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World economy: Good activity data, inflation too high

The US economy – by far the most important economy for the global capital markets – has remained in good shape, despite tight monetary policy. Europe's economies have recovered slightly in recent months. Due to overall rising real wages, there is continued expansion potential for private consumption in Europe, despite consumers exerting some restraint. Although China's economy grew slightly better than expected in the first quarter, the activity data for March show more subdued trends.

Following a decline in inflation in Europe and the US in the second half of 2023 that exceeded the expectations of both central banks and investors, inflation rates have recently risen again. Due to the price trends of important service components, the thesis of a reduction in inflation towards central banks’ targets is currently under scrutiny.

Inflation is primarily a question of supply and demand, in other words, how high the supply of goods, services and the labour market is in relation to demand. Inflation is more likely to rise when supply is tight than when there is excess capacity (e.g. during a recession).

In the goods markets, the capacity bottlenecks that built up during and after the pandemic were largely eliminated in 2023 and goods prices have stabilised. In the labour markets, wage growth has moderated in line with the fall in inflation rates, despite very low unemployment rates. However, wage growth in Europe and the US is still higher than would be consistent with inflation of around 2%. In the services sector, inflation currently is clearly higher than in the second half of 2023. Given the fairly good economies, near-term trends are difficult to predict, in particular whether and when inflation will ease towards the central banks’ targets. Although there is no need for key central banks to raise interest rates again, interest rate cuts require greater certainty that inflation will move sustainably towards targets. (April 2024)


Equity markets: Normal correction risks, though unlike 2022

Stock markets have risen significantly since the end of October. The rally has been fuelled in part by the expectation that central bank interest rates will be cut in 2024. That market participants have had to backtrack on unrealistic expectations of early and outsized rate does not call into question the direction of an eventual trend towards lower rates. Compared to the rather pessimistic expectations of many investors, the company reports for the final quarter of 2023 were mostly good. Recent economic data have also shown reasonably good trends compared to the prevailing modest expectations.

Equity valuations have risen in recent months (see charts). The current situation is different from that at the beginning of 2022, when share prices were well above the medium-term trend channel. At the time, rising inflation rates and the shift towards higher interest rates have called these price levels into question. Although inflation data currently are slightly higher than market expectations, we do not see this as reason enough for a significant stock-market correction, given that a renewed strong rise in inflation is unlikely. (March 2024)


Middle East conflict: Rising transportation costs

As a result of the Houthi attacks in the Red Sea, most container ships have been diverted from the Suez Canal (which handles around 12% of global trade) to the route around Africa, increasing transport times by almost a third.

Freight rates (see the World Container Index) have already doubled but are still well below the peak values of 2021. The limited navigability of the Panama Canal due to drought has added to global shipping woes. The New York Fed's global supply chain indicator was at zero as of the end of December 2023, which indicates normally functioning supply chains. The January figure will rise due to higher freight rates and certain bottlenecks (evident in the supply chain component of the January purchasing managers indices).

Until supply chains are adapted to the longer transport routes, there will be a temporary shortage of selected intermediate products, which recently has been flagged, especially by car manufacturers. However, a shortage of goods as in 2021 is not in the making as global goods supply and demand are currently quite well balanced and, unlike in 2021, there is even surplus capacity in China.

Sea freight costs only play a modest role in the retail prices of goods. Supply chain problems nevertheless could delay the reduction in inflation in the coming months but are unlikely to significantly change the underlying trend in inflation. (January 2024)

World economy: Consumer spending supported

The global economy is in a slow-growth mode with core inflation stable in the US and slightly declining in the euro area. The US economy is key for the global capital markets, followed by China and, less importantly, Europe. After an above-average third quarter, growth in the US will be slowing to normal levels in the current and coming quarters, although we would not interpret signs of a slowdown as recessionary tendencies. In China, economic growth, which is still at a historically low level, has picked up slightly, supported by government initiatives. In Europe, there are signs of weakness but no slump, with recent economic data overall matching expectations. In the current quarter, economic output in all major European economies is expected to increase slightly. The significant fall in oil prices in the past weeks is helpful in reducing inflation and supportive of economic activity.

The environment for private consumption remains positive overall. With most Western economies enjoying full employment and some drop in inflation, real income growth (i.e. incomes adjusted for inflation) has improved. Savings from the pandemic are still higher than usual, and there are hardly any negative wealth effects present. Property prices, with property being the most significant part of household wealth, have not fallen sharply on average in continental Europe and have recently even risen somewhat in the US and the UK.

