Gilles Moec

If the US economy avoids a hard landing, equities should continue to outperform bonds. We are not in a recession. The soft landing scenario is very much priced in and for the US at least, the data suggests it might be the softest of soft landings. The recession – if there is to be one – is delayed. Interest rates might have peaked but a long plateau could be ahead of us.

The ‘macroeconomic fate’ of 2024 will depend on whether the disinflation process which started last year can continue swiftly, allowing central banks to remove some of their restriction. Disinflation in 2023 was primarily driven by exogenous factors – the normalisation of supply lines and energy prices – and unfortunately, we are seeing the return of “polycrisis” risks which could derail the general slowdown in the price of tradables in the global economy.

The recent developments in the Red Sea suggest that the inflationary impact of the Middle Eastern crisis could take a different form than the ‘usual’ oil price shock, as supply lines are starting to be disrupted again. The election in Taiwan of a DPP President for the third time in a row forces us to confront again the possibility of another escalation of the Sino-American rivalry, with the potential to trigger another trade war.

Yet, we still see reasons to remain reasonably confident. The Red Sea disruption cannot be compared with the general seizure of supply lines when economies reopened after COVID-19. The fact that the Taiwanese President-elect did not secure a parliamentary majority, in a configuration in which China is not in the best position to take the risk to lose support from foreign demand, could help avoid tension between Beijing and Washington escalating too far.

Still, even if the exogenous inflationary forces are kept under control, the latest consumer prices print in the US suggests that the “last mile” of disinflation remains bumpy.

Potential inflation shocks

Another inflation shock remains the main potential channel through which the ongoing Middle Eastern crisis could affect the global economy, but it may materialise in an unexpected form. Indeed, observers are all bracing for a steep rise in oil prices if public opinions in Arab producer countries end up forcing their governments to use the energy weapon to incentivise the West and the United States (US) in particular to heap pressure on Israel, and/or if Iran threatens or effectively decides to blockade the Strait of Hormuz. This may still happen. Yet, the latest move by Saudi to cut the price of its exports relative to benchmark (apparently to support its market share within the Organization of the Petroleum Exporting Countries (OPEC)) is another sign that for now there seems to be a strong disconnect between the deteriorating situation in the Middle East and the oil market.

In addition, we have always seen such a drastic move by Iran as an existentially dangerous “one shot gun” for this country. Indeed, by blockading the Strait, Iran would probably be unable to avoid a direct confrontation with the US while cutting itself from its main economic resource at a time of heightened social and political tension on the domestic front. However, the attacks by the Houthi on ships cruising through the Red Sea have triggered concern over supply lines and freight costs. After all, 12% of world trade transits through this route.

There is however another potential shock to global prices which we need to explore – once again: the risk that another surge in the China-US rivalry, fuelled by the aftermath of the elections in Taiwan last weekend, would trigger another episode of “trade war” between the two countries. Even though President-elect Lai (he will take office in May) has not explicitly advocated formal independence for Taiwan since 2017, he was seen in Beijing ahead of the election as even more reluctant to engage in concessions towards the People’s Republic than his 2-term predecessor Tsai, hailing from the same party. In his victory speech he made plain his readiness to maintain dialogue with the continent, but his points on resisting “intimidation” were unambiguous. Although Lai received only 40% of the votes (Taiwan operates a “first past the post” electoral system), the fact that his party, the Democratic Progressive Party (DPP) has been able to maintain its grip on the presidency for three mandates in a row may be analysed in Beijing as a sign that only stronger pressure will shift a reluctant Taiwanese opinion towards accepting unification which the People’s Republic of China (PRC) called “unstoppable” again a few days ago. Fear among observers is that China would engage in economic action against Taiwan, eschewing a direct military intervention which would probably trigger a confrontation with the US, but resorting to a naval blockade. Trade and financial sanctions against Chinese products would likely be the US response.​

There are however good reasons to believe such costly scenario could be avoided. First, Beijing may take comfort in the fact that Lai will be constrained in his domestic policies by the fact that the DPP has lost its majority in parliament. The nationalist Kuomintang (KMT) – favourable to a rapprochement with continental China – now holds one more seat than the DPP, without having secured a majority either. Lai will probably have to cut deals with KMT and a third party which has been taking a “middle way” between the two big rivals when it comes to the relationship with Beijing (note however that even KMT supported a further increase in defence spending during the campaign). Second, the current domestic configuration in continental China is not conducive to taking the risk of another instalment of the trade war. Deflation continued in December, with consumer prices falling by 0.3%yoy (from -0.5% in November). The situation is less concerning when stripping energy and food, but core inflation remains weak (service prices rose by only 1%yoy in December). This in our view reflects the persistence of significant slack in domestic demand – particularly consumption. Losing external traction in those circumstances would be ‘brave’. Third, a purge took place in the Defence department at the end of last year, and according to US Intelligence briefings mentioned by Bloomberg (see article here), the Chinese leadership is taking the measure of corruption issues in the military, which may be another reason to avoid engaging in overly aggressive action.

A polycrisis scenario – with higher energy prices, supply line disruptions and an escalation of the US/China trade war – would be particularly toxic because it is unclear how central banks could react in such configuration (both energy and core inflation would probably rise). Yet, for now we want to keep it as an alternative narrative, without altering our central scenario. Yet, the return of these issues should be another reason to be cautious on the future trajectory of inflation in the US, when some signs of downward resistance are emerging, and hence on how speedily monetary policy can start removing restriction.

By Gilles Moec, AXA Group Chief Economist and Head of AXA IM Research

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