Outlook for the third quarter: high core inflation makes key rate cuts unlikely anytime soon

Bond markets: High hurdles for key rate cuts, should core inflation rate fall only slowly

Government and corporate bonds in the euro zone recorded performance of +/- 0 in the second quarter. The yield on 10-year Bunds trended sideways, while the yield on 2-year Bunds rose by about 50 basis points to 3.2 percent. The yield curve thus became more inverted. Overall, therefore, for a broad bond index, interest income more or less compensated for moderate price losses.

In the coming quarter, conflicting forces could affect the bond market. On the one hand, the European economy is weakening, so we no longer expect the European Central Bank (ECB) to raise the key interest rate to 4.0 percent in December, but an interest rate step to 3.75 percent in July has more or less already been announced by the ECB. On the other hand, historical experience shows that after a rapid rise in core inflation (inflation excluding energy and food prices) to 6.0 percent or higher, it often takes several years for it to fall back to 2.0 percent – a level that inflation swaps are already pricing in for next year. Thus, financial markets are very optimistic. So far, however, core inflation has followed the historical pattern and has remained above 5.0 percent since December last year. A declining trend cannot be discerned so far. If core inflation were indeed to fall only very slowly, the hurdles for key rate cuts by the ECB would be very high.  

Overall, we expect sideways movement in the yield of 10-year Bunds and a further moderate increase in the yield of 2-year Bunds, as financial markets are too optimistic in their expectations of key interest rate cuts in the coming year.

Equity markets: The air for further price gains is getting thinner

In the second quarter, prices on the global equity markets recorded positive performance. The MSCI Europe gained about 2.1 percent, the MSCI World even gained about 7.3 percent and the MSCI Emerging Markets Index gained about 1.8 percent – in local currency in all cases. The US equity markets benefited from surprisingly good US economic data: the interest-rate-sensitive housing market showed first signs of recovery, consumer confidence rose and the labor market remained strong. Obviously, the generous bailout of small and medium-sized banks in the USA provided more liquidity to financial markets and acted also as an economic stimulus. At the same time, a decline in inflation was also observed. Economic data from Europe and China, on the other hand, were characterized by weakness. Of all the equity markets, however, Japan stood out: the MSCI Japan recorded performance of 15.6 percent in the second quarter. Positive impulses for the equity market came from good economic data, an unchanged ultra-loose monetary policy and a weak yen.

After the very good run of global equity markets since October last year, the air is getting thinner for further price gains. US stocks were trading at a price-earnings ratio based on estimated earnings over the next twelve months of 19.3 at the end of June, compared to an average of only 15.6 since 1988. The estimates also seem rather optimistic with expected earnings growth of 7.2 percent over the next twelve months. The biggest risk is that inflation in the USA could remain stubbornly high – contrary to what is generally expected by market players. The consequence would be that more key interest rate hikes by the US Federal Reserve would have to be priced in and the chances of key interest rate cuts in the near future would decline. An overall higher interest rate level could in turn put pressure on the valuation of US equities. In Europe, on the other hand, there are increasing signs of a downturn. Against this background, expected earnings growth of 2.4 percent in the coming twelve months appears optimistic. The European Central Bank (ECB) is also likely to raise the key interest rate further in July, thus increasing the braking pressure on the economy. Japan, on the other hand, remains a bright spot. The Japanese central bank is likely to tighten monetary policy only cautiously and economic data could remain reasonably stable. In addition, Japanese equities are still rather favorably valued.

Euro zone economy: A cut in the key interest rate in the second half of 2024 at the earliest   

Towards the end of the second quarter, there were increasing signs that the euro zone economy could now be experiencing an economic downturn after a pleasing upturn in growth in the first half of the year. Among other things, economic downturn tendencies have become clearly visible in the purchasing managers' index for the overall economy which fell from 54.1 in April to only 49.9 in June. However, the ifo index has also been on the decline since its interim high in April. 

