By J.P. Morgan Asset Management

 

Driving in a storm is never easy. The driver needs to observe road conditions ahead, but not lose track of the direction to our destination. We can stop the car and wait for better weather, but this comes at the cost of trailing further behind in our investment objectives. The same applies to investing in 2024

After two years of monetary tightening, the global economy is expected to decelerate. We believe the ongoing obsession with inflation among central bankers could risk turning a much-needed policy response to curb price increases into a policy error that potentially tips the economy into a recession. This could create a challenging environment to generate returns. Difficult market conditions could be further exacerbated by a large number of elections in the world’s largest democracies next year.

Despite the challenging backdrop, the pains of the past two years—such as surging bond yields, disappointing Chinese and Asian stock markets and underperformance of a stock-bond portfolio relative to cash—have created a more constructive setup for investors in the year ahead. Fixed income is finally providing income to investors. For most markets, equity valuations do not look as stretched as they once were. We think it is time for investors to get back on the road.

In our 2024 Year Ahead, we address 12 frequently asked questions by investors in the region and beyond. We hope our insights can help you navigate the road ahead, on the way to your investment objectives.

• Can the U.S. avoid a recession in 2024?
• Could the Federal Reserve turn more dovish?
• How much higher/lower could U.S. Treasury yields go?
• What could be the potential impact of the elections taking place around the world in 2024?
• What would it take for Beijing to step up economic stimulus?
• Can Asian equities outperform in 2024?
• Do Asian central banks have room to cut rates?
• How could investors manage volatility in 2024?
• What opportunities lie between equities, bonds and cash?
• Can the AI-driven rally continue?
• What could push the U.S. dollar lower?
• What could go wrong?

 

1.   Can the U.S. avoid a recession in 2024?

 

Over the course of 2023, U.S. macroeconomic indicators have continued to surprise on the upside, presenting a picture of resilience, with the U.S. economy growing at a 4.9% annualized rate in 3Q 2023. This, coupled with the progress made on subduing inflation, supported our base case of decelerating growth without the risk of an imminent recession. However, we still think economic risks are tilted toward the downside, warranting some investor caution.
Breaking down U.S. gross domestic product (GDP) into its component parts, personal consumption, which accounts for around 68% of GDP, could face headwinds in the year ahead. Looking at the consumer balance sheet, credit card balances are risingwhile excess savings are dwindling. Other factors, such as rising energy costs and the expiration of the student loan moratorium and childcare benefits, could further weigh on consumption. However, firmer-than-expected retail sales data this year continue to buck the trend, demonstrating resilient consumer demand and potential buffers built into household balance sheets. On balance, we think absent a sharp spike in unemployment, consumption growth will likely remain positive, albeit with slowing momentum.
Historically, the swing factor that often tips the U.S. economy into a recession is investments. Residential investments have already exhibited meaningful declines. With mortgage rates north of 7%, homebuyer sentiment and demand have dipped as evidenced by data from the National Association of Home Builders. This, in turn, has significantly dragged construction activity.
Turning to corporates, enthusiasm about artificial intelligence (AI) and the CHIPS and Science Act have bolstered business investments this year, despite elevated borrowing costs. Looking ahead, corporate margins will likely be squeezed on account of the softening inflation backdrop and weaker pricing power. This could be exacerbated by high interest rates and limited signs of moderating wage growth. As it stands, private non-residential investments in 3Q 2023 only grew 1.6%, compared to a massive 23% increase in 1H 2023. Data highlighting future capital expenditure intentions are also weakening. The cautious sentiment among corporates could trigger not just a pullback on investments but also hiring, which could push the economy toward the edge of a recession.
Ultimately, the state of the economy in 2024 will largely hinge on the Federal Reserve’s (Fed’s) policy stance. Overtightening or keeping rates high for too long could exacerbate the strain on various sectors of the economy. For one, higher-for-longer interest rates could exert undue pressure on the financial sector, whether it is through banks’ balance sheets or via the private market.
Should we skirt such an outcome, we expect the U.S. economy to meander slowly through late cycle dynamics in 2024. Any recession will likely be mild, given the lack of excesses or systemic imbalances. However, we would caution that the overhang of political risks, both within the U.S. and other regional blocs, could increase the tail risks to our core scenario and outlook. This merits some degree of caution as we look ahead into 2024.

