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February 6, 2024 | Podcast
Our 2024 Global Outlook

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Will 2024 be the first year of “normal” economic expansion post-COVID? In this episode of The Active Share, Hugo sits down with William Blair’s Olga Bitel, partner, global strategist, and Simon Fennell, partner, portfolio manager, for a wide-ranging conversation about the outlook for 2024. Together, they touch on key topics such as inflation and interest rates, Japan’s investment story, the impact of generative artificial intelligence (AI) and GLP-1 medications, and what new growth opportunities could be on the horizon.

Comments are edited excerpts from our podcast, which you can listen to in full below.

 

What will inflation look like in 2024?

Olga: 2024 is shaping up to be an interesting and exciting year. It’s also shaping up to be an ordinary, expansion-like year—2024 may be the first post-COVID year in which we are sitting comfortably in an expansion.

Inflation is increasingly in the rearview mirror, and we are decelerating with each monthly print. Soon, we are going to be debating whether monetary policy settings are too tight for the level of inflation that we’re currently enjoying.

To play devil’s advocate, why are you so sure that inflation is in the rearview mirror?

Olga: When we’re looking forward, it’s difficult to say with any kind of certainty what’s right and what’s wrong. But the latest bout of inflation post-COVID was most likely of the supply-side variety, meaning that the supply side could not adjust rapidly enough to the massive shocks that permeated it on a global scale.

That led to distortions in supply chains of all kinds of goods and services. In the United States, we saw that in housing. In Europe, we saw that in energy prices. In Asia, specifically in Japan, we saw that in food prices. But supply shocks tend to go away over time, and suppliers, companies, and demand adjust.

What are the risks if the U.S. Federal Reserve (Fed) acts too slowly?

Olga: When central banks set monetary policy, they aim for real rates, which are nominal rates minus the rate of inflation. When all else is equal, and when your rate of inflation decelerates, your de facto real rate becomes higher.

We’re observing that in the United States in real time. There are different ways to proxy real rates, such as the 10-year U.S. Treasury yield or the federal funds rate minus the current rate of inflation. All of these point to structurally higher real rates than in the past—so much so that U.S. real rates are nearly breaching the 2% threshold, a challenging place to be for a mature economy at the frontier of technological progress.

The consensus among economists is around a 1% to 1.5% real rate, which is probably what the Fed and other central banks will aim towards. If we don’t see a change in the monetary policy stance as inflation continues to decelerate, it means that the Fed is raising real rates.

The challenge for monetary policy in 2024 is to be proactive—to not wait for last month’s Consumer Price Index (CPI) print to be sufficiently low, but to move well in advance to signal to the market that rates need to come down.

2024 may be the first post-COVID year in which we are sitting comfortably in an expansion.

What does Japan’s inflationary environment look like?

Simon: Japan is coming out of roughly 30 years of deflation, a shift that is matched by a resolve in different groups.

The first is the Japanese stock exchange. The possibility that a stock could be delisted has changed the approach of corporate management. We’re also beginning to see some cultural industrial elements, such as cross shareholdings, high cash levels on balance sheets, and low net gearing, begin to unwind.

People are also beginning to question some of the unwritten rules about Japanese business. For example, there are 10 major car companies in Japan. The lack of mergers and acquisitions (M&A) has been significant. If Japan is to improve its returns, it will mean a different cultural landscape for their industrial powerhouses, which I think would be very positive.

So, where’s the growth? One of the interesting things around inflation is the expectation of inflation and how it moves through an economy—think wage inflation and wage expectations. Japan’s inflation rate hit just below 3.6% in spring 2023, and there’s a possibility of a similar or higher number going into 2024. This starts to change the dynamic in terms of expectations, both at a consumer, corporate, and investor level.

This was also part of the reason behind the good performance in Japanese stocks in 2023, but I think it’s broader. What we saw was a consistent effort across a broad consensus of a possibility for change.

