Economic growth – the road ahead remains rocky

The war in Ukraine, energy supply, high inflation, rising interest rates and concerns about economic growth – these are the topics that have been dominating the news in recent weeks. But what impact do these individual factors have on the capital markets and what is the outlook for the rest of the year?

Amid a plethora of adverse influences such as Russia’s war in Ukraine and high inflation, the capital markets have been performing very poorly in the year to date. Both equities and bonds suffered losses in the first half of 2022. The EURO STOXX 50 index, for example, shed 20 per cent of its value, while European government bonds weakened by 12 per cent. However, in July, the global equity and fixed-income markets turned the corner and started to pick up again. This was driven partly by demand for safe havens and partly by the corporate reporting season for the second quarter. It seems that many companies are still managing to pass on their higher input costs (e.g. procurement costs of intermediate products and energy costs) to customers and even to offset some of their falls in sales volumes in this way.

Inflationary pressure is becoming established

Higher input costs due to rising gas prices and wage demands are creating persistent inflationary pressure in the eurozone. In July, year-on-year inflation reached 8.9 per cent – the highest level since the introduction of the euro. The German economy is not immune to this inflationary environment. Until now, prices have been driven up primarily by non-domestic and supply-side factors. The crucial question now is to what extent the price pressure will broaden. It seems that neither the eurozone as a whole nor Germany have reached peak inflation yet. One-off factors that restrained prices in June and July will cease to apply when Germany’s fuel tax rebate and subsidised rail travel cards for €9 per month are discontinued, which will add fresh fuel to upward pressure on consumer prices.  Union Investment’s economists believe that double-digit inflation rates could be on the cards from September. They do not expect inflationary pressures to ease until next year.

In the US, the picture is looking slightly different. Consumer prices did not rise as sharply as expected, with year-on-year inflation coming in at 8.5 per cent in July, down from 9.1 per cent in June. Upward pressure on prices thus seems to be easing in the US in the short term, although inflation remains at a high level by historical standards. Union Investment’s economists predict an inflation rate of 8.3 per cent for the year as a whole. However, by mid-2023, it should have dropped back to below 3.5 per cent.

Inflation creates pressure to act

Inflationary pressure shows no sign of easing

Inflation creates pressure to act
Source: Bloomberg, as at 17 August 2022.

Curbing inflation is the central banks’ number one priority

The US Federal Reserve (Fed) will likely regard these first signs of a slowdown in inflation as confirmation of its course of action. In order to bring inflation under control, the Fed has already raised interest rates by a total of 225 basis points in the year to date. Union Investment anticipates further hikes totalling 100 basis points for the second half of 2022, but believes that the US cycle of interest-rate increases will not extend into 2023. Moreover, the Fed has already started to scale back its balance sheet (quantitative tightening). It aims to reduce its assets by about US$ 1,100 billion per year. Adding this quantitative tightening to rising interest rates is likely to further slow down economic growth.

The European Central Bank (ECB) took a more tentative approach than its US counterpart and only started to raise interest rates at its last meeting. In July, the ECB increased its deposit facility interest rate by 50 basis points to 0 per cent. The main reason for the ECB’s more cautious response is that inflationary pressures are coming from different sources east and west of the Atlantic. In the US, domestic demand has been a key driver, whereas inflation in the eurozone has been fuelled mostly by external influences. But the aforementioned risk of inflation becoming more entrenched means that the ECB, too, will continue with its cycle of interest-rate hikes. Union Investment’s experts expect the deposit facility interest rate to reach 1.25 per cent by the end of 2022 and 2 per cent by the end of 2023.

  • Further interest-rate hikes ahead, but increments will grow smaller

    Fed: further hikes of 100bp in total priced in for 2022

    Further interest-rate hikes ahead, but increments will grow smaller
    Sources: Bloomberg, Union Investment, as at 2 August 2022.
  • Further interest-rate hikes ahead, but increments will grow smaller

    ECB: hikes of 150bp in total expected for 2022

    Further interest-rate hikes ahead, but increments will grow smaller
    Sources: Bloomberg, Union Investment, as at 2 August 2022.

Mounting concern about a recession

Above all else, the central banks’ aggressive action to rein in inflation has fuelled investors’ fears of a looming recession, i.e. a substantial, broad-based contraction of the economy. Going by the technical definition, the US is already experiencing a recession, because gross domestic product (GDP) has declined relative to the prior-year quarter for two consecutive quarters. However, from a qualitative perspective, it does not seem appropriate yet to speak of a recession as domestic demand and labour market conditions were still very robust in the first half of the year. Consumer spending remains supported by a steady upward trend in employment and wages. At present, the biggest source of risk of a significant decline in US value creation is a scenario in which the Fed overshoots the mark with its interest-rate increases and triggers a collapse of domestic demand. This would deal a painful blow to the US economy. The Fed is therefore walking a tight line between a ‘soft landing’ for the economy and a recession.

Concerns about a recession are also mounting in the capital markets. The US yield curve has flattened noticeably over the past few months and recently even became inverted. Yields on two-year US Treasuries are now considerably higher than those of their ten-year counterparts. The Fed’s interest-rate hikes have driven up yields at the short end while concerns about economic growth are weighing on yields at the long end. Historically, an inverted yield curve has sometimes been an indication of an approaching recession. But the stability of the US labour market and domestic demand do not support this interpretation at present. Union Investment’s economists anticipate that economic growth will continue to weaken over the further course of this year but that the US economy will not slip into a deep recession.

By contrast, the economists’ outlook for the eurozone economy is much gloomier. For the next few quarters, they predict that economic output in the eurozone will stagnate or contract. For the German economy, they anticipate a mild recession. This forecast crucially depends on the proviso that Russia continues to supply at least some gas to the EU. Should this not be the case, and gas shortages arise in the short term, a deeper recession will be inevitable. In this event, the ECB would likely put further interest-rate increases on ice for the time being.

It is therefore fair to say that the economy and the capital markets are subject to significant uncertainty arising from various quarters. This means that volatility will probably remain high in the months ahead. Diligent fundamental analysis and relative positions remain key elements of a successful investment strategy in this environment.

 

As at 17 August 2022.

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