digitalization as increasingly important areas for national security.9 Many Japanese businesses already hold leading positions in materials and precision manufacturing, robotics, and factory automation—sectors that are likely to see strong demand as global supply chains realign and companies seek efficiency gains.

The backdrop for Japan's semiconductor industry also looks favorable with US trade restrictions on China and global semiconductor supply chains being rebuilt. Some of world's largest semiconductor makers have announced plans to deepen tech partnerships in Japan following moves by the government to provide subsidies for domestic chipmaking. This may complement the country's already advanced standing semiconductor packaging and substrate technologies—increasingly important areas given future technological trends like artificial intelligence (AI) rely on improved semiconductor performance.

In some areas, private capital may be advantaged by its ability to provide a long-term, patient investment that reacts less to near-term geopolitical gyrations. On the other hand, public market investors with the ability to draw on both global intellectual capital and on-the-ground expertise in Japan may also be able to navigate uncertainty and generate long-term outperformance.

The Road Ahead

Japan's economic revival and intense focus on improving governance standards have captured investors' attention and may provide a powerful tailwind for corporate earnings in the years to come. In the near term, we expect earnings to remain resilient driven by a weaker currency, rising inbound tourism, strong corporate capex and other positive long-term structural changes that are underway. However, we expect the upcoming quarters to be key in determining whether the recent macroeconomic and market resurgence can turn into a more permanent positive reality for Japan.

If both consumer and corporate activity changes in line with a shift from a deflationary to an inflationary mindset, this would likely have positive long-term implications for business, investment, and growth. Over the long-term, investment success in Japan may require an active investment approach across public and private markets. Japan seems on the cusp of a new dawn. Investors that focus on companies that are both secular growth winners and committed to corporate reforms may end up on the right side of change.

To stay updated on all economic events of today, please check out our Economic calendar

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Michelle

Commodity

Slower-than-expected consumer adoption of electric vehicles (EVs) in 2023, wavering economic growth in China since the pandemic and burgeoning lithium and cobalt supplies have sent prices of both metals lower even as producer/hedger interest in futures contracts has expanded dramatically. China is the biggest market for EVs, while lithium and cobalt are used in the manufacture of EV batteries. Since their 2022 peaks, cobalt prices have fallen by over 50% from $40 to $16.5 per pound, while the price of lithium hydroxide has fallen nearly 75% from $85 to $23 per kilogram (Figure 1).

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Figure 1: Lithium prices have fallen by about 75% while cobalt is down by over 50%

Open interest (OI) in both lithium hydroxide and cobalt has increased significantly amid the price declines, stretching out well into 2025, which is more than typical in the metals complex. As of the end of October 2023, lithium and cobalt futures had open interest as far out as March and December 2025, respectively. These futures curves point towards only a modest hope of recovery in cobalt prices, with December 2025 contracts pricing at around $20.68 per pound compared to $16.50 for November 2023. It was a similar story in lithium, with March 2025 contracts closing in October at $26.85 compared to $23.83 for the November 2023 contract (Figure 2).

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Figure 2: Lithium and cobalt futures curves display modest contango

Neither the steep decline in prices over the past 18 months nor the modest expectations for a recovery in prices over the coming 18-24 months have prevented either contract from seeing dramatic growth in aggregate OI. Indeed, OI has soared to nearly 10,000 contracts for lithium hydroxide and to around 20,000 for cobalt in recent months (Figure 3).

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Figure 3: Open interest has soared for both lithium hydroxide and cobalt futures

Part of the reason for the strong growth in OI may have to do with the needs of producer hedgers to manage their price risk. Both cobalt and lithium have seen explosive growth in global production in recent decades as well as strong increases in battery use. This is especially the case for lithium, whose mining production has grown 20-fold from 6,100 metric tons in 1994 to 130,000 by 2022 (Figure 4).

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Figure 4: Lithium mining output has grown by over 2000% since 1994.

Much of this increased production has been directed to the battery sector. As recently as 2012 only 23% of lithium was used to make batteries. Today, its 80% (Figure 5).

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Figure 5: Lithium battery demand has grown from 20% to 80% of use in the U.S.

