SFC Outlook 2024｜Arend Kapteyn: This Year's Elections Could Greatly Impact Financial Markets

南方财经全媒体记者 施诗 李依农 上海报道

In an in-depth interview with SFC Markets and Finance, Arend Kapteyn, UBS Global Head of Economics and Strategy Research, offered profound insights into the current economic landscape, providing valuable perspectives on various market aspects. The discussion covered crucial topics such as the potential trajectory of inflation, the performance of the U.S. labor market, the likelihood of a mild recession, and anticipated actions from central banks, with a focus on the Federal Reserve and the European Central Bank.

Addressing the U.S. economy and the Fed’s policy, Kapteyn anticipates the U.S. experiencing the mildest hard landing in its recession history. 

Kapteyn also predicts a global economic slowdown in 2024, attributing it to weaker growth in China and the United States. Despite this, he underlines a more optimistic outlook for Asia's growth and acknowledges the resilience demonstrated by Chinese tech sector.

Additionally, Kapteyn discussed the impact of geopolitical conflicts are likely to be limited, yet he highlighted the upcoming elections, particularly the U.S. presidential election, could have great effects on global financial markets.

U.S. May Experience Mildest Hard Landing This Year

《SFC Markets and Finance》: The recent data showed the inflation continued to fall. Do you think the inflation will go up again in the U.S. and Europe?

Arend Kapteyn: It could go up in the monthly numbers, which we actually do forecast to happen. The monthly numbers are quite volatile, but the trend is unambiguously downwards. We've now reversed about 90% of the global run up in inflation, if you look at the monthly sort of annualized run rates, and it's really across all the components. It's not just energy, foods coming down, goods inflation are already completely normalized, and even service inflation is now starting to come down quite strongly. So I think that the big story for 2024, we are going to land very close to pre-pandemic inflation levels.

《SFC Markets and Finance》: The U.S. labor market performed much better than expected in December. Will the U.S. economy head for a soft landing?

Arend Kapteyn: The payroll number came in better than expected. I think it's a bit misleading in terms of how strong it really was. If you take out the government sector and the healthcare sector, then on a three-month moving average basis, private payrolls are barely growing. So, there's a clear slowdown in the labor market.

If you measure it through the aggregate hours worked, then the last three months, the sector has been contracting. So there's a real slowdown underway in the labor market, and you're running probably about half the level of employment growth that you had six months prior. So if you extrapolate from those trends, and you think where are we going to be in about one or two quarters from now, then we think payrolls are going to start to contract.

We have a very mild recession in the forecast. In the middle two quarters of the year, we will have a mild recession. Now, whether you call that a hard landing or soft landing, it's technically a hard landing, because it's a recession, but it is the mildest hard landing that you can think of. This would be the mildest U.S. recession.

《SFC Markets and Finance》: What factors will lead to a mild recession?

Arend Kapteyn: Few things. This is going to be a very unusual recession in the sense that it's coming from consumption, not really from the usually volatile investment components. The way we sort of think about it is that, normally what happens in a recession, there's some kind of shock. It can be an interest rate shock, or some exogenous shock. And then the volatile sectors of the economy, investment in particular go down very quickly, and everything else gets dragged on with it.

That's not what's happening now. We've had effectively already a recession in the investment sector, the housing sector of the US economy, that's sort of starting to stabilize a little bit. But now consumption is going to follow with a lag. And the reason it's following with a lag is because we had so much stimulus that has taken a lot of time to sort of use up all the extra money that people had to spend. So, having a consumer led rather than an investment led recession makes it a little bit milder.

The other big factor, which is already sort of happening now is that while we've had a very big hiking cycle by the central banks, that's going to start to get reversed. We have not just the Fed, but every single central bank in the world, excluding the Bank of Japan, going to be easing policy this year. We think that's already, if you look at the market pricing, that's reversing about a third of the total tightening that's taken place. That's going to start to reverse a lot of the headwinds that we've seen last year.

The Fed Should Begin Rate Cuts in March

《SFC Markets and Finance》: UBS expects the Fed will cut interest rates by 275 basis points this year. What’s the logic of this forecast?

