We examine the key macro developments that have defined 2023 so far and consider potential risks investors should monitor heading into 2024.
November 30, 2023
By Joseph Wu, CFA
Despite gloomy projections heading into 2023, another push higher in interest rates, and geopolitical upheaval, the world economy managed to exceed expectations. The U.S. economy, as the major engine for global growth, continued to prove its mettle, performing stronger than the rest of the world on the back of steadfast household spending, reinforced by steady job creation and income gains.
Firmer-than-anticipated economic growth enabled corporate profits to exceed subdued forecasts. Not unlike those for the first two quarters of the year, Q3 earnings for large-cap U.S. and European companies came in better than expected, with roughly 80 percent and 60 percent, respectively, of companies reporting positive surprises.
Line chart showing global economic and inflation surprise indices (Citi Economic Surprise Index – Global and Citi Inflation Surprise Index – Global) since January 2021. In 2023, economic data has broadly surprised positively, while inflation data has generally surprised on the downside.
Note: Surprise indexes measure how economic data compares with consensus expectations.
Source – RBC Wealth Management, Bloomberg; data through 11/24/23
Finally, inflation receded considerably from worrisome levels in most economies thanks to a combination of lower energy prices, base effects from year-over-year comparisons, and slower demand for goods and services. This has allowed most major central banks, including the Federal Reserve, to shift to a more balanced stance on the trade-offs between the path of interest rates, inflation, and growth.
Cautious optimism and resilience remain apt descriptors for the global economy, but we believe growth prospects will continue to be tested by a mix of persistent headwinds. A significant source of uncertainty stems from the progressive impact of the rate hikes that have already been deployed by many central banks around the world.
As price pressures have subsided to more palatable levels, it looks like we may have finally reached a plateau in interest rates. Although central bank officials in the U.S., Canada, and Europe have signaled a desire to pause rate hikes, they have also been guiding markets to expect interest rates to linger at higher levels for longer, given inflation is still at above-target levels.
Higher rates and a reduced willingness of banks to extend loans suggest to us that credit conditions for households and businesses are likely to remain challenging in the near term. Restrictive borrowing costs and tougher access to credit tend to act as drags on economic activity. After consistent positive revisions this year, the current consensus projections are for global and U.S. real GDP growth to moderate to 2.7 percent and 1.2 percent in 2024, on a year-over-year basis, respectively, from 2.9 percent and 2.4 percent this year.
Line chart showing U.S. bank lending standards and commercial and industrial loan growth since 1997. Changes in bank lending standards tend to lead loan growth by roughly a year, with the recent significant tightening in lending standards pointing to a further slowdown in loan growth in the quarters ahead.
Note: Bank lending standards is the net percentage of banks tightening or loosening standards
Source – RBC Wealth Management, Bloomberg; data through 10/31/23
These forecasts partially reflect the view that the effects of higher interest rates will continue to permeate the economy by tapping the brake on private sector activity. Signs of strain from the monetary tightening campaign are starting to show up in various pockets of the economy. Most major economies are generating fewer jobs relative to a year ago, while wage gains have decelerated, job openings have fallen, and corporate default activity has begun to pick up. The good news is that most of these metrics are worsening from very healthy starting points, but the risk is that they could continue to trend in the wrong direction heading into next year.
The story for much of 2023 has been a macro environment that has generally surprised in a constructive way. Sustained economic growth and central banks that are now less motivated to hike again provided a more supportive environment for equity markets to scale the proverbial “wall of worry.”
We acknowledge that receding inflation and sturdy labour markets have made it easier for investors to envision a more upbeat outlook for major economies. However, we are mindful that it is difficult to distinguish between the typical growth slowdown preceding a “soft landing” and one that eventually lands in a deeper economic downturn.
Meanwhile, the longer rates are kept at restrictive levels, the greater the likelihood that they start to materially weigh on the economic activity as consumers and businesses would increasingly feel the pinch of the more expensive cost of borrowing and refinancing over time.
Consensus estimates are currently projecting low double-digit profit growth for major equity indexes in 2024. While these full-year numbers are usually revised lower as the new year progresses, our sense is that as long as the world economy maintains an upward trajectory, this should allow companies to surpass (lowered) earnings estimates over the coming quarters.
For most portfolios, we continue to view an “up-in-quality” approach to allocations as sensible. Within equities, this can be expressed through a preference for companies with more consistent cash flows, lower debt levels, and/or growing dividends – quality and defensive attributes that can help strengthen resilience in equity portfolios if economic conditions begin to undershoot market expectations.
The additional upward repricing of interest rates in 2023 has dented returns in fixed income markets. But the silver lining of the substantial pullback in bond prices (higher bond yields) over the past 20 months is that expected returns and the overall risk-reward profile in bonds have improved greatly. Even though bond yields have fallen somewhat recently, we continue to see a compelling case for allocating into fixed income, with many bond markets offering ample opportunities to deploy capital and lock in all-in yields ranging from mid-to-high single digits. Historically, the end of rate hike cycles has typically brought with it a more favourable environment for fixed income securities.
Column chart showing the current forward earnings yield for the MSCI All-Country World Index and the S&P 500 and the yield to worst for the Bloomberg U.S. Corporate Index, the Bloomberg Global Agg Credit Index, the Bloomberg U.S. Corporate High Yield Index, and the Bloomberg Global Corporate High Yield Index, compared to January 1, 2022, and the average since 2002. On a relative basis, the yield advantage that equities commanded over corporate bonds has sharply diminished over the 20 months.
*Earnings yield is the inverse of the forward price-to-earnings ratio. Bond yield refers to yield to worst for the Bloomberg U.S. Corporate Index, the Bloomberg Global Agg Credit Index, the Bloomberg U.S. Corporate High Yield Index, and the Bloomberg Global Corporate High Yield Index.
This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.
The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.
This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.
Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiary is not covered by the UK Financial Services Compensation Scheme; the office of Royal Bank of Canada (Channel Islands) Limited is a participant in the Jersey Bank Depositors Compensation Scheme. The Scheme offers protection for ‘eligible deposits’ up to £50,000 per individual claimant, subject to certain limitations. The maximum total amount of compensation is capped at £100,000,000 in any 5 year period. Full details of the Scheme and banking groups covered are available on the Government of Jersey’s website www.gov.je/dcs or on request.
We want to talk about your financial future.