Cobalt's growth in production hasn't been as fast as lithium's but has still seen a spectacular 10-fold increase from 17,000 metric tons to over 190,000 between 1994 and 2022 (Figure 6). Battery usage has grown from around 25% to around 35% of cobalt use in the U.S. (Figure 7).

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Figure 6: Cobalt mining production has grown by over 1000% since 1994.

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Figure 7: Batteries are taking up a greater share of cobalt end use as well.

The recent declines in lithium and cobalt prices have been mirrored in other metals. Both aluminum and hot-roll coil steel prices have fallen by around 50% since their respective highs in 2021 and 2022. Both metals are closely connected to the pace of growth in China, which has disappointed expectations for strong growth following the country's sudden reopening from Covid-19 lockdowns late last year. That said, not all is gloomy in China when it comes to the prospects for battery metals: EVs accounted for nearly 40% of vehicle sales in China so far this year.

While EV sales have disappointed expectations in the U.S. prompting some automakers to delay investments in lithium battery plants, sales continue to expand. In 2020, there were only 50,000 EVs sold in the U.S. per quarter. That figure has now grown to over 300,000 per quarter. Moreover, the revolution in battery technology continues apace. Since 1991, the cost of storing one kilowatt hour of electricity in a lithium battery has plunged by over 98% from over $7,500 to around $100 (Figure 8). That number ticked higher in 2022 from 2021, perhaps owing to the surge in lithium prices between March 2021 and May 2022. However, the recent 75% drop in lithium hydroxide prices as well as the more than 50% decline in cobalt prices might set the cost of lithium battery storage back on its downward trend, fuelling greater adoption and ultimately a renewed surge in demand. The main question is can any renewed rise in demand keep pace with growing supplies?

Lithium, Cobalt Open Interest Soars as Prices Plunge_8

Figure 8: Lithium battery storage costs have plunged 98% over the past 30 years.

Source: CME Group

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Justin

Economic

sustainable development

Developing countries are highly vulnerable to climate change. To add, emerging markets are on average further away from meeting the United Nations’ sustainable development goals than developed nations. Significant capital is therefore needed to close the sustainable funding gap in these countries.

According to the UN Conference on Trade and Development, in developing countries alone, SDG investment needs amount to $4.5tn for basic infrastructure, food security, climate change mitigation and adaptation, health and education.

To mobilise private capital for sustainable development, capital markets are a critical source of long-term funding. In the past, emerging markets have lagged developed markets in terms of sustainable finance. But luckily their relative share of financial flows has increased in recent years. To ensure this positive trend continues, we need innovative financing instruments for sustainable development.

The global fixed income market, with a volume of more than $100tn, is one important source of innovation to support the transition to a more sustainable future. Hence, we must investigate the sovereign sustainable bond segment, in which sustainability-linked bonds have successfully found their place since last year, alongside the traditional use-of-proceeds variants (green, social and sustainability bonds).

But first, it’s important to clarify what target-linked financing, which is still relatively new, entails. SLBs, which first emerged in 2019, are forward-looking and performance-orientated financial instruments in which issuers explicitly commit to future improvements in sustainability criteria within a predefined timeframe.

Understanding SLBs

Sustainability development is measured using predefined key performance indicators and evaluated against sustainability performance targets. The financing costs of SLBs are linked to the achievement of these targets. If the issuer fails to meet the targets, financing becomes more expensive.

As the use of proceeds of SLBs are not earmarked and can therefore also be used for general financing, they are also suitable for issuers who do not have the necessary volume for a use-of-proceeds bond.

Governments, for example, can use the instrument as a source of funds for general budget spending like any other government debt. It can also use the instrument to mitigate balance sheet risks by reducing maturity or currency mismatches, but with a link to a refinancing mechanism if nationally determined contributions or other targets are met.

For credible sustainable financing using SLBs, it is important to choose KPIs that are relevant, measurable and comparable. These factors are central to the issuer’s sustainability goals. They should also have a high strategic importance for the issuer’s future. In addition, the SPTs should be in line with the issuer’s sustainability strategy and be ambitious, i.e., go beyond a ‘business-as-usual scenario’.

Are SLBs here to stay?

By the end of the third quarter in 2023, 49 sovereigns have issued sustainable bonds with a cumulative volume of more than $400bn, with the use of proceeds structure clearly dominating. So far, 32 countries have issued green bonds, three countries have issued social bonds and 16 countries, sustainability bonds.

