Steady crawl without a real fall
The previous six months were peculiar. All major economies recorded growth well below long-term historical averages, yet the figures were generally better than expected. Especially the US displayed strong numbers on the back of a resilient labour market and an uptick in productivity. The eurozone economies narrowly avoided a recession by stagnating in the fourth quarter of 2023. The UK and Japan were probably in a recession in the second half of last year. Japan, however, performed strongly in the previous quarter, buoyed by a weakening yen. December inflation numbers surprised to the upside. In Q1, US inflation numbers kept surprising to the upside, and unemployment held low and stable across advanced economies. These signs of resilience had the market consensus on the first rate cut move back in time throughout the first two months of this year. Whereas at the start of 2024 markets were expecting the first US rate cut as early as March, the consensus now is June, with a similar delay for the eurozone.
Sticky core inflation, pressure on profit margins
Real wages in the US and the eurozone have diverged. In the US, real wages grew for most of 2023, whereas in the eurozone only in the last quarter. It seems that real wages in the eurozone continued their growth in the first months of 2024, probably slowing the disinflation process somewhat. Given the near-stagnating eurozone economy, profit margins will likely remain under pressure. In the US, on the other hand, the expanding economy and productivity gains so far allowed profit margins and real wages to simultaneously grow slightly. With growth slowing down going forward, we expect profit margins to come under pressure in the US as well.
Both the Fed and the ECB have begun signalling that they will likely cut rates in June, if incoming data confirms a disinflation process, even without if some types of inflation run above 2 per cent at that point. We expect three 0.25% rate cuts this year from the Fed and four from the ECB and the BoE.
Soft landing leads to weak bounce, with risks to both sides
Our most likely scenario is a soft landing. We do not expect economic activity to abruptly drop in the near term. The recession in the UK may last another quarter, but the US might well avoid one, even though we expect low growth figures for the middle quarters. The eurozone probably has the worst behind, narrowly avoiding a recession. However, small dips imply very little space for rebound, too. With interest rate hikes having little damage to the economy, we can’t expect big effects from cuts on economic activity either. Labour markets are tight, as the low and stable unemployment rates indicate, and aging implies a shrinking workforce in both the eurozone and the US. This leaves productivity increases as the only potential source of growth. We therefore expect that eurozone growth will pick up but remain at very low levels for the year. Even if economic activity is sluggish, interest rate cuts could boost asset prices. In the US, we see an increase in productivity, possibly related to AI developments. This makes us more positive about the US growth outlook than about the eurozone outlook. A turn to tighter fiscal policy and the effects of elections could hurt growth prospects in both economies.
However, there are multiple risks that could lead to alternative trajectories. Firstly, the ongoing wars in Ukraine and Gaza and shipping disruptions could escalate, distorting supply chains, either through direct disruptions or rising transport prices. This would hamper growth and boost inflation, implying a hard landing. Secondly, China is in trouble, having recorded deflation four months in a row over the winter. If government support cannot stop the deflationary dynamic definitively, export prices might be pressured down. In this case Chinese export prices could speed up disinflation elsewhere. This, in turn, might imply a ‘no landing’ for advanced economies. Thirdly, resilience could again be stronger than expected, for example by consumer confidence increasing, which could accelerate consumption. While this is a positive scenario in the short-term, an increase in consumption without matching increase in productive capacity might pull up wages and prices with it, leading to rate cuts being delayed anyway. The negative consequence of this scenario could therefore be that in the medium-term rates would remain higher for longer. Fourthly, commercial real estate is struggling in the high-rate environment, especially in the US. If this were to affect financial stability, that would probably cause central banks to cut rates significantly faster than we foresee. In short: we see both up- and downside risks across advanced economies regarding both growth and inflation.
Soft and sluggish implies a neutral stance
Given our expectations of sluggish global growth, which will likely put pressure on profit margins, and the risks for inflation that go both ways, we do not think risk assets look particularly attractive. The rate cuts we expect this year would support bond markets first and foremost. They could boost asset prices in general, especially in interest-rate sensitive sectors such as renewables. We therefore have a neutral position in both equities and bonds. We are also neutral in duration in our bond portfolios. The main reason is that we expect term premia to build as policy rates come down, which makes the long end of the curve less attractive.