An unusual divergence has emerged between a severely recessive industry and a solidly growing service sector. One explanation could be that industry built up far too much inventory in the wake of supply chain difficulties last year and, because of the normalization of supply chains, is now able to reduce excess inventory again. This means that in two to three months industrial production could stabilize again and contribute to economic growth. Another explanation would be that the services sector is still benefiting from catch-up effects from the pandemic – tourism and entertainment in particular are currently booming. This means that the services sector could also weaken in the coming months and the European economy as a whole could fall into recession. 

Fundamentally, the restrictive stance of the ECB's monetary policy suggests that the downturn tendencies could prevail in the economy as a whole. Lending rates have risen noticeably and lending to the private sector has fallen considerably – from EUR 73 billion in August 2022 to only EUR 2 billion in April 2023. Against the backdrop of economic weakness, the ECB is likely to make only one more interest rate move in July – to a key rate level of 3.75 percent. However, since core inflation in June is still far too high at 5.4 percent, the hurdles for key rate cuts will also likely be very high. The ECB will probably not be able to consider a first cut in the key interest rate until the second half of 2024 at the earliest.

US economy: Rapid decline in inflation unlikely this year

The US economy had a strong tailwind in the second quarter, which should even be sufficient for growth to accelerate in the coming months. The generous bailout of US banks apparently improved the liquidity situation in the banking system and on the financial markets, with the result that overall economic financing conditions improved. The early-cycle residential real estate market in particular has recently shown astonishing signs of recovery. In May, for example new housing starts recorded one of the strongest monthly increases since January 1990. Consumer confidence also recovered and the labor market showed continued strength. 

However, the price for the generous bank bailout could be higher inflation in the future due to stronger economic growth. The probability is therefore very high that the US Federal Reserve will make at least two more interest rate steps in July and November and raise the key interest rate to 5.6 percent. The hurdles for interest rate cuts will also likely be high. A look at economic history shows that it usually takes several years after a sharp rise in inflation before it returns to a level of 2.0 percent. Thus, the optimistic expectations of financial market players of a rapid decline in inflation could be disappointed in the course of the year.

Asia's economy: Stagnation could end in Japan, up-swing in China

Shinzo Abe became Prime Minister of Japan in January 2013 and initiated a reform policy of many small steps that is still being pursued today. Germany's experience with Agenda 2010 shows that it often takes several years before positive effects of reforms on economic growth become visible. The surprisingly good economic data in Japan this year could thus be a signal that the reforms are now beginning to take effect. Japan could thus be facing a golden decade after decades of stagnation – like Germany in the years from 2009 to 2019. 

No indicators better reflect the long phase of stagnation in Japan than nominal consumer spending, which only trended sideways from 1992 to 2021. This shows the Japanese yen that actually goes over the counter – so it is a good indicator of the development of consumer demand. In 2022, a new significant upward trend began, clearly signaling that the Japanese economy is leaving its long phase of stagnation. The growth rate of wages also accelerated during the year, although the momentum is still somewhat subdued. It will probably take some time before wage growth shifts up a gear. So, the economy is on a very good path. The probability is thus increasing that the Bank of Japan will tighten its monetary policy this year: In a first step, it will likely adjust the upper limit for the yield on 10-year government bonds from currently 0.5 percent to 1.0 percent. In a second step, it could raise the key interest rate from -0.1 percent to 0.0 percent, which should also benefit the Japanese exchange rate.   

The Chinese upswing after the reopening of the economy lasted only one quarter. As early as April, economic data took another step backwards. The hoped-for consumption boom failed to materialize as private households did not liquidate their high savings but continued to save out of caution: On the one hand, there is considerable weakness in the labor market. Although the labor force is shrinking – by -0.2 percent last year – youth unemployment rose steadily to 20.8 percent in May. This summer, these youth will be joined by some 11.6 million university graduates who are also looking for work. This is due, on the one hand, to a complete standstill in private investment, following substantial state intervention in the market in recent years. On the other hand, the real estate market continued to show weakness. According to surveys, most Chinese expect property prices to fall in the future, which clearly limits the attractiveness of real estate as an investment vehicle. Therefore, without a significant government stimulus package, the Chinese economy is unlikely to return to a growth path. The problem is, however, that the traditional areas for stimulus like the real estate market and infrastructure have been exhausted. Stimulating extremely weak consumption is very difficult, as experience shows.