Although the sharp rise in interest rates over the past two years has hit the highly interest-sensitive areas of Western economies, there is no generalised financing stress. There are some factors arguing for a delayed impact of rising interest rates on the economies in the current cycle: an increase in the proportion of fixed-rate mortgages in Europe, a significant number of fixed-rate mortgages refinanced at record-low rates during the pandemic in the US and still-high disposable savings available from the pandemic. We continue to expect a meaningful economic slowdown in both the US and in Europe, although a pronounced recession is unlikely on both sides of the Atlantic. Based on past time lags of monetary policy and the special factors currently at work, the time window for an economic downturn is unusually large. (December 2023)

Central bank policy: On hold for now

As monetary policy is currently about neutral (with real interest rates in the euro area no longer negative) and restrictive (around 1.5% real central bank interest rate in the US based on the core PCE deflator), the highs for key interest rates have largely been reached, in line with the statements made by central banks in Europe and the USA.

At the same time, it is too early to sound the all-clear on the inflation front, which is why central bank interest rates will remain high at least until signs of macroeconomic weakness become apparent. (November 2023)

China: Medium term prospects

China's 14th Five-Year Plan of March 2021 envisages a doubling of economic output by 2035. This corresponds to annual growth rate of 4.7%. Compared to over 6% before the pandemic, economic growth is likely to nearly halved by the end of the decade as the ageing of the population is also contributing to a decline in potential growth.

The economic focus of the government is on innovation, the environment, financial stability and "common prosperity". Private consumption, renewable energies and innovation sectors (especially technology) are promoted as growth sectors. On the other hand, the real estate sector, which has been a central growth driver (and important recipient of stimulus money in phases of economic weakness) in recent decades, is losing importance. This trend reversal also affects construction companies (many of which have significant debt and are in arrears on bonds and loans) and investors (owners of houses and apartments; trusts as financing vehicles).

China is thus facing a phase of lower growth, as the new growth drivers, in all likelihood, will not be able to fully compensate for the weaker real estate sector. However, especially during the growth transformation, China's government will continue to actively steer the course of the economy, which is why a disorderly development is highly unlikely. This line of argument also applies to risks in the financial system (incl. the non-banking sector).

Under Xi Jinping's reign, the role of the Chinese Communist Party has been expanded, including in the corporate sector, which has increased the weighting of political criteria in capital allocation (which suggests increased inefficiencies).

As the world's second largest economy, China will continue to grow at an above-average rate, but at the same time it will no longer be the outstanding growth engine it was in the past twenty years. Globally, this means less economic growth in purely arithmetical terms and thus a tendency towards low real interest rates. Nevertheless, China will remain attractive for Western companies due to the increase in private consumption and the growing share of the population that can afford a broader basket of goods. (October 2023)

How interest-rate-sensitive are Western economies?

That rising interest rates will eventually cause a downturn remains undisputed, although a downturn is now less likely later this year than in the first half of next year. It is worth noting that interest rate sensitivity appears to have declined over the past two decades. In Europe, the share of fix-rate mortgages has risen over time, reducing short-term interest rate sensitivity. In the US, private household debt service as a share of income is currently lower than before the pandemic, despite much higher interest rates, which is likely due to a historically low share of variable-rate loans and a mortgage refinancing boom during the pandemic. In contrast, corporate investment spending is more strongly influenced by earnings trends than interest rates. (September 2023)

Market width: Advance-Decline

The five largest listed companies in the USA each had a stock market value of over 1 trillion US dollars in mid-2023, while the largest company in Europe (LVMH) had a value of 433 billion euros (or around 470 billion US dollars or position 10 in the US). Accordingly, the change in the stock market value of the largest companies in the US in the first half of the year was up to ten times higher than in Europe.

This year, but also in the last five, ten and twenty years, the largest companies have outperformed the index, in other words, their share of total performance was far higher than their weighting in both Europe and the US. In the US, an extreme value was even reached in the first half of 2023: 83.2% of the total market performance was attributable to the largest ten contributors.

History shows that this is less of a warning signal than a catching up after a weak performance (as in 2022). At the same time, a broadening market is to be expected.

Unlike the performance of the top 10 stocks, the advance-decline-difference (AD) shows the general market breadth. The AD is the difference between the number of stocks with positive and negative performance in a given period.

A stock market rule widely used over decades is that a low AD in a positive market environment implies an increased correction risk. The table shows the performance in all periods, as well as in positive and negative market phases. In positive market phases, low AD values are associated with a performance that is only slightly below the mean but still clearly positive. The share of positive periods, at over two-thirds, is also high. It, therefore, is not worthwhile to reduce the equity allocation due to a low AD. Conversely, good market breadth is an argument for overweighting equities in a positive market environment (given a very high proportion of positive periods and above-average returns). (August 2023)

World economy – Sluggish growth, lower inflation

The global economy is currently being shaped by an unusually large number of opposing factors. Positive factors are declining energy prices, which strengthen consumers' disposable incomes (especially in Europe), the largely normalised supply chains and China's growth spurt, which is, however, already visibly slowing. The services sector (including travel/hospitality and parts of healthcare) is benefiting from continued post-pandemic normalisation.