Is growth possible in Japan?

Olga: While demographics and geographics are important to gross domestic product (GDP) growth, the main growth driver in Japan is productivity gains.

When you look at the fastest growers in the world, such as China over the last few decades, it’s about productivity growth. And when we’re looking at productivity growth, there is no better place to start looking than at a change from low-but-persistent deflation to low-but-persistent inflation.

GDP is nothing more than the sum of wages and corporate earnings. When you have volume minus pricing, wages must be stagnant to accommodate that constraint. You’re not moving to something like volume plus pricing, where nominal variables are starting to grow. Hopefully, that growth will be sustained. This is a totally different dynamic, and it alchemizes a lot of the changes that we are talking about here.

Japan’s government is helping drive liquidity into the Japanese markets by reforming Nippon Individual Savings Accounts (NISAs), which are tax-exempt retail accounts for households. Japan’s population is encouraged to put their money in these accounts, and it’s estimated that over half of the savings in Japan is held in cash in these accounts.

This is not a trivial change.

Let’s talk about China. Is the country running out of growth opportunities?

Olga: In 2023, economic growth in China was challenging, more so than many had expected. I would argue it is at unacceptably low levels.

What China does now bears watching, but I do think it’s premature for us to write off China in terms of growth. Just look at its auto exports, which rose ninefold in just three years. And a large chunk of that is electric vehicles (EVs). By many standards, the models that Chinese automakers are manufacturing are some of the best in the world.

Other areas in which China is keen to close its technological gap are anything to do with the next leg of technological progress, such as artificial intelligence (AI), quantum computing, and next-generation chips.

How China’s continued efforts to improve and grow manifests into better consumption remains to be seen. In the aftermath of COVID, I think consumption growth in China will remain relatively depressed. Most households experienced significant losses of wealth, and it takes a while to rebuild those household balance sheets.

I think there will still be profitable growth to come from China. But whether we as investors can exploit that growth is a different question.

The proliferation of the power of AI is just starting.

Simon: This was one of the big disappointments of 2023. We’ve known the nature of Chinese growth has not been domestic consumption. And we thought that could change after the abrupt ending of COVID restrictions. Many countries saw some element of revenge spending, but China didn’t. It’s not necessarily weak for everyone or every class of consumption, but we have further issues of course on the property side.

Could generative AI help create productivity upside?

Simon: I think so. Recently, we visited some Indian information technology (IT) services companies, and AI was front and center. The companies’ estimate that AI has increased the productivity of their workforce by 20% to 30%. Those are encouraging numbers, especially coming from leading Indian tech companies, and rolled out more broadly would result in significant changes in productivity, but I think the effects won’t show until 2025 or later.

What is India’s growth story looking like?

Olga: India has reaped tremendous gains from massive structural reform conducted in 2013. It removed the middlemen when the government tried to hand out cash payments to roughly 900 million people. Today, the government can now directly deposit those funds into people’s bank accounts, disintermediating bureaucrats and intermediaries along the way. That resulted in significant improvement in efficiency and in rural and urban consumption.

The next stage of India’s policy is to channel that small but significant savings back into domestic capital markets for infrastructure spending and various other capital improvements.

Unfortunately, the liquidity surge that has been enabled by the efficiency gains has masked a strong rebound in GDP growth. While infrastructure spending in India is picking up, productivity growth has yet to materialize. Private-sector investment has also been relatively lackluster.

If you’re an optimist in India, the broad-based productivity gains are still to come. But it hasn’t been the case so far.

Olga, what do you think about the current wave of AI?

Olga: The proliferation of the power of AI is just starting, whether it’s in productivity gains or closing the gap between the mediocre and the better in terms of repeatable skills. Personally, I am excited about the changes that we’re likely to see in the speed and quality of material sciences and improvements in the healthcare space. It’s not an accident that large pharma companies are becoming data companies.

