Prudent risk management is key
High inflation, the turnaround in interest-rate policy, supply chain disruptions in connection with coronavirus, the war in Ukraine – at the moment, investors seem to be facing challenges wherever they turn. Nonetheless, it is best to take an active approach. There are no signs of an imminent recession, especially in the US, and the bond markets are already pricing in high-flying interest-rate expectations.
The capital markets currently face challenging conditions shaped by a cocktail of adverse factors such as high inflation, the turnaround in interest rates, worries about economic growth and persistent geopolitical uncertainty. The concerns are not diminishing, but they are changing in nature. Whereas persistently high inflation had given markets the greatest cause for concern in recent months, the determined steps taken by the major central banks to rein in this trend have now shifted attention towards economic growth.
But what are the prospects for the future? Union Investment’s experts do not expect a further increase in price pressures, but they do expect the pressure to remain at an elevated level for some time. This is based, in part, on the assumption that the risk of energy supply embargoes will increase in the second half of the year, especially in Europe, as individual countries get closer to achieving their self-imposed goals of independence from Russian energy imports. In addition, the energy market continues to be affected by pronounced shortages. But persistently high energy prices are weighing on economic growth. The central banks thus need to act swiftly in order to keep a lid on inflationary pressure. But they will be very aware that they are walking a tightrope between a ‘soft landing’ and a potential recession.
Inflation expectations in the real economy and in the capital markets have risen sharply
Inflationary pressure is a global issue
Nonetheless, there is cause for cautious optimism. The US consumer price index (CPI) recently showed signs of levelling off. Consumer prices were up by just 8.3 per cent year on year in April, after a year-on-year increase of 8.5 per cent in March. The core rate of inflation in the US was 6.2 per cent in April and thus fell slightly from the prior-month level of 6.5 per cent. Overall, the momentum of the upward trend in prices has diminished a little. But this slowdown should not distract from that there are signs of inflationary pressures starting to widen out across the economy. For the US, Union Investment predicts an average rate of inflation of 7.4 per cent for the current year, followed by 3.6 per cent in 2023.
The eurozone is also seeing first indications that inflationary pressure is easing, but in light of the war in Ukraine and the risks associated with the conflict, it is still too early to sound the all-clear. In Spain, consumer prices rose by 8.3 per cent year on year in April, compared with 9.8 per cent in March (based on the European Harmonised Index of Consumer Prices). By contrast, inflation in Germany reached 7.8 per cent in April and does not seem to be levelling off yet. Luis de Guindos, Vice President of the European Central Bank (ECB), explained that upward pressure on prices in the eurozone would likely remain high in the coming months, mainly due to the surge in energy costs. But he said Europe was approaching peak inflation and should see inflation rates decline again in the second half of the year. Union Investment’s experts generally agree with this assessment. They predict inflation of 7.3 per cent in the eurozone for 2022, followed by 3.7 per cent in 2023.
The current wave of inflation is a global phenomenon. Emerging markets also continue to feel inflationary pressures, especially on transport and food prices. In Brazil, for example, inflation reached 12.1 per cent in April – the highest level since October 2003. Rising food prices, in particular, are also exacerbating inflationary pressures in other emerging economies, with adverse implications for consumer spending and growth.
Our macro forecast
Year-on-year change in real GDP
ECB likely to start raising rates in July
What does this mean for monetary policy? Initial signs of a slight slowdown in US inflation are hardly enough to allow the central bankers to sit back and relax. Consequently, the US Federal Reserve is expected to push ahead with its swift policy normalisation schedule. Union Investment anticipates two interest-rate hikes of 50 basis points each in June and July and expects the US key interest rate to reach a range of 2.50 per cent to 2.75 per cent by the end of the year. This should leave only one more interest-rate increase of 25 basis points for 2023. From June, the Fed will also embark on a large-scale programme to reduce the size of its balance sheet. Under this programme, the bank will let bond holdings with a volume of up to US$ 95 billion per month mature without being reinvested. Adding this ‘quantitative tightening’ to rising interest rates is likely to further slow down economic growth. Initial signs that inflation is starting to ease will take some pressure off the Fed and make it less likely that the bank will need to resort to extreme measures. This improves the chances of achieving a ‘soft landing’ for the economy – the best possible outcome for the capital markets.