While SLBs have become popular among corporate issuers, they are far less established among sovereign borrowers. Although SLBs are a suitable instrument for linking sustainable sovereign financing to, for example, NDCs, only Chile and Uruguay have so far opted for the target-linked funding variant. Scaling up SLB issuance in developing countries would offer more and more issuers access to new sources of finance.

By issuing the world’s first sovereign SLB in March 2022, Chile successfully demonstrated that sustainable bonds could monetise not just sustainable public expenditure and infrastructure but can also be instrumental in monetising sustainable policies and national commitments. These include the NDCs set by the country under the Paris Agreement on climate change. In October 2022, Uruguay also linked the coupon of its SLB to compliance with the climate and environmental goals that the country set in its first NDCs to the Paris Agreement. In addition, it also featured a nature-based KPI.

Major potential in sovereign sustainable bond market

Following the success of Chile and Uruguay, it is likely that SLBs will attract issuers from beyond Latin America and that we will see issuance from southeast Asia or Africa, for example. SLBs are expected to become increasingly popular among sovereign issuers from emerging markets as the flexibility in how the borrower uses the money raised makes this type of debt attractive to smaller issuers that may not have an extensive pipeline of green or social projects that would qualify for green or social bond proceeds.

Looking at the numbers, the sovereign sustainable bond market offers enormous potential here. About 170 countries are issuing sovereign debt. Hence, there are plenty which have not come to the market yet. This includes three sovereign issuers with the largest outstanding volume (the US, Japan and China) as well as many issuers from developing countries.

Source:Marcus Pratsch

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Glendon

Political

In one year's time, Americans will head back to the polls to elect their president for the next four years.

Incumbent Joe Biden is seeking a second term and – facing little opposition - is set to win the Democratic ticket. His predecessor, Donald Trump, faces a crowded field heading into the Republican primaries. But he has established a near 45 point lead over his closest challenger, Florida Governor Ron DeSantis. So, while nothing is guaranteed in politics, a second bout between Biden and Trump looks almost certain.

It would not be the first presidential rematch. There have been six in total, with the most recent being Dwight Eisenhower and Adlai Stevenson in 1956. But only one individual has been elected to a second non-consecutive term as president: Democrat Grover Cleveland, when he regained the presidency from his Republican rival Benjamin Harrison in 1892. And this was achieved partly because the nascent Populist party, which won 22 of the 444 electoral college votes up for grabs, subtracted more from the Republican voter base than from the Democrats.

US Election Countdown: What Investors Need to Know_1

Chart 1 Betting markets expect Trump to beat Biden, but could he lose some supporters to RFK Jr?

Just as in 1892, it's possible a third-party could disrupt the status quo. Robert F. Kennedy Jr. recently announced an independent presidential bid, having dropped his bid to become the Democrat nominee. He is currently polling as high as 14%, which would be the most for an independent candidate since Ross Perot won 19% of the popular vote in 1992, helping Bill Clinton to defeat the incumbent George H.W. Bush in the process. However, the jury remains out on whether RFK Jr can maintain his momentum and, if so, whether he poses a bigger threat to Biden or to Trump.

Regardless of who eventually triumphs, victory will not mean much if they fail to take control of the legislative branch. All 435 seats of the House of Representatives are up for re-election and 34 of the 100 Senate seats will be contested. Each party currently controls one chamber each and by the slimmest of margins. This has hampered Biden's legislative efforts since the start of this year, not least because a minority of ultra-conservative Republican lawmakers have been able to obstruct their own party's leadership.

But assuming that either Biden or Trump manages to carry Congress along with the presidency, what might the implications for markets be?

US Election Countdown: What Investors Need to Know_2

Chart 2 Market returns have been sub-par since Biden was elected president

What if Biden secures a second term?

Biden has many reasons to be optimistic about his re-election chances. Beyond the incumbency advantage, he is also overseeing a strong economy, tight labour market and sharply easing inflation. And the recent conflict in Israel could also provide some support, as rising geopolitical tensions have historically led to a “rally round the flag” effect. But despite these favourable factors, he continues to be dogged by low approval ratings. Not only is his popularity currently near the lowest level of his presidency so far, it is also below that of many of his predecessors at this stage of their first term.