Exhibit 1:

 

2.    Could the Federal Reserve turn more dovish?

 

We have witnessed arguably the most aggressive monetary policy tightening cycles in the U.S. since the Great Inflation of the 1970s. The good news is that headline inflation in the U.S. has come off its 9.1% peak in June 2022 to 3.7% in September 2023. This is still some ways away from the Fed’s target of 2%, consistent with its mandate of maximum employment and price stability.
With the Fed still focused on inflation, it is worth considering what could push prices higher and prevent the central bank from adopting a more flexible stance.
First, looking under the hood of the consumer price index (CPI) reveals some pockets of price pressures. This is evident in the uptrend of Fed Chair Jerome Powell’s “super core” (core services ex tenants’ rent and owners’ equivalent rent) CPI measure. While adjusting for one-off factors, such as a surge in mass transit prices, shows a moderation in the underlying super core trend, a reacceleration could keep the Fed on guard.
Second, absent an improvement in long-term productivity, the tight labor market in the U.S. could keep wage growth elevated,hence keeping upward pressure on core CPI.
Third, uncertainties around the U.S. fiscal impulse in the medium term, set against the backdrop of the upcoming 2024 elections, could keep inflationary pressure somewhat elevated, adding further complication to the Fed’s already difficult task. Should these factors stay persistent, the Fed may find it difficult to cut rates in a meaningful way
Following the end of the pandemic, the Fed embarked on quantitative tightening (QT) in a bid to shrink its balance sheet after purchasing significant amounts of U.S. Treasury (UST) bonds and mortgage-backed securities (MBS). Our central scenario is that QT moves as planned with the Fed drawing down its balance sheet by an orderly USD 1trillion per year. The risk to our view centers around the intersection of the Fed’s QT and the looming supply of UST securities to fund a near USD 2trillion federal deficit next year.
All told, our baseline is for inflation to be well behaved with the likelihood of the Fed cutting rates only in 2H 2024, in line with prevailing market expectations. In this scenario, investors could consider locking in higher yields for capital appreciation.
However, if inflation surprises on the upside, investors should look toward inflation-hedged assets such as real estate and commodities that could provide income.

Exhibit 2:

 

3.   How much higher/lower could U.S. Treasury yields go?

 

Since the regional U.S. banking crisis in 2Q 2023, the 10-Year UST yield has soared from a bottom of 3.4% year-to-date to around 5% in early November, reaching multi-year highs. It is important to differentiate between rising yields that reflect a stronger economy and rising yields that are driven by higher term risk premium (TRP), where investors are demanding more return to invest in the long end of the yield curve due to increased risks and uncertainties.
Firmer-than-expected economic data drove the rise in yields over the summer, as market participants priced in a higher-for-longer interest rate environment amid evidence of a stronger economy. More recently, however, the rise in yields reflects a higher TRP, which is broadly driven by demand-supply dynamics for duration. Markets are currently bracing for a deluge of UST supply to fund the government’s deficit. Meanwhile, the uncertain path of future inflation and interest rates has prompted investors to demand higher compensation in the form of higher yields
Given current valuations and the economic outlook, lengthening duration remains an appropriate strategy going into 2024, in our view. Over the last five hiking cycles, 10Y UST yields had peaked before the fed funds rate. Between the last rate hike and first rate cut, 10Y UST yields also fell 107 basis points (bps). With disinflation gaining momentum and financial conditions becoming tighter (partly driven reflexively by the rise in yields), we are near, if not already at, the end of the Fed’s hiking cycle, limiting the upside in yields. Also, our base case of slower growth calls for lower yields, while potential flare-ups in geopolitical risks could prompt a flight to safety into UST.
While the direction of travel is likely to be downwards from current levels, we are less optimistic about the magnitude and speed of the potential decline in yields relative to past cycles. This is in part due to higher TRP being priced into yields for the long run, and in part due to lingering risks of longer-than-expected Fed tightening, driven by energy-related price pressures.
On credit, we acknowledge that current yields may look relatively attractive, especially in high yield fixed income. Looking at fundamentals, such as margins, coverage ratios and free cash flow, high yield bond issuers are exhibiting greater resilience than in past cycles. Default rates had reached 6.4% in October 2020, largely weeding out the weakest issuers from the market, while prompting surviving corporates to manage their balance sheets more conservatively. While fundamentals have not deteriorated significantly, the softer macroeconomic outlook could put this to the test. With current spreads consistent with robust economic growth, the risk is for spreads to widen with weaker economic data.
Should growth show signs of a meaningful slowdown, corporates could experience further margin squeeze and an increased need to refinance at higher borrowing costs. A spike in defaults could easily cause risk-off sentiment to ripple across the market, triggering a rapid widening of spreads. As a result, we continue to favor higher quality bonds, unless investors have the risk tolerance and investment horizon to ride out higher volatility as growth slows.