Hawkish voices advocating a commencement of the cycle of interest-rate hikes very soon are also growing louder at the European Central Bank (ECB). Our economists expect the ECB to announce a first increase of its deposit interest rate at the meeting in July, followed by two further increases over the further course of the year. In 2023, it will probably implement two to three increases of the main refinancing rate to a level of just above 1 per cent. The endpoint of the current cycle of interest-rate increases (the ‘terminal rate’) should not be higher than originally expected, given that economic growth is already starting to slow down. Union Investment thus believes that the market’s current expectations of high-flying terminal rates are exaggerated.
Slowdown in growth on the horizon
The economic environment remains characterised by geopolitical uncertainty. However, the recovery that set in as coronavirus-related restrictions were lifted, particularly in the service sector, means that an economic slump is unlikely, provided that the situation in Ukraine does not escalate further and energy supplies are not cut off entirely at short notice. That said, the war in Ukraine and dependency on Russian energy are affecting the European economy more severely than other economic areas around the world. Union Investment predicts that the eurozone’s gross domestic product (GDP) will grow by 2.1 per cent in 2022 and by 1.5 per cent in 2023. For the US, our experts forecast growth of 2.4 per cent in 2022 and 1.9 per cent in 2023.
Growth in the world’s second-largest economy, China, is currently being adversely affected by the country’s strict zero-COVID policy. For the near term, the purchasing managers’ indices continue to point downwards. The problem is that the areas with the highest risk of coronavirus outbreaks are in economic hubs such as Beijing and Shanghai, but the geographic distribution of cases has recently reduced significantly. Coronavirus cases – both symptomatic and asymptomatic – have already fallen substantially. The policy of targeted lockdowns is therefore starting to prove effective, albeit with a certain time lag. For key international supply chains, it is an encouraging sign that backlogs at some Chinese ports are currently much less severe that during the early stages of the pandemic in 2020. In addition, the government in Beijing stands ready to support the recovery with stimulus measures when lockdowns are lifted. This should help to counteract the pandemic’s adverse impact on consumer spending. Union Investment’s experts expect China’s GDP to grow by 4.6 per cent in 2022 and by 4.5 per cent in 2023.
All in all, high levels of uncertainty remain a prominent feature of the economic outlook, but the baseline scenario does not currently foresee a deep recession. The central banks will therefore probably continue to tighten their monetary policy approach in a measured but determined way. The emergence of a broad-based wage-price spiral or an escalation of the situation in eastern Europe could pose a threat to this outlook, but we currently do not expect either of these eventualities to materialise.
Caution is warranted, but greater upside potential may await
In light of the geopolitical situation and ongoing measures to tighten monetary policy, conditions in the capital markets will likely remain volatile for the time being. It is therefore advisable to approach investment decisions with a degree of caution. The sharp rise in bond yields means that the bond market has already priced in fairly high-flying interest-rate expectations. For investors, this shifts the focus from interest-rate risks to credit risks. Union Investment’s experts are not anticipating a credit squeeze, meaning that medium-term opportunities could arise for investors. Active credit risk management is therefore a priority and companies whose business models are stable even in a challenging environment for growth will be favourites.
In addition, increased future upside potential could arise following the sell-off in the interest-rate markets. This should also restore the interest-rate markets’ diversification benefits for multi-asset investors to a certain extent. On the equity side, a bit more patience will be required in light of slowing profit growth. But, for instance, companies that aim to capitalise on intact megatrends such as digitalisation, the reorganisation of energy supply, infrastructure or healthcare will offer opportunities. Active security selection will pay off in this segment.
As at 16 May 2022.