In contrast, the interest rate-sensitive parts of the economy are burdened by higher interest rates. The weakness in the industrial sector, especially in Europe, is likely to have several causes. These include some reluctance on the part of companies to invest in capital goods. Some of the weakness, however, likely will prove to be temporary as it is linked to destocking following the renewed availability of selected input goods (which also explains part of the weak order intake). The data for June, including the weak purchasing managers index data, show some cooling of the economy, while an immediate slide into recession remains unlikely.

With the positive factors fading, economic risks will increase later in the year as the impact of higher interest rates will be more broadly felt, arguably though with an unusually long lag in this cycle. The US yield curve continues to show a recession window from May 2023 to May 2024. In the absence of significant imbalances (e.g. prolonged periods of overinvestment in the corporate sector or elevated consumer debt), the risk of a severe recession appears low. Moreover, consumers in Europe and the US still have higher-than-normal savings from the pandemic.

The development of important components of inflation – energy in Europe, rental costs in the USA – indicates that inflation rates will tend to decrease further. Lower energy costs will eventually lead to reduced core inflation rates as companies are no longer forced to pass on higher energy prices. (July 2023)

Tighter bank lending standards

As usual when central banks raise interest rates, commercial banks have started to tighten lending standards (which includes higher interest rate spreads). This trend, however, has not accelerated in the US as feared.

Higher interest rates and stricter credit standards have had no material impact on the growth of bank loans so far.

We do not assume that there will be an abrupt drop in lending. In addition, central banks would have the tools to counteract a stronger than expected credit crunch (interest rate cuts, with additional liquidity assistance for specific banks). (June 2023)

World economy: In reasonably good shape

Despite still-high inflation and sharply higher central bank interest rates, the world economy has remained surprisingly resilient, with unemployment rates remaining around record lows in both Europe and the US. Factors supporting growth are the moderation of energy prices after their steep rise last spring and the once again largely normal functioning of supply chains.

The effects of interest rate hikes will eventually start to weigh somewhat on economic activity, even though we do not expect this effect to materialise in the coming months. It is worth noting, that there are no significant macroeconomic imbalances, i.e. excessive corporate investment or high private household debt, which makes a steep economic downturn unlikely. We do not see a credit crunch building, especially as fears about the stability of the financial system have faded again. However, we expect a correction in property prices, which rose sharply during the extremely low interest rate phase before and during the pandemic.

Inflation, especially core inflation, is still higher than hoped. Nevertheless, headline inflation keeps falling due to significant relief in energy prices, especially in Europe. At full employment, however, some inflationary pressure remains, which is why it would be premature for central banks to respond to the first signs of weakening economic activity with interest rate cuts. (May 2023)

Financial system: Solid, with outliers

Collateral damage of the strong rise in interest rates

Along with the problems facing Britain's pension funds last autumn, Silicon Valley Bank (SVB) was a prominent victim of the inflation-induced rise in interest rates. Cryptocurrencies were at the centre of the failure of two other US institutions in March (SilvergateCapital and Signature Bank). Credit Suisse, weakened by legal claims and a lengthy and unconvincing turnaround, was hit with another bout of mistrust from clients and investors. On 19 March, UBS announced the take-over of Credit Suisse in a deal brokered and supported by the Swiss government, the supervisory authority FINMA and the Swiss National Bank.  

That the enormous increase in interest rates over the past 12 months would cause collateral damage was to be expected. In an environment of increasingly pressured real estate prices, problems are likely to surface at institutions that are heavily involved in mortgage lending.

Financial system in good shape, but no regulation can guarantee confidence

Compared to 2008, the banks have much more solid balance sheets and, in particular, much higher equity capital. Nevertheless, regulatory measures can never guarantee confidence in the financial system, though they can help in strengthening it.

It remains a risk that a loss of confidence in individual institutions will eventually affect the entire financial system, but this is by no means the most likely scenario, given the solid profitability of banks overall and reasonably good capital ratios.

Much also depends on what measures (including communication measures) banks, governments, supervisory authorities and central banks will take in the event of a crisis. We would expect comprehensive state intervention, such as a temporary increase in the upper limits of deposit insurance or even guarantees for all deposits (and possibly other liabilities), both for individual banks or even an entire banking system. (April 2023)

Europe: Gas and electricity prices

Supply and demand disequilibria keep driving natural gas and electricity prices. The largest supply gap for natural gas and electricity occurred in 2022. The years 2023 and 2024 will be transition years, while structurally normal electricity and gas prices can be expected starting in 2025. Liquefied natural gas (LNG) import capacities will increase significantly in 2023 and 2024. Renewables (wind, solar and biogas) and the retrofitting of conventional power plants (oil-firing of gas-fired power plants, coal-fired power plants) will continue to increase electricity supply.