But there is a time lag between when we as investors get excited about new technology and when we see the impact in aggregate economic statistics. We’re likely looking at the end of this decade before we conclusively see an economic impact from AI.

The impact of weight loss drugs is still unknown. Is there a clear path to growth?

Simon: One company that manufactures glucagon-like peptide 1 (GLP-1) medications became Europe’s largest company by market cap in 2023.

These medications are more than just a fad when we consider the second- and third-order effects. Tackling obesity is important enough. But the accompanying data we’ve seen, particularly around the reduction of cardiovascular events and the risk of stroke, is very promising.

You couldn’t see the mobile internet from the start of the internet. You couldn’t see the app economy from the first app. These things unfold slowly, yet it always looks as if it was inevitable.

I think there is potential around that with GLP-1s and AI. We question it, to begin with. We wonder who would want it. Then suddenly it becomes ubiquitous. The value is only evident after 10 years.

You couldn’t see the mobile internet from the start of the internet. You couldn’t see the app economy from the first app. These things unfold slowly, yet it always looks as if it was inevitable.

Aside from GLP-1s and generative AI, what other growth opportunities are on your radar?

Olga: We are tracking nuclear fusion. The possibilities in a world in which energy is abundant and almost free are enormous. Today, there are reactors that can sustain a nuclear reaction for an indefinite period, but they take in more energy than they put out. However, that is a massive change from where we were just five years ago.

While we likely won’t see impacts from nuclear fusion this year, I would not be surprised if we are talking about it in the years to come. Nuclear fusion will be a game changer.

Paradoxically, AI is greatly aiding in bringing it forth. It’s quite possible that the changes in compute power and the evolution of AI-enhanced analytics can deliver faster improvements to nuclear fusion.

Simon: I think it’s more interesting to ask that question under the guise of what’s not changing, such as demand for compute power. The demand to solve problems with extra compute power is something that will be around for years whether it’s for the cloud, new chip architecture, or new quantum computing architecture.

What are we going to apply that to? One example is protein folding, which is the process by which a protein chain acquires its functional three-dimensional structure. Applying advanced compute power to this process could radically change the approach to the nature of drug discovery. Another is space exploration, which is predicated on the ability to provide compute power ever faster and cheaper.  We could apply it to the consumer element, because better and cheaper products are not going out of fashion.

Has there been a shift in corporate thinking in our current post-COVID world?

Simon: COVID was thought to be the ultimate disruptor, but soon after moving back to some level of normality, a significant geopolitical shift occurred—the Russia-Ukraine war. We’ve now seen additional conflicts on a global basis, and that has changed the nature of our expectations of growth. Add to that AI coming firmly into the picture.

All these factors have changed the way CEOs are allocating capital, as meaningful capital allocation is a core skill of the best management teams in the world. It’s also impacting the way CEOs are thinking about growth. Some of what we thought were going to be growth areas forever have closed, while other growth areas have opened.

The above-mentioned events have forced companies to focus, and the best companies are seeing all this as an opportunity. But the risk is still there, and the stakes are arguably higher now than they have been for some time.

To return to where we started, can emerging markets perform better amid falling interest rates and a potentially weakening U.S. dollar?

Olga: Broadly speaking, emerging and non-U.S. equities perform better when the U.S. dollar is lower, or the strength of dollars to the various respective currencies is declining rather than rising. And so, to the extent that we expect growth differentials and interest rate differentials, the two dominant drivers of the U.S. dollar’s appreciation in the last several years are in the rearview.

In our view, this paves the way for better equity performance in non-U.S. (including emerging) markets. That is because a lower U.S. dollar buoys these markets’ dollar-denominated earnings relative to everyone else. So, when you’re comparing earnings growth in a constant currency, a lower U.S. dollar means stronger dollar-denominated earnings across the board.

There are a lot of bilateral nuances, but that argument certainly applies to Japan and some other developed economies.

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