Exhibit 3:

 

4.   What could be the potential impact of the elections taking place around the world in 2024?

 

2024 is expected to see key elections around the world, including India, Indonesia, Russia, South Africa, Taiwan, the UK and the U.S. While these elections will doubtlessly hog news headlines and TV airtime, the impact on markets could be subtler.
Generally speaking, local asset markets could be more volatile ahead of the votes and perform more constructively once there is higher certainty about the future policy outlook. Of course, market reaction could show greater caution if there is a hung parliament, a fragile coalition or a new government that is perceived to be less business friendly. When assessing the market performance around an election, we need to take into account the prevailing economic climate and monetary policy.
In the U.S., we are probably too early in the election cycle to extrapolate the outcome and potential policy implications. That said, historical data suggest that the next president’s party affiliation has limited impact on market performance after the election result, as noted in the 2016 and 2020 presidential elections. Some of the current candidates for the upcoming U.S. elections have policy track records that can help mitigate uncertainty for investors. Investors are also likely to pay particular attention to the outcome of the congressional race, as the composition of the House and Senate in recent years has raised concerns over whether the federal government debt ceiling can be raised in time or if the potential passage of economic stimulus could be blocked by a minority of lawmakers due to slim majorities.
In India, the current opinion polls suggest that Prime Minister Modi’s Bharatiya Janata Party (BJP) could retain a majority, albeit a slimmer one, in the Lok Sabha (lower house of the parliament) in the general election that should take place around May 2024. This should allow the government to maintain its economic reform momentum and potentially attract more foreign investment into infrastructure and manufacturing.
For Indonesia, President Joko Widodo will need to step down as he completes his second term. The next president is seen to play a key role in the regions ongoing transition toward developing its infrastructure as well as harnessing its natural resources, including nickel, to be part of the new energy revolution.
For the economies of India and Indonesia, the potential for more reforms and continued efforts to develop their manufacturing industries would be constructive for long-term growth, especially as more international companies look for alternatives to reduce concentration in their supply chain and diversify away from China.
Taiwan’s presidential and Legislative Yuan elections on January 13, 2024 carry geopolitical importance as the presidential candidates’ campaign, and the outcome of the vote, could influence U.S.-China relations in the medium to long term. Nevertheless, we believe the global investment cycle and demand for semiconductors would be more dominant drivers of Taiwan’s equity market.

Exhibit 4:

 

5.   What would it take for Beijing to step up economic stimulus?

 

China’s economic outlook in 2024 will largely depend on the scale of macroeconomic stimulus from the government and its ability to boost consumer and business confidence. Based on recent policy announcements, we expect Beijing to remain supportive of growth, but we think dramatic measures are unlikely. This implies interest rates are likely to stay low, and the additional CNY 1trillion bond issuance announced in late October should support growth in 1H 2024. Fiscal policy is likely to be directed toward infrastructure, as well as addressing the deterioration in credit quality in local government financing vehicles (LGFVs). The housing market recovery is expected to be gradual at best, since public expectation on property prices is still conservative. Overall, we would describe China’s growth outlook for 2024 as stable, but not spectacular. Consumption is likely to remain a bright spot, but investment, both in corporate spending and the real estate market, could take longer to recover.
Despite the subdued economic outlook, we do see some opportunities in the Chinese equity market. Corporate earnings, based on analysts’ earnings per share forecast for MSCI China, are expected to grow by 15.6% in 2024, after a projected 7.7% growth for 2023. Communication services and consumer discretionary, which include a number of leading tech names, are projected to deliver consistent earnings growth in 2023 and 2024, despite their price-to-earnings ratio currently trading below their 15-year averages. Hence, there are sectors with good earnings outlooks at reasonable valuations. Moreover, emerging sectors, such as renewable energy, electric vehicles and advanced manufacturing, are still enjoying ample policy support and the potential to be a new export engine for China.
In addition to the earnings outlook, selected Chinese stocks also present attractive dividend yields. At 2.7%, the CSI 300 dividend yield is higher than the 3-year government bond yield, reflecting the relative attractiveness of Chinese stocks over government bonds..
One hurdle to overcome for Chinese equities would be international investor sentiment. The geopolitical events around the world in the past two years and challenges in U.S.-China relations has impacted the willingness to invest in Chinese assets by U.S. and European investors. There has been renewed dialogue between Beijing and Washington in recent months, which is encouraging and helps to contain potential geopolitical tail risks. That said, this might not be sufficient to convince western investors to revisit investing in China in a material way.
In our view, despite disappointing performance in recent years, Chinese equities remain an essential part of Asian investors’ portfolios. With an economy in transition, amid ongoing challenges in the housing market, sector and stock selection remains critical to separate the wheat from the chaff. Significant shifts are occurring within the manufacturing sector, while the services sector is increasingly playing a more important role in driving growth.

