Bond markets: Still vulnerable to a reassessment of the inflation outlook
Never before have I correctly predicted a substantial acceleration in global growth and noticeable increases in inflation rates and at the same time been so wrong in my forecast of rising yields on ten-year US Treasuries. At the beginning of the quarter, the yield on ten-year US Treasuries was still trading at around 1.7%, at the end of the quarter at 1.5%. Not even the US Federal Reserve was able to bring about a rise in yields with the prospect of earlier-than-expected key interest rate hikes. Yields on ten-year German Bunds, on the other hand, still behaved somewhat normally, rising from -0.3% to -0.2%. The decline in yields in the USA is due to the fact that inflation expectations fell. Obviously, financial market players assume that the current high inflation rates are one-off price increases due to the opening of the US economy – according to the motto: the higher the inflation now, the lower it will be in the future. The good economic development also ensured, as expected, that corporate bonds outperformed government bonds.
The high propensity of companies to invest suggests that private demand will be strong enough to sustain the upswing – even if the fiscal impulse slowly begins to weaken. We thus consider the scenario of weak economic growth and significantly falling inflation rates to be rather unlikely. Such a scenario would result in further falling yields. The chances of a sustained dynamic upswing and decreasing inflation in the coming year are still good, as seen by the noticeable price declines for individual commodities like lumber. The bottlenecks in semiconductor production also seem to be dissolving. Accordingly, there is much to suggest that government bond yields will remain stable. However, the risk scenario of persistently rising inflation should not be underestimated. In the US, about 25% of the current outstanding money supply has been newly created since the outbreak of the pandemic. In the euro zone, this figure is around 10%. All that new money could contribute to excess demand and trigger a wage-price spiral. It is already a matter of concern that currently no inflation risk premiums whatsoever are being priced into government bonds. The bond markets thus remain vulnerable to a sudden reassessment of the inflation outlook and thus to a yield shock.
Equity markets: Opportunities for European equities to outperform
Declining yields on ten-year US Treasuries eased the fears of an interest rate shock on the global equity markets during the quarter. Government bonds thus remained unattractive as an alternative. Market players thus focused on the good economic situation and the associated good prospects for corporate profits. The MSCI Europe achieved a gain of 6.8%, the MSCI World of 7.7%, while the MSCI Emerging Markets Index lagged behind with a return of 3.9% – all in local currency.
As long as government bond yields remain stable and economic growth is robust, the outlook for equities remains positive (probability of occurrence: 60%). However, a sudden reassessment of inflation risks in the bond market could also affect the equity market and contribute to a noticeable price correction. We see the probability of occurrence for this risk scenario at 30%. By contrast, we estimate the probability of a marked economic slowdown due to structurally weak private demand at only 10%.
We also see good opportunities for European equities to outperform. For example, Europe has already surpassed the US in first vaccinations and is likely to be ahead in August in second vaccinations as well. A new wave of corona requiring lockdown restrictions in autumn is therefore unlikely. Moreover, the economy is only now reopening in Europe. Thus, there is a lot of catch-up potential – especially since the European economy will still benefit from the fiscal stimulus of the Next EU Generation Fund that was passed in the wake of corona while US fiscal stimulus peaked in March. Also, the inflation rate in Europe is much lower and thus, inflation risks that could call the ECB into action are also significantly lower. Moreover, European companies now seem to be slowly responding successfully to the new challenges of digitization, electrification and "green energies".
Economy euro zone: Outlook has brightened considerably
In the second quarter, the economic situation in Europe improved considerably. One reason for this was the high vaccination rate. While only about 10% of the population had been vaccinated at least once at the end of March, this figure stood at more than 50% by the end of June. As a result, infection rates dropped noticeably and European countries were able to gradually ease lockdown restrictions. According to an online survey by the Bundesbank, the unusually high savings rates in Germany were due in particular to ordered business closures as well as travel restrictions and concerns about infection. This is probably also true for other European countries. Classical precautionary motives due to feared loss of income played only a subordinate role. As the vaccination campaign progressed and containment measures were eased, there were initial signs that the pandemic-related reasons for saving were quickly losing importance. As a result, private consumption increased strongly and the savings rate fell again. This caused the service sector to recover rapidly towards the end of the quarter. The industrial sector, on the other hand, was already booming throughout the second quarter due to good domestic demand and promising export prospects. Supply bottlenecks for some important raw materials even slowed growth in Europe’s industry.