Part of the reason for his unpopularity is because immigration has been rising up the list of voter concerns. Crossings at the US-Mexico border reached new highs in September amid a large increase in undocumented immigrants from Venezuela.

Polls also show that voters hold reservations about Biden's age. He became the oldest president in history when elected in 2020 at 78-years old. By the end of any potential second term, he will be 86. Although Trump is just three years younger, one poll showed only 1% of voters considered him to be out-dated or elderly, compared to 26% for Biden.

US Election Countdown: What Investors Need to Know_3

Chart 3 Will Biden join the one-term president's club?

However, Biden is neither as unpopular nor polarising as Trump. This means that moderate, non-partisan voters might ultimately back Biden for a second term, even if it is reluctantly so.

He may also benefit from RFK Jr's independent bid if it can go the distance. RFK Jr, a vaccine-sceptic who has tilted towards conservatism since ditching his Democratic bid, may split some of the anti-establishment votes that would otherwise have gone to Trump.

For these reasons, it would be premature to rule out Biden retaining the presidency.

If re-elected, Biden could look to resurrect his initial legislative agenda. His initial Build Back Better proposals in 2021 included $3.5 trillion of spending on environmental and social programmes, over 10% of GDP. After being trimmed down to $2.2 trillion by the House, it then faced opposition from centrist Democratic senator Joe Manchin, who is at risk of losing his seat next year's elections. As a result, it was eventually watered down further to become the Inflation Reduction Act. While the $437 billion of stimulus this included was still sizable, it was just one-eighth of the original proposals.

Biden may attempt to enact some of the measures that were ultimately dropped, such as funding for subsidised childcare, universal pre-kindergarten or paid family and medical leave. But this could fuel growing concerns about fiscal sustainability, pushing Treasury yields higher still. Investors should also be wary of Biden potentially seeking to raise the top rates of corporation, income and capital gains taxes as well as tightening regulation in areas such as banking and healthcare. This might result in some equity sectors coming under some degree of selling pressure.

US Election Countdown: What Investors Need to Know_4

Chart 4 If re-elected, Biden may look to resurrect the unrealised $1.7tn of his Build Back Better Act

Or will Trump complete his comeback?

Trump may be the bookies' favourite to win the election, but he must first secure the Republican nomination. While he is polling miles ahead of his other candidates, George W. Bush commanded an even bigger lead of over 50% in 1999 and nearly failed to win the nomination. After being roundly defeated in New Hampshire by John McCain, Bush went on to survive a make-or-break battle in South Carolina only to then suffer an upset defeat in Michigan. Finally, he managed to get his campaign back on course to win enough states on ‘Super Tuesday' to force McCain to concede.

Also, Trump's well-documented legal battles are set to keep him off the campaign trail as the primaries get underway. He is due in court on 15 January for the E Jean Carroll defamation trial, coinciding with the first-in-the-nation Iowa caucuses. And the trial for his alleged efforts to overturn the 2020 election result has been set for 4 March, just one day before Super Thursday, when 14 Republican state primaries are set to be held. Even so, his strong social media following means that Trump won't necessarily be hindered by his physical absence.

US Election Countdown: What Investors Need to Know_5

Chart 5 Trump's lead is formidable, but Bush Jr. almost ceded a bigger one in 1999

Assuming that Trump is successful in his bid to retake the White House, it is difficult to determine what he would seek to achieve given his reputation for bluff and bluster. According to PolitiFact, he broke just over half of his campaign pledges and only fully delivered on a quarter. And of his nearly 1000 statements that have been fact-checked, some 75% were found to be at least mostly false. Still, Trump's fiscal pledges this year have been to repeal Biden's tax hikes, “immediately tackle” inflation and end what he has called Biden's “war” on American energy production.

When it comes to a second Trump presidency, the only certainty is uncertainty. For one, he could be convicted of a crime and incarcerated. This could well lead to a lengthy constitutional crisis and perhaps even insurrection. Also, his foreign policies could further isolate the US, particularly if he chooses to scale back sanctions levied against Russia. As a result, investors should brace for volatility which could result in a flight to safety that sees safe haven government bonds and gold rally.