Exhibit 5:

 

6.   Can Asian equities outperform in 2024?

 

Asian earnings remain highly correlated with export growth. Despite the challenging backdrop for exports in 2023, green shoots of recovery have emerged in Asian exports that should provide a foundation for earnings growth in 2024. Moreover, Asian economies with strong local demand,solid tourism recovery and ability to capitalize on AI demand could bolster earnings growth.
From a valuations perspective, Asian equities are trading at relatively attractive levels. In particular, from a price-to-book (P/B) perspective, most regions are trading more than one standard deviation1 below their 15-year averages. Historically, at current P/B levels, Asian equities tend to clock positive returns over the next 12 months. Earnings expectations have also been revised downwards significantly since the beginning of year, largely driven by South Korea and Taiwan.
Despite the rise in equity volatility in the past few weeks, high dividend stocks in Asia have been outperforming. While the MSCI Asia Pacific ex-Japan Index has declined by 0.1% while S&P 500 rose by 1.9%, since the end of June, the MSCI Asia Pacific ex-Japan High Dividend Yield index has outperformed both indices, returning 3.4%.
Looking ahead, Asian high dividend stocks remain relevant even as global growth momentum slows. First, Asia corporates are supported by robust balance sheets and lower debt levels relative to their historical average, which bodes well for dividends in addition to providing a shelter from deteriorating economic conditions. Second, valuations are undemanding compared to developed markets. Moreover, from a macro perspective, Asian economies are likely to enjoy a healthy growth differential relative to the U.S. in 2024, and the region’s monetary policy continues to be supportive on a comparative basis
Dividends have, in the past, played a critical role in Asian equity returns. From 2000 to the end of September this year, Asia Pacific ex-Japan and Japan dividends contributed more than 60% and 65%, respectively, to total returns, compared to 44% in the U.S. In addition, the MSCI Asia Pacific ex-Japan High Dividend Index tends to provide a better risk-adjusted return relative to the broader MSCI Asia Pacific ex-Japan Index as shown in Exhibit 6. Given the macroeconomic uncertainties and the likely decline in cash rates over the next 6 to 12 months, it will be increasingly essential to find complementary pairing of fundamental resilience and stable dividends to preserve and enhance the total return of a portfolio.
Other than Asia high dividend stocks, Japanese stocks have risen 28% year-to-date (TOPIX, as of 16/11/2023), outperforming the U.S. and Europe. Although Japanese stocks have historically displayed a strong correlation with the global economic cycle, active management can help shift focus toward domestic factors to drive returns. These factors include the Tokyo Stock Exchange (TSE) governance reforms (which prompted companies to shift retained earnings into growth investments, wages and higher shareholder returns), Japan’s stronger economic recovery and resilient domestic demand as it emerges from deflation. Coupled with the revamped Nippon (Japan) Individual Savings Account scheme starting in January 2024—a tax exemption program for small investments—these domestic tailwinds should help drive retail investor flows and support sustained outperformance by Japanese stocks going forward
However, stock selection is key when investing in Japanese equities. The economic recovery is likely to benefit companies that are predominantly exposed to domestic or tourist demand. Meanwhile, the TSE’s push to boost shareholder value is focused mainly on value stocks. Yet, there are plenty of companies with strong technical and innovation intellectual capital that have constructive long-term earnings potential. Hence, pointing the sail in the right direction can help investors capture enduring opportunities

Exhibit 6:

 

7.   Do Asian central banks have room to cut rates?

 