Demand for natural gas is currently falling due to globally very warm winter weather, high prices (which help reduce demand) and the Covid-related weak economy in China. As of late, European electricity production from wind power and LNG imports have been higher than expected. Gas storage facilities, therefore, are likely to reach a level in April that is far above the average of the past few years. The risk that gas storage facilities cannot be sufficiently filled before the winter of 2023/24 thus has decreased considerably (in 2023, unlike in the spring 2022, no gas will be available from Nord Stream).

However, the risks in the gas and electricity markets have by no means disappeared. For example, no new LNG production capacities are expected worldwide this year. At the same time, demand for LNG in China will rise in the coming months as the economy recovers from the current Covidwave. Nevertheless, it is highly unlikely that European gas and electricity prices will again return to the highs seen in 2022. (February 2023)

Investment strategy – Constructive, with tail risks

The years 2020 and 2021 were marked by the pandemic, lockdowns and the subsequent economic normalisation. In 2022, an inflationary phase, which indirectly was a result of the pandemic, started, with central banks’ fight against it lasting at least through 2023. From a capital market perspective, periods of central banks’ interest rate increases are associated with below-average returns and, in inflationary phases, negative returns. An end to interest rate hikes by central banks triggers a rally in bonds and stocks. Historically, the equity market rally tends to end in recession, which often occurs only a few quarters after the rate hike cycle has ended.

Medium-term outlook remains positive

In a reasonable medium-term scenario (after the inflation phase ends in 2-3 years at the latest), economic trends will be similar to those before the pandemic, with global economic growth subdued and inflation largely under control. Bond yields in Europe and in the US are currently higher than they likely would be in such a scenario. In a scenario of non-inflationary growth, total annual equity returns can be expected to be in the mid-single digits in the coming years (see our scenario simulations in the equity section).

Scenarios 2023: Weaker economic momentum a prerequisite for a positive medium-term capital market outlook

The path to the medium term will not be a straight line. This is particularly true when considering that leading central banks (i.e. the European Central Bank and the US Federal Reserve) seek a weaker economy to successfully end the inflation phase, which, in turn, is a prerequisite for a positive medium-term scenario.

It should be noted that inflation (negative for equities and bonds) and phases of economic weakness (negative for equities, positive for government bonds) are the best-documented factors influencing capital markets in the long term. Short-term movements in recent years have also been strongly driven by these factors.

In terms of the timing and extent of the build-up of spare production capacity, there are a number of scenarios. The most positive for equities and bonds would be a soft landing (i.e. a prolonged period of economic softness, associated with only a minor increase in unemployment), even though in this scenario it would take a comparatively long time for inflationary pressures to subside and central bank interest rates to fall. Indeed, capital market prices currently imply a soft-landing as the most favoured scenario.

A problematic scenario for bonds and likely also for equities would arise if interest rates, after a pause in the spring, needed to be raised again later in 2023 as neither the economy nor inflation show the softening required by the central banks. Even in this scenario, however, we would not see price trends to be as negative as in 2022.

Baseline 2023: News flow in the first half better than in the second

The most likely scenario a rather mild recession by historical standards (i.e. an increase in unemployment rates of 1.0-1.5% in Europe and the US) in the second half of 2023 (we would not consider slightly declining GDP figures in Europe in the fourth quarter of 2022 as a harbinger of an imminent recession with a meaningful increase in unemployment). In such a scenario, bonds would outperform equities in 2023 as a whole. News flow – inflation rates stable to lower, end of central bank rate hikes on the horizon and major economies do not enter recession –will on balance remain incrementally supportive of equity markets in the coming months, despite occasional profit-taking. Our asset allocation reflects our mild recession scenario. We currently have no regional stock market favourites as any outperformance of the US later in the year would likely to be associated with a weaker US dollar (now underweight). In our baseline scenario, we see the quality-growth equity segment, which we prefer in the medium term, start outperforming in the course of the year.

In industrial metals and agricultural commodities, the price correction is well advanced, with correction risks remaining in line with global economic risks. Gold and the energy sector can be considered for inflation hedging, although we do not see a great need to hedge these risks at present. (January 2023)

Inflation: Key components improve

Inflation, as measured by the consumer prices index, is made up of the price change in the index components. This component view currently points to relief. Despite the easing of important inflation components, underlying inflationary pressures will remain high as long as full employment prevails, which is currently the case in Europe and the USA. Overall, however, measured inflation in 2023 will most likely be lower than in 2022.

Better-functioning supply chains, lower transport costs and somewhat cheaper commodity prices mean that goods prices are not rising any further or are even falling. These trends are already clearly visible in the US, but they are increasingly easing the burden on inflation in Europe as well. The US also benefits from lower energy prices. Starting in the middle of next year at the latest, shelter costs (with a weight of over 30% the most important component in the consumer price index) will moderate in the US (while rents are already falling in the US, this will only become apparent in the consumer price index with a delay of 6-9 months). (December 2022)

Households with excess savings

Despite high inflation, private consumption has been more robust than expected in recent months. One supportive factor has been the labour market, with unemployment rates in both Europe and the US at record lows.