US Election Countdown: What Investors Need to Know_6

Chart 6 Most of Trump's claims are false and the majority of his 2016 campaign pledges were broken

A close contest should benefit investors

It is difficult to predict how asset classes might perform under a second Biden or Trump presidency as we can only speculate on what their policies would be. But we can compare how markets shaped up during their respective first terms. Based on a 60/30/10 portfolio, Trump had overseen total returns of 35% at this stage of his term, in line with other first-time presidents since the early 1970s. But Biden, by comparison, has only delivered 8.5% at this stage of his presidency. And this would be lower-still if not for the ‘Magnificent Seven' of high-growth tech companies.

But investors hoping that a second Trump presidency might boost returns could well be disappointed. Our analysis shows that returning presidents have generally seen lower nominal returns across major asset classes, with the exception of 10-year Treasury yields. But it is not all bad news. Inflation has historically been more subdued over second presidential terms, even when excluding the elevated rates experienced during the Jimmy Carter and Ronald Reagan administrations of the late 1970s and early 1980s. On top of this, GDP has typically been higher and unemployment lower compared to presidents' first terms.

US Election Countdown: What Investors Need to Know_7

Chart 7 Aside from Treasuries, assets have historically seen lower returns under presidents' second terms

Some of these differences in market performance may be partially down to factors unrelated to who occupied the White House. Global economic shocks such as the energy crises of the 1970s and the 2007-2008 financial crisis are prime examples of events that were beyond the president's control. As was the pandemic and its aftermath, which has overlapped Biden and Trump's presidencies. Another common feature of their presidencies is that they both started their presidencies with control of Congress. What looks less certain this time round is whether the winning candidate will be able to secure another trifecta.

Of the 34 Senate seats up for grabs, the three that are currently ‘toss-ups' are all with the Democratic caucus in the Senate. As such, a Biden victory could easily see him paired with a hostile Senate. Likewise, Trump may well manage to clinch the presidency but lose the Republicans' narrow 221-212 majority in the House if he were to lose the popular vote a third time. Either scenario would create a legislative roadblock for the president. effectively scuttling their ability to deliver the partisan policies they pledge during their campaign.

But gridlock on Capitol Hill should be supportive for markets. Divided governments are forced to compromise, which serves to moderate the more extreme inclinations of each party, providing a more stable policy backdrop for investors. Since the 1948 presidential election, US equities have averaged total returns of 14.3% when a president has had to contend with a split Congress compared to a more modest 13.0% increase under a unified government. This divergence is even wider on a party basis; Democratic presidents have seen gains of 18.8% under a divided Congress versus 12.0% under their Republican counterparts.

So, while there is still a lot that can happen before next year's the election, the fact that the contest looks set to be a close one should be good news to investors.

US Election Countdown: What Investors Need to Know_8

Chart 8 Equities tend to perform better under a divided US government than a united one

Source: Schroders

Risk Warnings and Disclaimers

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Justin

Central Bank

Economic

Inflation remains a priority

The US dollar fell by 1% against six major currencies after traders saw a slowdown in hirings and concluded that the Fed won’t raise rates again. At the same time, a group of investors became more confident that signs of economic weakness might motivate rate cut talks in 2024, although the Fed chief, Jay Powell, kept that scenario out of the radar during November’s FOMC policy meeting.

Monetary tightening to fight inflation has been a story for more than a year, and this may not change soon as the Fed is not convinced that inflation is on a sustainable path towards the central bank’s 2.0% target. Growth in consumer prices has eased significantly from the 2022 multi-year highs, falling as low as 3.0% y/y in June before edging up to stabilize around 3.7%. The next CPI update is scheduled to take place on Tuesday and investors will look at whether progress has halted particularly on the core measure, which is a better proxy of the general inflation trend.

According to forecasts, the monthly headline CPI change is expected to slow down to 0.1% from 0.3% previously, while the core CPI is forecast to stay steady at 0.3% m/m.

The core CPI inflation, which excludes food and energy prices, has been slowly decreasing over the past six months and reached a two-year low of 4.1% in September. In October, the ISM services PMI survey found that price pressures remained within the expansion territory, with businesses stating that increased labor costs were the main cause of elevated prices.

Is additional tightening necessary?

Additional tightening may be the easiest way to cool inflation, but its impact on the economy and price pressures has been a puzzle so far.