As inflation continues to move lower, a natural question for investors would be whether Asian central banks have the capacity to cut interest rates to support their economy if momentum in the region were to slow down over the next 12 months.
While Asian central banks may be tempted to ease monetary policy in response to adverse economic conditions, they are unlikely to cut interest rates in the near term given their foreign exchange stability mandates, concerns over capital flight and lingering upside risks to energy prices.
With the Fed staying higher for longer, yield differentials between the U.S. and Asia have widened in favor of U.S. dollar strength and has made Asian yields relatively less attractive. While long-end bonds have rallied in recent weeks, the 10-Year UST yields have risen more than 50 basis points over the period of January to mid-November this year. However, the 10-Year Asian government bond yields have risen to a lesser extent given the more moderate monetary policy tightening cycle witnessed in Asia.
As a result, economies such as Malaysia, South Korea, Taiwan and Thailand, which until recently were enjoying positive yield differentials relative to the U.S., have now turned negative. In addition, economies such as the Indonesia and Philippines, which used to have substantially wider yield differentials over the U.S., have seen yield differentials shrink significantly over the past year. High UST yields and a weaker currency have therefore reduced the room for rate cuts in the short term.
Asian central banks will also be wary of calling off the fight against inflation too soon. With energy taking up a significant share of the CPI basket in emerging Asia, the potential pass through of higher energy prices may stall further disinflationary pressures. Net energy importers will be particularly wary of the potential pass through of higher energy prices on domestic inflation
The odd ones out would be China and Japan. While the People’s Bank of China remains in an easing mode, further policy support will be needed on the fiscal side rather than more monetary easing by cutting key policy rates. Japan, on the other hand, is taking nascent steps toward tightening, and there are growing speculations of a move away from yield curve control and negative interest rate policy.
In the long run, should the Fed cut rates in response to slower growth in 2H 2024, Asian central banks would have more scope to cut interest rates to support growth. That said, the decline in UST yields might be more gradual given technical factors and supply and demand dynamics. This could significantly limit the scope for meaningful rate cuts among Asian central banks

Exhibit 7:

 

8.   How could investors manage volatility in 2024?

 

At the start of 2023, negative stock-bond correlation re-established itself as rising yields pressured the bond market while optimism about artificial intelligence boosted equity performance. Yet over the past few months, and similar to 2022, equities and bonds have moved lower in tandem
As we head into 2024, there are questions about how investors can manage through market volatility. Admittedly in the near term, with inflation likely to settle at higher levels relative to the past, investors may have to be more nimble and flexible with their 60/40 stock-bond allocations. While we think a well-diversified portfolio of stocks and bonds remains important to ride out volatility and outperform cash, investors may want to expand their diversification toolkit to include alternatives to create more resilient portfolios.
Within alternatives, real assets such as real estate, infrastructure, transport and timberland can provide a good hedge against higher inflation and interest rates. In particular, these assets benefit from inflation-adjusted revenue streams, which can help boost portfolio returns from a real return perspective.
The longer-run question would be whether the 60/40 stock-bond portfolio will regain its former diversification potency. And if so, what conditions would be necessary to turn stock-bond correlations negative again?.
Historically, positive stock-bond correlations are associated with a surge in inflation, and this tends to persist for a while. However, with increased asymmetry in the potential returns for fixed income given elevated yields, and our base case scenario for a slowdown in the U.S. economy, the diversification potential of bonds has improved meaningfully relative to 2022. This is especially true if the Fed is forced to cut interest rates in the event of a recession. Equities, on the other hand, may come under pressure if there is a significant slowdown in growth. Yet, they could just as well prove resilient if the economic landing is softer than expected.
With inflation trending down and growth likely to slow in the near term, current macro conditions suggest that negative stock-bond correlation should re-establish itself sooner rather than later. That said, it will be important for investors to calibrate exposure to equities, fixed income and alternatives in a proactive manner to achieve an optimal risk-return profile in 2024.

