Surprise in ‘23. Growth has been far better than was forecast, especially in the US where expectations for 2023 have more than doubled to above 2 percent. But even here the chance of recession next year is higher, not lower, than it was just six months ago.

Implication for ‘24. Most forecasts now predict a lower probability of recession than a year ago, but State Street’s recession likelihood index has risen close to 90 percent based on the yield curve, payrolls growth, equity performance and industrial production.

Surprise in ’23. US growth did not falter as anticipated in 2023 and beat initial forecasts by more than a full percentage point.

In response, long-term investor holdings of US cyclical sectors has risen above benchmark once more, especially in consumer discretionary and industrials. The flip side of this is that their holdings of defensive sectors such as consumer staples and health care are unusually low.

Implication for ‘24. Cyclical stocks are still vulnerable to a rotation. Investors are not well-positioned for a recession if it comes, and there is plenty of room to rebuild positions in defensive sectors.

Surprise in ‘23. For all the concerns that onshoring and disrupted supply chains had permanently changed the direction of goods price inflation, our PriceStats sector series on household equipment and furnishings suggests deflation in goods prices returned a few months ago.

Implication for ‘24. The “easy” part of the disinflationary process, driven by supply-side adjustments in the goods markets is now over. But core inflation is still running comfortably above target.

This means that the next leg of disinflation will need to come from the service sector, which will likely require slower wage growth and slower demand. This is likely to be harder and may require a recession.

Surprise in ‘23. Interest rate markets have been repeatedly willing to attempt to discount interest rate cuts even though the tone of Federal Reserve Bank (Fed) commentary has for the most part being more hawkish than dovish.

Implication for ‘24. The Fed tone needs to change quickly to prevent hopes of rate reductions being dashed once again, creating headwinds for risky assets and some equities in the process.

There was some evidence of this at the end of 2023 as Fed commentary became more balanced, but it is not yet outright dovish.

Surprise in ‘23. Equities enjoyed a good start to 2023, but throughout the year long-term investors were allocating more and more funds to cash. Cash holdings are now some 3 percent above their long-term average and have risen 5 percent from their low in 2022.

Implication for ‘24. Investors are ready for a recession, but not a broader crisis. Long-term investors have a degree of ‘dry powder’ to come back into markets should conditions prove attractive.

Our metrics show that while equity holdings are slightly above their long-term average, investors’ fixed-income holdings are close to a 14-year low.

This suggests any rebalancing toward benchmarks out of cash should still favor bonds over equities.

Surprise in ‘23. The volatility in US Treasuries has been unprecedented. The combination of macro uncertainty and significant supply has generated wild swings in long-term yields. This in turn has raised questions of fiscal sustainability and whether the US government will find willing buyers for its bonds. The good news is that State Street’s indicators show that long-term investors are still buying. This is significant, as while demand for hedge funds is often fickle, the flows of long-term investors are usually more persistent. This certainly proved to be the case so far this year when both domestic and foreign demand from long-term investors remained close to five-year highs.

Implication for ‘24. With the Fed allowing its Treasury holdings to gradually sunset, and weaker than average demand from US commercial banks, it is vitally important for the 2024 outlook that long-term investor demand for Treasuries remains.

Hedge fund demand may come and go, but if long-term investor sentiment were to sour toward Treasuries, the bond vigilantes would be back.

Surprise in ‘23. Most forecasters, the Bank of Japan (BoJ) included, thought Japanese inflation would slow. But the trend in online prices captured by PriceStats has shown a clear and sustainable uptrend in Japan’s price level for the past three years. This time really is different!

Implication for ‘24. Japan is one country were yields still need to rise. The BoJ has already begun to change policy, but more tightening is needed; a fact reflected in the still significant (more than 40 percent) undervaluation of the Japanese yen that is only beginning to correct.

Watching how Japanese investors react to this in terms of their foreign bond purchases could prove an important tipping point for global fixed income markets next year.