The outlook remains very good. Europe's industry has an immense backlog of orders, the services sector still has a lot of catch-up potential, and money from the Next EU Generation Fund will start flowing in July. Overall, estimates by economists show that the growth stimulus from the EU Reconstruction Fund could add up to about 1 percentage point of gross domestic product (GDP) over the next twelve months. Especially the countries in southern and eastern Europe will benefit. While the rapidly spreading delta variant of the coronavirus poses a risk to the outlook, recent studies show that currently available vaccines work well with this variant, too.
Against this backdrop, we have raised our 2021 GDP forecast for the euro area from 4.3% to 5.1% (consensus: 4.4%) and maintained our 2022 forecast of 5.3% (consensus: 4.4%). This would mean that GDP would return to its pre-crisis level as soon as the fourth quarter of 2021, one quarter earlier than previously expected. In addition to the good outlook, the smaller-than-expected decline in GDP in the first quarter of 2021 (corrected to -0.3% quarter-on-quarter) has prompted us to adjust our forecast. A major risk remains the emergence of new variants – even though Europe should be able to keep the delta variant under control due to the high efficacy of the currently available vaccines.
Economy USA: Peak passed, further development depends on inflation and monetary policy
The US economy reached the expected peak of its growth momentum in the second quarter with an annualized increase of about 9% compared to the previous quarter. We expect growth to slow to about 8% in the third quarter – and to about 3% in the fourth quarter. By comparison, most estimates for the long-term equilibrium growth trend are around 2%. If the economy grows faster than this, there will be excess demand resulting in higher capacity utilization in the overall economy and a falling unemployment rate. The intriguing question will then be: at what point will steadily growing excess demand lead to rising inflation. Before the pandemic, the US unemployment rate fell as low as 3.5% without triggering rising wage and inflation dynamics. In May, the US unemployment rate was 5.8%, so there still seems to be a lot of downward potential before inflation risks actually materialize. However, according to OECD calculations, household net wealth rose to 750% of disposable income last year, an all-time record. Anecdotal evidence suggests this has reduced the pressure to work at all costs and the high level of wealth seems to have been used for early retirement. Thus, there may be much less labor available than before the pandemic, which could lead to a rapidly declining unemployment rate and accelerating wage growth. We see a 30% probability for the risk scenario of a wage-price spiral in motion.
As long as the scenario of moderate inflation remains the most likely, the US Federal Reserve is likely to be very cautious in initiating a turnaround in its monetary policy. The strong reaction of financial market players to the Federal Reserve meeting in June shows how great the concern is that a monetary policy tightened too early could cause a recession. Despite high growth rates, the underlying foundation of the US economy seems to be very fragile due to high debt. A first cautious step towards a less expansive monetary policy should therefore, in our view, be announced in the course of the third quarter by US Federal Reserve Chairman Jerome Powell, namely that the US central bank will slowly reduce its bond purchases from currently USD 120 billion per month starting in January of 2022.
Economy Asia: Signs of new lockdowns in Japan and slightly weaker growth in China
In Japan, new daily infections peaked in mid-May at 7,500 per day, but have since dropped noticeably to around 1,500 per day thanks to new lockdown restrictions. However, the government restrictions cost growth, so the Japanese economy is likely to have almost stagnated in the second quarter. The vaccination campaign started late in Japan. However, by the end of the quarter, it reached a high tempo and about 20% of the population had been vaccinated. However, it is not until the end of the third quarter that Japan is likely to have vaccinated enough people to achieve a high level of immunity against the delta variant. Thus, it is questionable how quickly the government will be able to relax its lockdown restrictions and the Japanese economy will have to be patient for a while.
China's economic policy is focused this year on debt reduction. Spending on state infrastructure projects has been reduced, access to mortgage loans has been restricted and monetary policy has been tightened. Disappointing economic data since the beginning of the year shows these steps have slowed economic growth more than expected. Accordingly, we have reduced our 2021 growth forecast for China from 8.5% to 7.5%. Currently, we assume that the Chinese government can get along well with the somewhat weaker growth. We therefore do not expect any easing of monetary policy or new stimulus from economic policy. Demographic development is also becoming an increasingly important issue in China. For example, data from the 2020 census showed that population growth in China has slowed to 0.53% per year over the past decade, the average age of the population has risen to 38.8 years and the working-age population (15-59 years) has shrunk by 40 million people. On the positive side, the average time spent getting an education by the working population has increased by more than one year and urbanization continues. More than 900 million people now live in cities, especially in the eastern region. China's population could peak as early as the next decade. The working-age population is expected to shrink by another 60 million. Nevertheless, we see a good chance that China can achieve average annual GDP growth of 4.5% between 2020 and 2030. In our view, further migration from the countryside to the cities and a higher retirement age in particular open up further growth potential, but so does better education and vocational training among the workforce.
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