Arend Kapteyn: There’re two steps to it. The first bits, which is only worth 75 basis points, is what the Fed itself says it's going to do. The Fed has a very transparent framework, they actually publish forecasts. And in their own forecasts, they have 75 basis points, 3(times) 25 basis points cuts this year. And where that's coming from is they have a particular level of the real Fed funds rate, the real policy rate that they're targeting. That level has already been reached. So as inflation now continues to come down, they're going to start to exceed that level of tightness that they were aiming for. Just because of that, they're going to start to cut. Now that's the first bit and that's a small part of the cuts. 

What will they do more than that, which they're not forecasting is dependent on having a recession. If you get a recession, unemployment starts to go up. And then they have to basically react the way they normally would, which is they have to push the policy rate back below neutral. And in the case of the U.S. that's below two and a half percent. So that's where we think we're going, but that last bid really depends on the recession and that is not a certainty.

《SFC Markets and Finance》: Do you still believe the Fed will begin to cut rates in March?

Arend Kapteyn: That's our forecast, the first cuts is in March. Now the market is only pricing about a 50% probability of that. The logic of that is by March, the real Fed funds rate is going to be running close to 3%. That’s way above where they themselves had forecasts that intended level to be in 2022.

Now, in reality, you probably need some cooperation from the other data, not just inflation. I think they can sort of make two types of errors. They can cut in March, a small cut, and then ended up being wrong. For that reason, I think they would be more comfortable if they saw payroll data weakening or other activity data weakening. Or they could cut later and then cut faster. There's certainly a risk that they prefer to cut a little bit later, but then maybe cut faster so that they don't had, as they say, egg on their face for cut rates too early.

So I think March, the market is sort of fairly pricing that. It's not a certainty that they go in March, but based on their own forecasts, they should go in March.

《SFC Markets and Finance》: What's the risk if the Fed cuts faster?

Arend Kapteyn: I don't think there's a lot of risk to that. With inflation dynamics being so clearly to the downside, our forecast is we're going to land below 2%. There's a lot of sorts of what we call inertia in the forecast. If you look at the housing component of the U.S. inflation, that basically lags where the market rents have already gone. So we know that up until late summer, the biggest part of core inflation in the U.S. will continue to go down. The risk on inflation are more things like oil prices going back up, and that's always possible. But that's really not going to change the underlying dynamic. So I don't think that's a risk at all that they go too fast.

The ECB Will Unlikely Be the First to Cut Rates

《SFC Markets and Finance》: How about the European Central Bank? When will the ECB begin to cut rates?

Arend Kapteyn: We have that's happening in April. The ECB is much less clear than the Fed because they don't have a clear framework for what is the trigger to start cutting. Now, if you view it through the same lens as the U.S. sort of the overall tightness of monetary policy, then in Europe, the real interest rate, the real policy rate will be at an all-time high level by May. So that's partly the reason for saying ‘well, they probably go in April’. The reason they don't go earlier is because they would be the first if you look at the calendar of the Central Bank meeting dates, the March meeting is actually ahead of the Fed meeting. It's not that clear that they would have enough comfort or evidence in hand going into that meeting and want to be the first central bank to cut. It’s going to be whoever goes first, I think everyone else will follow. But it's not obvious that the ECB wants to be the first. So we think, April.

One thing that's a bit easier in Europe is that the economic data is awful. So in the U.S., you have some resilience in the economic data, but you have strong disinflation. In Europe, you have weak economic data and weak inflation. So in some sense the decision is a little bit easier. The one element that they keep citing about being nervous about is wages. And the problem with being nervous about wages is that they're not going to get a lot of evidence in the next few months that the wages are under control. So wages look to be peaking, but they might want to wait a few more months just to be sure that's actually happening.

《SFC Markets and Finance》: Like you mentioned, the economic data is very awful in Europe. How do you think about the Eurozone economy this year?