Exhibit 8:

 

9.   What opportunities lie between equities, bonds and cash?

 

The rise in bond yields to multi-decade highs has put fixed income back on the agenda for many investors. For an extended period of time, bonds presented little income and little diversification benefit, given their high price (low yield). This was at a time when ample liquidity was propelling equities higher, with investors broadly adopting the TINA (there is no alternative) trade.
In the past year, while equities and bonds went through a significant repricing, fixed income has adjusted more, given the sharp increase in cash rates. In the year to date ending in October, the yield on the 10-Year UST rose 100 bps to 4.88%, while the forward P/E ratio on the S&P 500 rose marginally from 16.7x to 17.2x. This has resulted in the highest bond yields in many years, while equity valuations remain above their long-run averages. It’s little wonder that bonds are looking relatively attractive compared to other asset classes such as equities.
However, complicating the investment picture is cash. The drag on portfolio returns from holding too much cash is well known, but when cash or cash-like instruments yield the same as part of the credit market, the hurdle to move out of cash is higher.
We can simply assess the relative attractiveness of the three main asset classes—cash, bonds and equities—by comparing the earnings yield on the S&P 500 (the inverse of the P/E ratio) with the yield on U.S. investment-grade bonds (to match the corporate risk in the S&P 500) and the three-month UST (a proxy for cash). There is little differentiation across the three, complicating the choice for investors
Our view is that cash rates and the yield on short-dated bond maturities are likely to be lower in 12 months’ time given the risks to the economic outlook and fading inflationary pressures across the developed world. This means that holding too much cash today creates reinvestment risks in the future and increases the opportunity cost of forgone returns in either the equity or the bond market.
The fact that the U.S. may be able to avoid a recession suggests that corporates may be able to maintain profits if they can generate enough top-line growth to offset higher financing and input costs. While this would support overall index returns, the rotation within sectors and styles given the dispersion of valuations may be more meaningful for investors. Return prospects may be higher in equity markets outside the U.S. given lower relative valuations and potential for earnings upgrades
Heading into 2024, the starting point presents plenty of opportunities across asset classes beyond cash. With the economic outlook appearing somewhat sluggish, investors will once again be able to count on bonds to add ballast to portfolios while adding equity exposure.

Exhibit 9:

 

10.   Can the AI-driven rally continue?

 

The possible end to the U.S. hiking cycle and the peak in rates have historically benefited stocks with higher valuations. Typically, falling yields are constructive for growth-style equities, such as technology stocks, as investors assume higher future growth rates to offset potentially falling but still elevated discount rates.
So far this year, enthusiasm over AI has fueled the outperformance in the tech sector. AI has accelerated the rate of technological advancement and has diffused across various sectors and the broader economy. Aside from the big tech firms, related computing infrastructure businesses that enable consumer and enterprise adoption also outperformed. We expect the growth of the AI market to continue as the breadth of applications expand, providing tailwinds to infrastructure, semiconductor and software companies.
Meanwhile, the rebound in classic cloud consumption may also provide a favorable backdrop over the next several quarters. We remain excited about internet and semiconductors as well as the secular drivers in AI, automation and electrification.
Many investors question the sustainability of the narrow return contribution of large tech firms and their rich valuations, and some are concerned about the possibility of another tech bubble. While valuations of the dominant tech firms are high, they can be justified by strong long-term growth potential. Nevertheless, we remain mindful of the potential regulatory risks that could impact earnings potential.
In the event of an economic downturn, high-quality technology stocks could prove to be relatively resilient compared to other sectors, given their strong balance sheets and low correlation to the economic cycle as it pertains to earnings. In fact, fundamentals of large cap technology stocks have improved since the dot com bubble, with less leverage, more cash, higher profitability and better productivity
Admittedly, persistent innovation and disruption imply an ever-evolving set of winners and losers from new technologies. The ultimate winners will likely be companies that innovate or adapt to leverage new technologies as they emerge. As market leadership shifts over time, being selective and picking businesses with high-quality growth remains key.
In sum, while developments in the AI space could continue to drive gains in the U.S. tech sector, its benefits will likely diffuse to a broader range of industries and companies.