In addition, private households still have higher-than-usual savings from the pandemic, with excess savings delaying and mitigating any economic downturn. In the euro area, the three-year cumulative household disposable income to consumption ratio is 6% higher than the pre-pandemic average, with the same number for the US at 5%, indicating substantial excess savings for households on average. (December 2022)



Government bonds: Market expectations

The table shows the yields for government bonds in Germany and the USA for maturities of 3 months to 10 years. In addition to the current yields, the table contains the yields in one, two and three years based on current market prices.

We compare these yields to the pre-pandemic average for the years 2017 to 2019. We assume that the global economy will again develop similarly to before the pandemic in about two to three years and will be characterised by comparatively low economic growth and inflation in line with central bank targets.

Forward yields are meaningfully above pre-pandemic levels. This is especially true for 3-month T-Bills, with current market prices suggesting that central bank interest rates will remain elevated in the years ahead. In contrast, in an economic downturn, as envisaged by the central banks, a drop in central bank rates could be expected in about two years at the latest. (December 2022)

Investment Strategy 2023

The main challenges in the coming 12-18 months remain the fight against inflation and the energy supply in Europe, which will continue to be an issue until 2024. In broad terms, the script for Western economies is weaker economic activity, followed by interest rate cuts by central banks when the economic slowdown is deemed to be sufficient to fight inflation. After interest rates are cut, the economies recover and move to the medium-term scenario of largely non-inflationary growth. This process likely will take some time and will be associated with increased capital market volatility.

For signs that inflation fight is completed, the US Federal Reserve remains central to the capital markets. The cyclical weakness necessary to fight inflation will be reached when the US economy has either underperformed for some time (and the unemployment rate ideally has risen not higher than the 4.0-4.5% range envisaged by the Fed) or fallen, possibly into a pronounced, recession. The yield curve (the yield on 10-year minus 3-month government bonds) signals a recession and thus an end of the high interest rate phase about 12 months in advance. The 10-year vs. 3-month segment of the US yield curve inverted for the first time in October. Conversely, a decline in inflation to the central bank targets of 2% is not necessary for the capital markets to sound the all-clear as inflation predictably falls after an economy has weakened, though usually with a significant lag.

While there is no immediate solution in sight for the fundamental problem areas of the capital markets, elements of a less negative news flow are discernible, at least temporarily. Lower energy prices and largely normalised supply chains will ease the pressure on inflation (although the underlying inflationary pressure will not abate for the time being). The central banks' interest rate path will flatten markedly in the new year, following further – especially in the US significant – rate hikes until the end of the year. At the same time, the global economy is weakening, though not significantly. Overall, the news flow is currently incrementally positive for bonds (slightly overweight, especially government bonds) and less negative for equities than it was a few weeks ago. In terms of the timing of news flow in the coming months, a flatter interest rate path appears to be either communicated (ECB) or has a certain chance of being addressed at the Fed meetings in November or December, while the economic risks (especially with regard to corporate profits) will manifest themselves to a greater extent in the coming quarters only. Such a constellation would be supportive of equity markets in the near term and in line with a number of previous Fed tightening cycles. (November 2022)

Inflation: Relief in the US

The rise in inflation since last year can essentially be attributed to three factors.

(1) The initial cause of the inflation outbreak was excessive demand for goods in the US, which has caused a global increase in goods prices, bottlenecks in the supply chains and high transportation costs (with the Ukraine war exacerbating supply constraints). Signs of easing are now clearly visible (shorter delivery times, lower transport costs, slight decline in demand for goods in the US and flattening goods price inflation).

(2) The sharp rise in energy prices has fuelled inflation, more so in Europe than the US. In the US, energy costs (especially oil and gasoline) have fallen noticeably, while in parts of Europe (especially Germany) natural gas and electricity prices have continued to rise massively in recent weeks.

(3) Full employment prevails in Europe and the US, which means that the classic inflation mechanisms – the passing-on of higher costs from producers to consumers and wage increases –continue to be active.

As evidenced in the July data, factors (1) and (2) will lead to significantly lower monthly headline inflation in the US (and, to a lesser extent, lower core inflation), while energy costs are likely to keep inflation high in Europe. The all-clear from central banks, in contrast, requires a weaker economy and somewhat higher unemployment rates, which are not discernible at present. (September 2022)

World economy: Scenarios from a capital market perspective

The economic data in July were weak, in both Europe in the US, but they are still consistent with a number of scenarios in the coming 6 to 12 months. The ideal scenario for the capital markets is a soft landing: recession is avoided, while economic growth slows just enough for inflation to fall gradually, supported by stabilising energy prices and normalising supply chains. In this scenario, bond yields are stable to slightly lower, and equity prices rally.

