Morningstar’s comprehensive 2024 Outlook report includes an exploration of the economic themes that will influence investments. It declares that portfolio construction must account for economic change – both expected and unexpected.

The base case and economic reality

We’ve seen the Australian economy continue to flatline, with falls in GDP per capita occurring over the first half of 2023 despite relatively low unemployment levels. Many Australians took on higher levels of debt in the past few years, and as interest rates have increased so have debt servicing commitments. In conjunction with other cost of living pressures, this leaves little room in our budgets and many indebted households are under pressure.

We’ve also seen the savings buffer that was built up from massive fiscal stimulus programs in 2021/2022 depleted. Household consumption has been trimmed.

Many economists still see a high chance of a recession in the next year.

Australian investors continue to increase their exposure to global markets. The U.S. market makes up a large component of international exposure. Additionally, the U.S. market influences the movements of many markets, including our own.

For the U.S., our economic outlook is optimistic relative to expectations of GDP growth and inflation for the next several years. The report outlines our expectation for GDP growth to slow in 2024 due to lagged effects of Fed rate hikes. Contributing to the slowdown is an expectation that consumers will reduce spending as household excess savings deplete. These conditions could induce aggressive rate cuts in 2024.

We believe monetary loosening will drive strong GDP growth over 2025-2027. An expected increase in labour supply and productivity will also contribute to this.

Our expectation is that by 2024, inflation will return to the Fed’s 2% target rate.

The swing factors that will influence your investments

Our base case scenario outlined above is what we consider most likely. However, we do not think it is the only outcome possible. There are a wider range of outcomes than what we see in a stable environment. There are three swing factors that can impact inflation, economic growth and interest rates. All three have profoundly influenced the course of economies and markets in recent years. In varying degrees they will continue to do so.

  1. Geopolitics has become a greater swing factor in the past few years with the return of military conflict in eastern Europe and the Middle East. We’ve also seen more abrasive relations between China and the U.S. and upcoming elections may result in large policy shifts. These conflicts have already impacted prices, with potential knock-on effects on commodity prices including critical energy supplies. We must also weigh the economic effects of an ongoing rise in military spending in Europe, Asia and the U.S.
  2. Natural events impacting our physical environment and health have the potential to impact growth and inflation depending on their severity and the subsequent government responses. Extreme weather impacted energy demand in 2021 with shortfalls in solar and wind in North Asia causing higher demand and prices for gas. The pandemic had tragic health impacts and ongoing constraints on supply that impacted the economy in China from 2020 to 2022.
  3. Our third swing factor is the adoption of technological innovation. Only when the breakthrough discoveries of the past like the printing press, steam engines, electricity and computing were applied at scale did they enhance productivity, increase growth and ease inflationary pressures. The faster artificial intelligence is applied, the faster the effects will be felt. We are at the point now where application is expected to ramp up.

 

Taken together, in periods of change like today, investors need to prepare themselves for a wider-than-usual range of potential economic outcomes.

Economic challenges appear to be priced into the market

Examining defensive and cyclical shares generally can uncover market expectations for the future. The performance of companies classified as defensive generally are not impacted by changes in economic conditions – think health care and consumer staples. The performance of cyclical companies generally follows the economic cycle.

We believe markets are offering a discount in both areas and in aggregate. We don’t usually see this in periods of economic weakness. Normally, we would see cyclicals offering a bigger discount relative to defensives.

Given the challenging economic environment, it appears as though defensive shares are favoured over cyclicals - but not by much.

Valuations

At a deeper level, our Australian Market Outlook and other regional outlooks see utilities, communication services, and financial services pricing in an economic deterioration. You can access our Australian Market Outlook through Morningstar Investor.

You can listen to our market update on a recent episode of Investing Compass. 

How to position your portfolio

Our base case macro-outlook is lower growth, inflation and rates, but without a recession. We believe this is supportive of classic multi asset portfolios invested in bonds and equities.

Bonds in particular have become more attractive as yields have increased.

Importantly, investors need to say the course to achieve their financial goals regardless of market and economic conditions. Holding well priced assets that will perform decently in varying scenarios is worthwhile. They should hold up in different economic growth and inflation scenarios.

One form of insurance is inflation-linked bonds. They have become more attractive as their price has fallen. This will benefit investors if inflation does turn out to be higher than expected.

Defensive equities still offer value and help smooth outcomes in scenarios where economic growth is weaker than expected. Should economic growth turn out to be higher than expected, there are attractively priced cyclicals including financials and smaller companies.

The report outlines the results of scenario testing. The key positions that make up a robust portfolio include:

  • Defensive equities, including healthcare and utilities,
  • Inflation-linked bonds,
  • Diversified currency exposure outside the U.S. dollar. For Australian investors this would mean preparing for a weaker US dollar which would detract from the return Australian investors receive from US investments. If we are correct and the US dollar drops against the Aussie dollar a hedged investment would provide better returns.

The report acknowledges that the outlook comes amid recent volatility and a wide range of possible outcomes. It anticipates a complex macroeconomic playing field, influenced by the swing factors to varying degrees.