Exhibit 10:

 

11.   What could push the U.S. dollar lower?

 

The U.S. dollar has softened since hitting its two-decade peak in September 2022 with the greenback now at levels seen at the start of the year as of mid-November. In the long run, however, there are structural and cyclical factors that could support a weaker U.S. dollar.
Structural factors such as the twin deficits—budget and current account deficits—in the U.S. will likely persist, and absent offsetting capital inflows, the greenback is likely to face downward pressure. Moreover, the issues around government spending and elevated debt and deficit levels bode negatively for the U.S. dollar. There is also some risk of prolonged political brinkmanship with a divided and partisan U.S. government. Absent a resolution, a risk premium might be warranted in the valuation of the U.S. dollar
There are cyclical factors that may guide the U.S. dollar in the long run. The U.S. exceptionalism narrative has arguably underscored the markets’ bullish views on the greenback in recent quarters. While U.S. growth momentum is expected to ease next year, a sharper deceleration in the U.S. economy could trigger an earlier-than-expected monetary policy easing cycle by the Fed. This may imply a narrowing of the U.S.-developed market (DM) government bond yield differential that could exert downward pressure on the dollar. Looking ahead, a weaker U.S. dollar may provide opportunities to rotate toward emerging market (EM) equities.
That said, the road toward a weaker U.S. dollar could be bumpy. Several factors could reaffirm the risk-off scenario, hence extending the resilience of the greenback in the coming months
First, the recent surge in long-end UST yields, widening in the U.S.-DM government bond yield differential, could persist on account of the expanding U.S. federal budget deficit, which implies an increase in UST issuance next year. This means long-end UST yields could still grind higher, elevating the fair value of the U.S. dollar.
Second, demand for safe-haven assets such as the U.S. dollar tends to rise with volatility, such as periods of heightened geopolitical tensions, which may warrant a premium in the U.S. dollar. These factors lend credence to the bullish U.S. dollar view in the near term.

Exhibit 11:

 

12.   What could go wrong?

 

Considering the experience of the last two years, we want to focus on the potential challenges facing investors in the Asia Pacific region, instead of the possible upside to investing.
Let’s start with the risk of a sharp recession in the U.S. and/or broader developed economies. This could be brought by central banks keeping monetary policy tight for too long and neglecting signals of weakening growth and tightening financial conditions. This scenario would require central banks to reverse their monetary policies, implying lower government bond yields.
While earnings could be adversely impacted by weaker growth, the turnaround in monetary policy could start a valuation re-rating. Historically, data on industry fund flows indicate that investors were often late in participating in equity rallies, as they demand more evidence of economic and earnings recovery, hence sacrificing return in the early stages of the market rally. Accordingly, it may be sensible for investors to rotate into equities once the deterioration in economic data begins to show signs of stabilizing
A more challenging situation would be a stagflationary environment, where economic growth is cooling on the back of tighter monetary policy but inflation remains stubbornly high. The unyielding focus on inflation could mean that central banks would opt to keep rates high to cool inflation, instead of cutting rates to boost growth. This could create a scenario where stock-bond correlations once again turn positive with negative performance across both asset classes. In this scenario, short duration bonds can provide income, especially given current elevated yields, while limiting the duration risk. This also provides the advantage of daily liquidity compared with time deposits. Alternative assets, such as infrastructure and real assets, can help manage downside risks during inflation due to the nature of their inflation-linked revenue contracts.
China’s real estate sector has yet to show signs of recovery and concerns remain about the potential spill-over contagion impact on the non-bank financial sector, and subsequently the broader economy. The risk of default with LGFV could be another source of financial risk in China. The Chinese authorities have started to address the LGFV issue with debt swaps. In addition, the government has relaxed policy restrictions on the property market. We believe support measures could be stepped up if systemic risk emerges. Nevertheless, we would urge caution on being too opportunistic toward assets that have direct exposure to these trouble spots.
Elections and geopolitics are likely to capture headlines in 2024. The ongoing conflict in Ukraine and the Middle East ought to have limited impact on the global economy. If tensions in the Middle East escalate, we could see higher oil prices due to concerns over supply disruptions. The U.S. and China have stepped up bilateral dialogue, which can help reduce the tail risk of military friction due to accidents or errors. Any rise in tensions between the two biggest economies in the world could prompt investors to seek safe-haven assets, such as gold, as well as liquidity assets, such as developed market government bonds.

Exhibit 12:

 

Conclusion

The economic environment in 2024 is likely to be more challenging, alongside unknowns such as geopolitics, policy errors and extreme weather events. A well-thought-out asset allocation can help investors to generate return, whether via income or riding on structural trends, and manage market volatility. The key here is that our portfolio construction needs to be ready for not just the core scenario but also for other contingencies that could come. This cannot be done with a single asset class, but instead requires a diversified portfolio of stocks, bonds and alternative assets.

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Diversification does not guarantee investment returns and does not eliminate the risk of loss.

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Information stated is general communication which is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professional, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment.

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