Private consumption has been surprisingly resilient in recent months, despite significant headwinds (especially inflation, energy costs and the Ukraine war). In the consumer-supported growth scenario the economy remains comparatively solid and inflation does not recede (fuelled possibly by a renewed surge in energy prices). In this scenario, central banks continue to tighten monetary policy, also in the coming year, yields on shorter-maturity bonds rise and share prices are likely to fall, despite a fairly resilient economy. The danger of recession is not averted but postponed until next year.

At the other end of the scale is a scenario of a downturn leading to a recession (which we presume to be mild, though this is not a foregone conclusion, given post-pandemic disequilibria in the US and energy woes in Europe). The downturn could be aggravated by a sharp drop in US goods demand, which is still excessive as a left-over from the pandemic, with goods price inflation (the original cause of current inflation) vanishing quickly. Energy and commodity prices would fall in response to lower demand. In this case, negative monthly inflation rates would materialise in a few months. Central bank interest rates do not rise further and bond yields fall. The verdict for equity markets is less clear, as corporate profit margins would be pressured.

Many manifestations of these scenarios are possible. At the moment, the sharp decline evident in recent economic data may suggest a recession scenario, but a more detailed look at the data makes the conclusion less obvious. The consumption-led growth scenario is supported by timely consumption data (e.g. the weekly Johnson Redbook data for the US, while in Europe high-frequency data availability is limited). A soft landing is historically not the norm and thus somewhat unlikely. (August 2022)

Central banks' economic forecasts

European Central Bank: The ECB adjusted its economic forecast in June. In terms of real economic growth, 2.8% is expected this year (after 3.7% in March, with the forecast dropping in line with the market consensus). Real GDP is expected to increase by 2.1% in 2023 and 2024, i.e. significantly above the growth potential. The unemployment rate is projected to be 6.7%-6.8% 2022 to 2024, in line with current levels of full employment. Average annual inflation (HICP) is forecast to be 6.8% this year, 3.5% in 2023 and 2.1% in 2024.

Federal Reserve: Growth remains solid according to the Federal Reserve's median forecast, keeping the unemployment rate at historically low levels around 4% in 2022 through 2024. At the same time, core inflation (Personal Consumption Expenditure Deflator/PCE) is expected to drop from 4.9% in April to 4.3% in the final quarter this year. At the end of 2023 and 2024, core PCE inflation is expected to be 2.7% and 2.3%, respectively. The risks to inflation are on the upside and the Fed would tolerate a rise in unemployment to achieve price stability, according to recent statements. In addition, the Fed wants to see  evidence that inflation really is coming down before declaring “any kind of victory”.

Assessment: The ECB's and the Fed's central scenario regarding economic growth, unemployment and inflation both imply a soft landing, i.e. the central banks assume that it will be possible to contain inflation by means of interest rate hikes without significantly damaging the economy. These are undoubtedly optimistic scenarios, which cannot be ruled out, but have so far failed to convince capital market participants. Historical evidence suggests that a weaker economy is needed to reduce inflation and that interest rate hikes have a delayed effect on the economy and an even more of a lagged impact on inflation (this might be different if the sharp rise in energy prices this year will weaken the economy in the coming months sufficiently to allow the expectation that inflationary pressures will abate soon). (July 2022)

Ukraine war and the global economy

While Russia and Ukraine are not very important for the world economy (around 2% of economic output and world trade), the countries key suppliers of a large number commodities (agricultural raw materials, incl. fertiliser components, energy and metals).

Energy has become more expensive (and even-higher prices can by no means be ruled out) but has overall remained available. This also applies to natural gas in Western Europe. The situation is more critical for grain, especially since exports from Ukraine will remain constrained, and the agricultural land in Ukraine will not be planted as usual. Especially for low-income countries, the sharp rise in energy and food prices has been an enormous burden.

With the pandemic and the war in Ukraine, global supply chains have moved in the limelight as an essential economic factor. Against this backdrop, security considerations in procurement are increasingly at the forefront for many companies, as producitonmoves from "just-in-time" to "just-in-case“. At the same time, a majority of well-managed companies have proven time and again in recent years that they have diversified supply chains (with news on functioning – quite different from problematic – supply chains hardly ever reaching the public). Supply chain strategies include "dual sourcing", "near- and onshoring" and "friendshoring". There is an opportunity for reshaped supply chains to become more efficient (especially in terms of transport and the use of resources). Global competition will ensure, however, that costs remain at least as important as safety considerations. The focus is thus on optimised procurement rather than risk considerations alone.

Europe's banks are most affected by Russia's isolation from the global financial system, but the risks are manageable. Almost 30 percent of Ukrainians have fled the war so far. For Europe, this means the largest flow of refugees since the Second World War. How many of these people will eventually work in Western Europe (and thus at least temporarily increase the economy's potential growth somewhat) remains to be seen. As a result of the war, defence spending will increase, especially in Western Europe (15 NATO countries have already decided to increase military spending, and a number of European members will exceed NATO's 2% spending target in the future). (July 2022)

Inflation data show no relief

Behind the surge in inflation in recent months are, in particular, a strong upward trend in goods prices and higher energy prices. In the euro area, the figures in April and May were above economists' estimates (monthly core inflation was higher than in previous months, reaching almost 6% annualised). Headline inflation in the euro area is higher than in the US, as measured by the Federal Reserve's preferred Personal Consumption Expenditure Deflator (PCE). In the US, inflation (measured year-on-year) may have peaked in March.

