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Central bank policy: Driven by economic data

Monetary policy follows the trends in economic data, with inflation and economic momentum being the determining factors (the exchange rate may also play a role, as for example, in Switzerland).

With the Taylor rule, monetary policy can be tracked quite well. This means that central banks use the same data as equity, bond and currency investors and often make similar forecast errors.

Following a marked drop in inflation in the second half of 2023, capital market participants and central banks assumed a higher potential for interest rate cuts than is now the case after several months of higher than forecast inflation rates.

Going forward, the focus remains on the duration of the current phase of high interest rates, while further key interest rate hikes are extremely unlikely even if inflation proves to be even more sticky than anticipated.

 

Regional trends: Technology weighting is key

The US stock market (S&P 500) outperforms Europe and the Asian emerging markets in terms of corporate earnings and returns over the long term. The US market is more defensive than Europe (e.g. a lower weighting of financial companies). When technology stocks and technology-related sectors outperform, the US market has a clear advantage (weighting of around 40%, compared to less than 10% in Europe).

The conditions for outperformance in Europe, where value stocks are over-represented, include a good global economy, high bond yields (positive for financials) and rising commodity prices.

Based on free cash flows, Europe has been valued more favourably than the US since 2022. However, a favourable valuation alone is unlikely to be enough for outperformance. (July 2024)

 

World economy: Improving activity data

The global upturn has broadened in recent months due to a slight economic upturn in Europe and China.

The US economy – by far the most important economy for the global capital markets – remains in good shape.

Europe's economies have recovered in recent months and are now growing modestly. This recovery is due to the normalisation of the economies following the energy price shock of 2022, while the persistently high interest rates have been less of a burden than feared. Rising real wages should increasingly support private consumption in Europe, despite a certain reluctance on the part of consumers. The growth discrepancies both within Europe and between the euro area and the US will remain significant in 2024, while European growth will catch up with the US in the coming year.

China's economy grew slightly more strongly than expected in the first quarter, and growth forecasts have recently risen, despite mixed data for the second quarter so far.

Following a decline in inflation in Europe and the US that exceeded the expectations of central banks and investors during the second half of 2023, inflation rates have, not unexpectedly, risen again in recent months.

Goods and energy price drove overall inflation rates massively higher in 2022. The capacity bottlenecks that manifested in the goods and energy markets during and after the pandemic were largely eliminated in 2023, which is why goods prices stabilised last year. Currently, in the service sector, it is more difficult to predict whether and when inflation will ease towards the central banks’ targets due to the relatively robust economies in both Europe and the US. Although there is no need to raise interest rates again, leading central banks need to be more certain that inflation is moving sustainably towards their targets. (May 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)

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)

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)