Arend Kapteyn: We actually have a recession model for both the U.S. and Europe, and they have the same recession probability about 90%. But if you look at the actual data in Europe, you would look at Europe and say ‘well, Europe is already in recession.’ And yet we're not forecasting recession. And the U.S. is, looking at the data, it doesn't look to be a recession and yet we're forecasting it. Now, the reason we're not forecasting it for Europe and we are for the U.S. is that in the U.S., there's an enormous imbalance between spending and real income. People are spending much more than the income that they have. In Europe, that's not the case. So in Europe, the starting imbalance is actually very low. But at the same time, consumer confidence is low, people are not spending, they're not using their excess savings that they accumulated. So the consumption is just much weaker than in the United States.

And I think there's a different level of confidence in Europe. Where that partly comes from is the housing prices have declined sharply, that's really having an impact on consumer behavior. The other reason is that Europe is in many ways like an emerging market. It’s very open, very trade dependent. That is the weakest part of the global economy, and so they're more exposed to that than the U.S., which is partly why growth is so weak.

《SFC Markets and Finance》: Will a deeper recession take place in Europe?

Arend Kapteyn: We don't forecast that, but that's very clearly a risk. What our forecasts hinges on in Europe is that as inflation comes down, real wages go up and people have more spending power. And then consumption, which is about 55% of GDP avoids the recession.

I think what we're actually seeing is that inflation is coming down, real wages aren't going up, and yet people are still not spending. So, the logic of that not happening immediately is that if you're a consumer, your price levels have not actually come down. So it doesn't feel like anything has gotten any cheaper. We economists always look at the changes, not the levels, but consumers sort of look at the levels, and they don't necessarily feel much better than they did three months ago, or six months ago.

I think that will come, but it may just take a little bit longer than we think. And then there is a risk of recession. We're not forecasting that, the ECB is not forecasting that. But it's possible.

Global Economic Growth Expected to Slow Down

《SFC Markets and Finance》: Many experts thinks the global GDP growth will slow down in 2024. What's your prediction?

Arend Kapteyn: We have a slowdown. Our estimate is that in 2023, global growth was about 3%, maybe 3.1%. In 2024, we have 2.6%. So we have that slowdown, really only coming from two economies, China and the United States.

In the case of China, that is mechanical. Because sequentially, we think things get better, but you don't have a repeat of the Q1 reopening bounce last year. The U.S. is because we have a recession. If you look at the rest of the world, there's actually not a whole lot of movement in the data. Now in parts, the rest of the world is already weak. So at the median level, if you look at the average country in the world, not weighting it by GDP or anything, you just look at the average economy, is growing at about 1%, 1.5% right now. That is historically weak. So when you do the forecast, we're not expecting that to get weaker.

The other thing that's happening is that all the central banks are starting to reverse the hiking cycles. So a lot of the headwinds that we had in 2023, this tightening, that withdrawal of credits from corporates and businesses, that's started to get better. So the first half of the year there is probably still a lot of those headwinds. The second half of the year, they start to go away, and it starts to get a bit better.

China’s Internet Stocks Looks Particularly Resilient

《SFC Markets and Finance》: UBS expects China's GDP growth will be 4.4%. It's lower than 2023. Why?

Arend Kapteyn: That's because of that, if you think about the first quarter of last year, the end of zero-COVID, economy opened-up, we had an incredibly strong first quarter. We don't have that happening again. We're not going to have as strong a first quarter as last year. But the other quarters are going to be fine. So sequentially, we have things getting better in China. The property market, we think starts to stabilize in the first half of this year.

《SFC Markets and Finance》: What will be the key drivers for China's economy?

Arend Kapteyn: The property market is the most important factor in a forecast that we're nervous about. On the one hand, we look at all the announcements, and enormous number of stimulus measures by number has been announced since the summer. It's not yet obvious that's fully turned the ship. So when we look at the monthly data on property activity, one month is up one month is down, there's no clear pattern yet or troughing in the data. We think we're getting very close to that, so we're becoming optimistic. But that is the single most important thing, because it has all kinds of spillover effects. So that's the thing we're most focused on.

《SFC Markets and Finance》: How about other industries besides property industry?