With oil prices rising again, the easing of the energy component of inflation is delayed, but remains a realistic scenario in the coming months (supported in Europe by energy tax cuts in some countries). A slight easing of pressure on goods prices also seems possible later in the year. This, however, would require fewer disruptions in supply chains (and thus no further lockdowns in China) and a shift in demand towards services. 

Overall, economic activity is robust and unemployment rates are historically very low in Europe and the US, with the US labour market even showing signs of overheating. Such an environment favours rising wages and companies passing on higher costs to consumers.

The monthly inflation data, especially core inflation, will remain pivotal for the capital markets and central banks, with currently no evidence of pressures easing.

An overview over the theme of inflation is provided here. (June 2022)

Equity market scenarios

In the medium term, i.e. in about three years, we assume a scenario of full employment and inflation within the central bank targets of 2%. If we feed this scenario into our Shiller price/earnings (CAPE) ratio model for the US (the model calculates a fair price/earnings ratio for the average of real corporate earnings over the past 10 years), we get a fair value of around 30. For comparison, in 2018 and 2019 the market valuation and the model averaged about 31, which also happens to be the current market valuation. The current market valuation would thus be roughly consistent with our fairly constructive medium-term scenario of full employment and 2% inflation. In a Goldilocks scenario (US unemployment rate at 3%, inflation at 1.5%), the model calculates a CAPE ratio of nearly 37. With the economy still in recovery from a mild recession in three years (unemployment rate at 4.5%, inflation at 2%), the model CAPE would be 27.

Globally somewhat lower real economic growth than before the pandemic (based on the same productivity trends as before the pandemic, slightly negative demographic factors and structurally lower economic growth in China) argues for outperformance of quality growth stocks in the medium term.

The road to the medium term will be bumpy, with phases of a more positive assessment and phases with negative news flow likely alternating. Elements of a positive scenario are lower inflationary pressures on goods markets, China’s economy operating normally again after the lockdowns and stabilising energy prices. At the same time, the European and US economy continue to grow solidly, supported by full employment. Lower US tariffs on imports from China, if enacted, would positively influence the profit margins of a number of US companies.

A negative scenario would include persistent inflationary pressures (also due to ongoing lockdowns in China) and declining corporate profit margins due to rising cost pressures (wages, energy and commodities). In a persistent inflation or recession scenario (we model an average recession with an increase in the unemployment rate by two percentage points, though we would not consider a recession a meaningful risk in the coming 12 months), the model suggests CAPE ratios of around 25 (i.e. about 20% below the current market valuation), with stock markets having fallen well below fair value in past bear markets. (June 2022)

Fed rate hikes, the US-economy and the capital markets

We have studied Fed rate hike phases since the 1970s with regard to the development of the US economy and capital markets (stocks and bonds).

Since higher interest rates impact the economy with a lag, growth was usually still solid when interest rates rose. The unemployment rate, on average, fell, and the growth of the gross domestic product (GDP) remained positive. In the past, the last interest rate hike usually took place when the first signs of a slower economic pace were already visible. On average, it took three quarters after the last rate hike for a recession to begin (the normalisation phases of monetary policy in 1983 and 1994 were not followed by a recession; the recession in 2001 was mild, and in 2020 the trigger was a pandemic-driven lockdown and likely not monetary policy).

Bond yields have risen during periods of Fed rate hikes but significantly less than the Fed funds rate, resulting in a flatter but rarely inverse yield structure (i.e. the yield on 10-year bonds has remained above that on 3-month Treasury notes).

Corporate bond spreads have tended to fall during rate hikes (i.e. corporate bonds have outperformed government bonds), which is consistent with the observation that economic growth has generally remained solid during Fed rate hike episodes.

Equity returns were below average, but slightly positive, during rate hike episodes. Of particular interest is the period in the months after the last rate hike, pointing to a strong relief rally. The stock market tended to be weaker to negative on average in the period around one year after the last interest rate hike (when the economy usually visibly weakened and the growth of corporate profits turned negative). (May 2022)

Equity markets – Advanced growth correction

Two trends have shaped stock market activity this year. The dominant trend in the US and Europe was the end of the outperformance of growth stocks. In retrospect, the last few months can be described as the bursting of the "pandemic bubble". As a second, less significant trend for the global stock markets, the Russia’s invasion in Ukraine, especially the associated very sharp rise in energy prices, has weighed heavily immediately after the start of the war.