Rising personal consumption, a low unemployment rate, and low savings indicate that higher interest rates didn’t dampen demand. Of course, this does not mean that monetary tightening was not necessary. Otherwise, inflation would have been a bigger headache as a weak dollar would have made import prices more painful to consumers.

Nevertheless, effects from monetary tightening will apparently become more obvious at some point, perhaps with a bigger lag if real wage growth turns positive in the coming months and consumers remain confident that their jobs are secured.

Meanwhile, supply-side effects might keep adding pressure on inflation, especially in the housing sector. If the Fed shuts the door to additional rate hikes but retains its higher for longer guidance, demand for loans and therefore for houses would probably decline, likely causing a negative spiral in prices.

The Fed’s latest economic projections for 2024 pointed to a softer GDP growth of 1.5% and a weaker inflation of 2.6%.

EURUSD levels to watch

As regards the impact on the US dollar, traders could sell the currency if CPI measures resume downleg, boosting confidence the Fed has reached the terminal rate. Looking at EURUSD, the pair might attempt to crawl above its 200-day exponential moving average (EMA) at 1.0730 and pierce the bullish channel on the upside at 1.0763.

Alternatively, if inflation keeps trending up, suggesting the battle for price stability might be trickier, investors might see another rate hike on the horizon. EURUSD could correct lower on the back of a stronger dollar, though only a slide below 1.0600 would violate the positive trend in the short-term picture.

Source:XM

To stay updated on all economic events of today, please check out our Economic calendar

Risk Warnings and Disclaimers

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Justin

Central Bank

Forex

Since 2010, a period marked by economic, financial and geopolitical shocks, the dollar has steadily appreciated relative to most other currencies. The dollar’s real effective exchange rate has increased by nearly 40% from the end of the 2008 financial crisis and remains the ultimate safe haven for investors.

Most of the calls for a demise of the dollar as the dominant currency in the global financial architecture rest on the changed structure of the global economy, particularly the rise of China. Over the last few decades, the US economy’s share of global gross domestic product has declined, while China’s and other emerging markets’ have increased. The dollar’s share of global foreign reserves has declined – falling from a peak in the early 2000s of around 65% to well below 60% in the second quarter of 2023.

The euro remains the second-largest reserve currency with a stable share of around 20%. After the euro, the most obvious contender to dollar dominance is the renminbi. The renminbi’s share has increased to more than 3% since the middle of the last decade, but remains well below the share of other ‘secondary’ reserve currencies such as sterling or yen.

When the Chinese currency was included in the special drawing rights basket, expectations for a rapid rise in the global financial architecture were high. In the 2023 UBS Reserve Management Survey, investors favoured the renminbi as a means for diversifying away from the dollar – largely due to its strong economy and positive interest rate differential with the dollar.

However, the disclosed average long-term allocation of reserves to the renminbi did not increase significantly in subsequent surveys. The recent rise in US interest rates, coupled with a slowing Chinese economy and negative interest rate differential, appears to have slowed this down. According to the 2023 RMS survey, the average long-term (10-year) target allocation of reserves to the Chinese currency has fallen from 5.8% to 5.2%.

If the world has been moving to a so-called ‘multipolar currency system’, the pace of this shift has been glacial. The dollar’s share of global reserves might continue falling slowly but this is hardly a demise of its dominant position.

Geopolitical impact

Most recent calls for the demise of dollar dominance have rested on geopolitical developments. Following the invasion of Ukraine, the US and its allies targeted reserves held by the Central Bank of Russia, raising concerns among central banks about sanction risks stemming from foreign exchange reserves and whether they can continue to be perceived as a ‘safe’ asset.

Respondents were split on whether the impact of the US-China confrontation on the internationalisation of the renminbi will be positive or negative. The currencies that are expected to benefit the most from geopolitical developments were the euro and dollar, followed by the renminbi and the yen. Geopolitical developments matter for reserve management but so far there is no broad consensus on what we can expect going forward.