Arend Kapteyn: So the bit that we're most excited about in terms of our outlook, when we look at the equity market is really the tech sector. The tech sector is now historically cheap compared to the rest of emerging markets, and certainly compared to developed markets. And what's interesting, when you look at the earnings trends in that sector, they've actually been improving. So despite the weakness that people see maybe in the economy as a whole or property, there are pockets of China that actually very, very resilient, and the tech sector is the one that looks most resilient. So, we like North Asia tech as an industry, but within that, we particularly like China Internet stocks.

More Optimistic Outlook for Asia's Growth

《SFC Markets and Finance》: Do you think which region will drive global growth this year?

Arend Kapteyn: I think on average, emerging markets are going to do a little bit better than developed markets. One reason is that, the weakest part of the global economy right now is trade and that is really emerging markets. But that is starting to turn. And particularly if you look at Asia, there's really been a decoupling since roughly the summer between Asia and the rest of the world where the trade data in Asia is starting to get better. The growth differential between emerging markets and developed markets will start to increase again. So, in that sense, we're more optimistic from a growth perspective on Asia.

Now whether from a market perspective, emerging markets can decouple from developed markets, I'm much more skeptical. So if we have a recession in the U.S., it is very unlikely, with the exception of China, I think that emerging market equity markets would not go down along with U.S. So I distinguish a little bit growth from markets, they might behave in different ways this year.

Prefer Bonds Over Equity This Year

《SFC Markets and Finance》: You said you prefer bonds to equities in an interview. Why bonds will be more attractive?

Arend Kapteyn: Mainly because we're going to start to reverse the tightening cycle. In level terms, yields are not historically high, but they're certainly back to where they were 15, 20 years ago. The central banks generally perceive themselves to be well above neutral levels, so as they start to go back towards neutral, the bond yields will decline, and bond prices will rally. As an entry point, the market is already responding to that. But I think that is sort of the most straightforward thing this year, is that when inflation comes down, bonds do well. That's the simplest thing to do this year. If you do anything, that's what you want to do. 

And equity, I think it is difficult, in part because risk premia are so compressed. If you go back in history, and you look at how do equity markets perform in a year when credit spreads are this low, when volatility measures are this low, they generally don't do so well. So equity markets do well when your starting point is very bad and then there's something to recover from. But the starting point in this case, is that things are not so bad, and then it's difficult to sort of do well. So for that reason we prefer this year bonds over equity. But that's really sort of a recommendation for 2024. It's not a medium-term recommendation. It's just the tactical recommendation.

《SFC Markets and Finance》: The S&P 500 performed very well in the past two months. How do you think about the U.S. stock market this year?

Arend Kapteyn: The S&P 500 is really split between the Magnificent Seven, the big tech stocks, and everything else. And the everything else is not doing so well. So the earnings for the non tech sector we think is going to be flat in the first quarter. It's severely underperformed tech stocks in the fourth quarter. So the S&P is this average of these two different parts of the economy. Now looking at what's going to happen this year, we still think the S&P will go up despite the recession, but not by very much. So what we think is going to happen, if you listen to our equity strategist, is that the market will for now, continue to go up.

If the recession happens, there would be a drawdown. This always happens in recessions. And then there would be a quick recovery if the Fed starts cutting. And then by the end of the year, you're back above where you started. If there were no recession, we'd be a lot higher than what we're forecasting.

《SFC Markets and Finance》: Which sectors do you prefer?

Arend Kapteyn: So right now because we're worried about that recession, we prefer to be in defensive sectors or high-quality sectors, which means firms that have a resilience to weaker demand, so that are not so sensitive to weaker demand. So in general, we like defensives versus cyclicals, healthcare stocks, utilities, things like that. That's sort of a general recommendation, not just for the U.S. but also for Europe. If you're looking at it globally, we're actually neutral on tech globally. But we like North Asia tech, we like China internet as we spoke about.

《SFC Markets and Finance》: If the Fed begins to cut rates, will the emerging market have more opportunities?