Rather weak global economic growth, low inflation and low interest rates – as expected in such an environment – led to a strong outperformance of growth stocks in recent years. With earnings growing solidly, valuations of growth stocks have risen steadily, a trend that has been reinforced in the pandemic and has affected all sectors, not only technology. With the end of the pandemic and rising bond yields, the tide has turned: In such an environment, value stocks (i.e. low-valued, mostly low-growth companies such as financials, energy, commodities and telecoms) tend to dominate.

The valuation premium of growth stocks over value stocks has narrowed in recent months, and many growth stocks have become more attractive again. This improves the chances for more stable stock markets. We see the rotation towards value stocks to be well advanced, though likely not yet complete. (April 2022)

Equity markets: Gulf Wars 1991 and 2003

We have analysed the price trend of European and US stock indices in the run-up to and during the hostilities of the Gulf Wars of 1991 and 2003. That these wars in distant Iraq may have been perceived differently on the capital markets than a war in Ukraine, a European country, is possible but not necessarily so.

The stock market performance during the Gulf wars largely corresponds to the uncertainty profile over time. The main uncertainty relates to the question whether a military confrontation will remain local or escalate to involve more countries.

Following the invasion of Kuwait by Iraq in August 1990, and at the beginning of 2003, when a military confrontation started to preoccupy investors, share prices fell by around 20% in Europe and 15% in the US over a period of two months. With or immediately before the military operations (12 January 1990 authorisation of the military operation by the US Congress, first hostilities on 16 January; 2003 first hostilities on 20 March, with the war ending on 1 May), share prices began to recover.

If the price decline in the Ukraine conflict is assumed to last exactly two months, it would already be over now (the Russian troop build-up has been discussed as a risk scenario on the capital markets for at least two months before the invasion). (March 2022)

Growth vs. value shares

MSCI divides the overall market into two segments of equally sized market capitalisation. The MSCI World Value Index contains stocks with comparatively low price-to-book values, low price-to-earnings ratios and high dividend yields. The MSCI World Growth Index contains stocks with above-average earnings and sales growth (based on historical data and forecasts).

Growth stocks outperformed strongly in the 1990s (characterised by a technology boom) and moderately after the financial crisis until the pandemic. Since the first lockdowns in early 2020, the outperformance has been almost as extreme as in the 1990s. There is no clear correlation between the economy or monetary variables (e.g. interest rates, inflation) and the relative performance of growth stocks. However, growth stocks generally perform better when economic growth is rather subdued, which was the case in the years after the financial crisis (and will be the case again starting in 2023 or 2024 at the latest).

In the second half of the 1990s until the bursting of the technology bubble, the valuations of growth stocks (mainly technology at the time) increased sharply compared to value stocks. After a moderate valuation expansion until early 2020, valuation expansion has been pronounced again. Overall, there appears to be further relative correction potential for growth stocks this year, despite good medium-term prospects. (February 2022)

Medium-term inflation outlook

The fact that a structural break took place in the early 1990s and that inflation has remained low and comparatively stable since then is well documented in the literature. Inflation has also ceased to correlate systematically with the money supply over the past three decades.

Although explaining such a structural break is inherently difficult, there are a large number of studies on the subject. Among the factors often cited to explain the decline in inflation is globalisation (i.e. local bottlenecks in goods or labour markets do not drive prices if the global supply of goods or labour is sufficient). Although this argument is convincing, there seems to be surprisingly little empirical evidence in its support. Moreover, in an ageing society, more and more employees with high wages retire at the end of their working lives, while those entering the labour force have lower wages (the argument is particularly compelling when the productivity gap between older and younger workers is smaller than the wage gap). This demographic effect is small but statistically significant in the US, according to the Federal Reserve. Due to technological progress, many products (e.g. semiconductors) are becoming more efficient and less expensive, which contributes to product price deflation. In recent decades, the industrialisation of the retail sector (examples include Walmart, Zara and IKEA) has also led to lower prices for many goods.

Last but not least, central banks have made a significant contribution to low and stable inflation rates. The number of central banks worldwide that are independent of politics has increased (inflation falls with the degree of independence), and since the late 1980s more and more central banks have introduced a formal inflation target, which helps to stabilise inflation expectations.

Although the influence of the above-mentioned factors on inflation cannot be determined quantitatively, there are hardly any indications that these factors would reverse course in the future. All in all, a comparatively moderate inflation environment, as in the past decades, thus remains the most likely scenario in the medium term. (January 2022)

Equity markets: Fundamental sensitivities

We have analysed how the MSCI World, its sectors and key market segments are performing in different fundamental environments.

The overall market rises when the economy is growing, but, on average, also when bond yields or inflation rise, and monetary policy is tightened. Financials are the best sector when inflation and interest rates rise. Industrial stocks also perform comparatively well in a rising yield environment. Conversely, consumer staples, healthcare and quality growth stocks are the preferred market segments when the economy is growing only slowly, and interest rates are low, which remains our base case for the medium term. (December 2021)

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