Some of the recent calls on the ‘imminent’ demise of the dollar also rest on the growing importance of the renminbi as an invoicing currency in international transactions and the debate about whether a Brics (Brazil, Russia, India, China and South Africa) shared currency offers a feasible alternative. The renminbi is currently the fifth-largest currency in international payments, constituting 3.7% of the global share as of September 2023. The Chinese currency has good momentum as more countries – including Brazil and Russia – switch to the renminbi for international payments. However, the Chinese currency still lags sterling and yen and is well below the dollar and the euro.

The Brics currency discussion is very much about politics, not economics, and appears to be a non-starter given the lack of a regional integration among the member countries. The ‘cohesion’ problems that surround the euro more than 20 years after its launch act as a reminder of the difficulties with creating a common currency.

What would need to happen for there to be a significant decrease in the use of the dollar as either a transaction currency or as a store of value in global reserves? There are several factors to watch in the years to come.

De-pegging from the dollar

While most currencies are free floating or managed, there are notable exceptions. First, Gulf Co-operation Council currencies are de facto pegged to the dollar and their oil exports are largely invoiced in dollars. The often-rumoured shift away from dollar invoicing, particularly for exports to China and other Asian countries, would only be a realistic assumption once the GCC currencies are de-pegged from the dollar and managed against a basket of currencies. Until this happens, it is very unlikely that GCC countries will shift away from the dollar either as an invoicing currency or as a means for accumulating wealth in global markets via central banks or sovereign funds.

This year will mark the 40th anniversary of the dollar peg for the Hong Kong dollar. The Hong Kong Monetary Authority has already made it clear that it has no intention of de-pegging the currency. The dollar peg has been a pillar of macroeconomic stability for GCC countries and Hong Kong over the years. A shift to another foreign exchange regime would mark a more serious challenge to the dollar-dominated global financial system.

US debt

The demise of a reserve currency can be self-inflicted. The dominant role of a currency not only rests with the positive network externalities generated by its widespread use in international transactions, but also on its ability to act as a store of value.

Demand for US dollar denominated assets – stocks and bonds – is still strong given the performance of the US corporate sector and the interest rate differential in favour of the greenback. This demand could however be dented in the future by unsustainable public debt dynamics and domestic political tensions. The euro’s challenge to dollar dominance came to an end following the euro fiscal crisis in the early 2010s.

China

The internationalisation of the renminbi is a strategic priority for China and shows no signs of changing in the future. However, the lack of convertibility is still a factor preventing the currency from competing at par with the dollar and the euro. Geopolitical tensions and sanction risk have somehow dented the appetite of central banks for onshore renminbi assets but there is no consensus among central banks. Many central banks remain fully committed to Chinese bonds and, should geopolitical tensions reduce in the future and the renminbi be made convertible, the internationalisation of the renminbi would accelerate significantly.

CDBCs

Central bank digital currencies are often mentioned as a potential game changer for the global financial architecture and progress has been made across multiple jurisdictions. However, their launch does not appear imminent as several issues – above all the interoperability across borders – still need to be addressed.

Demand for diversification of reserves away from the dollar is growing, driven by geopolitical, economic and financial dynamics. So far this process has been slow as the US economy – and its currency – outperforms expectations. The dollar is and will remain for the foreseeable future the main store of value for global investors, including reserve managers. Geopolitical tensions favour the dollar as investors search for a haven and further escalations do not necessarily point to an imminent weakening of its dominant position.

A more radical departure from current exchange rate and commodity pricing arrangements across Asia and the Middle East, dramatic US domestic political developments and an acceleration in the issuance and cross-border movement of CBDCs would significantly accelerate the diversification process.

Source:Massimiliano Castelli

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Chart 1 Betting markets expect Trump to beat Biden, but could he lose some supporters to RFK Jr?

Chart 2 Market returns have been sub-par since Biden was elected president

What if Biden secures a second term?

Chart 3 Will Biden join the one-term president's club?

Chart 4 If re-elected, Biden may look to resurrect the unrealised $1.7tn of his Build Back Better Act

Or will Trump complete his comeback?

Chart 5 Trump's lead is formidable, but Bush Jr. almost ceded a bigger one in 1999

Chart 6 Most of Trump's claims are false and the majority of his 2016 campaign pledges were broken

A close contest should benefit investors

Chart 7 Aside from Treasuries, assets have historically seen lower returns under presidents' second terms

Chart 8 Equities tend to perform better under a divided US government than a united one

Source: Schroders

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