Arend Kapteyn: I think the local fixed income, which is our favorite sector in emerging markets. So the way I'd frame that is emerging markets tightened more than develop markets and they did it earlier, and we're at higher levels historically than developed markets. Inflation is falling faster in emerging markets, which is interesting. So everyone had an inflation shock, but it's actually correcting faster in emerging markets than developed markets. What that means is that the central banks reverse those level of interest rates actually faster than the developed markets. So that is a sector that's really going to outperform, local fixed income, bond markets, we think is sort of the safest place to be in emerging markets.

Equity, much more tricky. So emerging market equity identified a few sectors, but if you take the entire asset class, when do emerging market equities outperform? It's when commodity prices go up. They're not going up. It's when credit spreads can compress, they're already very low. It's when growth differentials improve, yes, that's going to happen, but it's not that straightforward. And if the S&P does have a drawdown, so a correction because of a recession, emerging markets are going to go down more than the S&P. So that's the problem for equity.

If you look at currencies, they actually look pretty expensive. So again, we'd prefer to stay clear of those for now.

This Year's Elections Could Greatly Impact Markets

《SFC Markets and Finance》: To what extent will the geopolitical conflicts affect the market?

Arend Kapteyn: It's not having much of an impact. There's a conflict in Russia, Ukraine, obviously, there's a conflict in the Middle East. That did not have a big impact even on oil markets, which is interesting. So it's always a risk, I think oil prices going up is definitely one of the risks to our forecasts. 

I think, as a political risk, what's coming into focus is much more on some of the elections that we have this year. So, there's a whole range of countries with important elections, the most important one being the U.S. (election). The U.S. election later this year is becoming a major debating point whether or not we get a second Trump presidency. I think that would have a big impact potentially on markets.

《SFC Markets and Finance》: Will these elections cause Black Swan?

Arend Kapteyn: Well, that sort of one of these unforecastable. It's not clear, right? On one level, there's a lot of conventional wisdom around U.S. election, where people say that if Trump wins, then it's good for equity and bad for bond markets. It's good for equity, because people think they're gonna get a repeat of the last time, where you get deregulation, lower taxes, things like that. But it's bad for bond markets because the deficits don't come down. But that's sort of a little bit simplistic. Because if you go back to 2016, when Trump was elected the first time, we didn't actually know at that time how aggressive he was going to be on tariffs. So I think the way his potential victory would be interpreted this time could well be different from last time when the markets rallied. So I think we have to wait and see. People are definitely nervous. There's a lot of conversation about what that would really mean. But that is probably the biggest political events at least that the market is going to try to trade this year.

《SFC Markets and Finance》: What suggestions do you have for investors?

Arend Kapteyn: The main thing we've been recommending from a trading perspective is just to remain exposed to fixed income. Although I think the market is taking a breather here because it rallied so fast in the fourth quarter. But that remains sort of the asset class that should be most safe. We also think that the correlation between bonds and equities is going to turn back around to where it's been historically. We're much more defensive and cautious on equity, generally neutral globally on things like tech. We're also a bit cautious on credit, because the credit spreads are so compressed that we just want to see where growth goes this year, and then I think you can start to go back into credit and equity and things like that. That's the big picture recommendation.

《SFC Markets and Finance》: Should we keep more cash?

Arend Kapteyn: Yes, is the answer. But it's very difficult to be very overweight cash, as we saw last year. So we've been cautious for a while. But if you weren't invested in the second half of last year, or let's say the last three months of last year, you would have severely underperformed the market. So it's very difficult for a lot of our clients to be too overweight cash. Because the market has a tendency of grinding higher and you don't want to necessarily miss that. So what you actually tend to find speaking to clients is that that's actually what our equity analysts are forecasting, is that we think the market could continue to go up until it becomes much more clear that there's going to be a recession. And at that point, everyone's going to try to get out through the same exit door at the same time. Everyone wants to be overweight cash at that point, which is why you get the big drawdown because you get too many sellers at the same time. But you don't necessarily want to be overweight cash now. I think it's too early to be certain that we're going to get that recession. But certainly, there's a role for being somewhat overweight cash at some stage this year, and it has a role in your portfolio.

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