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Fed rate hikes, the US-economy and the capital markets

We have studied Fed rate hike phases since the 1970s with regard to the development of the US economy and capital markets (stocks and bonds).

Since higher interest rates impact the economy with a lag, growth was usually still solid when interest rates rose. The unemployment rate, on average, fell, and the growth of the gross domestic product (GDP) remained positive. In the past, the last interest rate hike usually took place when the first signs of a slower economic pace were already visible. On average, it took three quarters after the last rate hike for a recession to begin (the normalisation phases of monetary policy in 1983 and 1994 were not followed by a recession; the recession in 2001 was mild, and in 2020 the trigger was a pandemic-driven lockdown and likely not monetary policy).

Bond yields have risen during periods of Fed rate hikes but significantly less than the Fed funds rate, resulting in a flatter but rarely inverse yield structure (i.e. the yield on 10-year bonds has remained above that on 3-month Treasury notes).

Corporate bond spreads have tended to fall during rate hikes (i.e. corporate bonds have outperformed government bonds), which is consistent with the observation that economic growth has generally remained solid during Fed rate hike episodes.

Equity returns were below average, but slightly positive, during rate hike episodes. Of particular interest is the period in the months after the last rate hike, pointing to a strong relief rally. The stock market tended to be weaker to negative on average in the period around one year after the last interest rate hike (when the economy usually visibly weakened and the growth of corporate profits turned negative). (May 2022)

Headline inflation peaking

Behind the surge in inflation in recent months are a strong increase in energy prices and a strong upward trend in goods prices (excluding energy products).

The economy is robust overall, and unemployment rates are historically very low in Europe and the US. Such an environment fosters rising wages and allows companies to pass on cost inflation to consumers. Some persistence of inflation thus remains likely, especially in the US.

With energy prices no longer rising in recent weeks, the energy component of inflation will drop. We also expect some easing of pressure on goods prices as the year progresses (with fewer disruptions in supply chains, increased capacity and a shift in demand towards services). All in all, headline inflation (year-on-year consumer prices) is likely to have peaked in March – at least in the US. The forecast in the charts is based on the assumption that commodity prices have largely stabilised at current levels and that monthly core inflation rates (inflation excluding energy and food prices) will drop moderately (lower pass-through of increased commodity costs by companies). 

Despite declining headline inflation, monthly inflation data, especially core inflation, will remain the key indicator for the capital markets and central banks. (May 2022)

World economy – Medium-term anchors

There are currently an unusual number of negative factors for the world economy – war in Ukraine and sanctions on Russia, rising energy prices, disruptions in supply chains, local lockdowns in China, high inflation and rising interest rates – whose impacts on the global economy are difficult to assess but have already left their mark (see consumer sentiment). At present, it helps to look at the expected developments in the medium term, even if the path there is likely to be bumpy.

Over the medium term, global economic activity largely corresponds to productive potential, which is determined by the workforce and the production facilities (i.e. the capital stock) as long as production processes run largely undisturbed (intact supply chains). There are good reasons to assume that the productive potential of the global economy will not be significantly different in the coming years than it was before the pandemic. Full employment and rather low economic growth remain reasonable steady-state assumptions. With the exception of isolated write-offs due to the abandonment of activities in Russia (especially in Western energy companies) the sales and profit potential of most companies should change little (by comparison, in the financial crisis of 2008 disproportionately more capital was permanently destroyed in the financial sector).

We expect inflation in leading Western economies to remain within central bank targets of 2% in the medium term (which means that the current outlook cannot be compared to the inflationary uncertainties of the 1970s). In the coming 12 to 18 months, however, inflation – our focus is on core inflation in the US – remains a key imponderable. (April 2022)

Equity markets – Advanced growth correction

Two trends have shaped stock market activity this year. The dominant trend in the US and Europe was the end of the outperformance of growth stocks. In retrospect, the last few months can be described as the bursting of the "pandemic bubble". As a second, less significant trend for the global stock markets, the Russia’s invasion in Ukraine, especially the associated very sharp rise in energy prices, has weighed heavily immediately after the start of the war.

Rather weak global economic growth, low inflation and low interest rates – as expected in such an environment – led to a strong outperformance of growth stocks in recent years. With earnings growing solidly, valuations of growth stocks have risen steadily, a trend that has been reinforced in the pandemic and has affected all sectors, not only technology. With the end of the pandemic and rising bond yields, the tide has turned: In such an environment, value stocks (i.e. low-valued, mostly low-growth companies such as financials, energy, commodities and telecoms) tend to dominate.

The valuation premium of growth stocks over value stocks has narrowed in recent months, and many growth stocks have become more attractive again. This improves the chances for more stable stock markets. We see the rotation towards value stocks to be well advanced, though likely not yet complete. (April 2022)

Equity markets: Gulf Wars 1991 and 2003

We have analysed the price trend of European and US stock indices in the run-up to and during the hostilities of the Gulf Wars of 1991 and 2003. That these wars in distant Iraq may have been perceived differently on the capital markets than a war in Ukraine, a European country, is possible but not necessarily so.

The stock market performance during the Gulf wars largely corresponds to the uncertainty profile over time. The main uncertainty relates to the question whether a military confrontation will remain local or escalate to involve more countries.

Following the invasion of Kuwait by Iraq in August 1990, and at the beginning of 2003, when a military confrontation started to preoccupy investors, share prices fell by around 20% in Europe and 15% in the US over a period of two months. With or immediately before the military operations (12 January 1990 authorisation of the military operation by the US Congress, first hostilities on 16 January; 2003 first hostilities on 20 March, with the war ending on 1 May), share prices began to recover.

If the price decline in the Ukraine conflict is assumed to last exactly two months, it would already be over now (the Russian troop build-up has been discussed as a risk scenario on the capital markets for at least two months before the invasion). (March 2022)

Ukraine war and the global economy

Although volatility on the capital markets – the most important indicator of perceived global economic risks – temporarily rose sharply after the Russian invasion of Ukraine, the overall reaction was restrained. The market reaction does, however, correspond to that of earlier military conflicts (e.g. Gulf wars). For the capital markets, it is crucial that the war remains limited to Russia and Ukraine and does not spread to other countries. Provided this holds, the main risk for the global economy from the perspective of the capital markets is that Russia, a leading global supplier of raw materials and energy, has been sanctioned. A massive increase in the price of oil and natural gas would be the main transmission mechanism of the conflict to the global economy. Especially in the USA, consumers react quickly to changes in energy prices. In terms of supply security, Western Europe, especially Germany, is heavily dependent on natural gas supplies from Russia (in case of shortages, production cuts in energy-intensive industries are likely).

A central question remains to what extent Western Europe can and remains willing to access Russian natural gas in the near future. With the deliberate exclusion of some, but not all, Russian banks from Swift (the central platform for global payments communications), there is a possibility that Russia will continue to export energy and commodities. With less than 2% of global economic output, Russia (let alone Ukraine) is otherwise of minor importance, which is why economic development in Russia (regardless of how much this is restricted by sanctions) is of little relevance to global capital markets as a whole.

In total, potential economic risks related to the conflict are higher in Western Europe than in America and Asia. Europe's banks are also the most affected by Russia's isolation from the global financial system. (March 2022)

World economy: Normalisation and inflation

On the path to full employment and growth in line with potential thereafter, inflation has emerged as a potential stumbling block, with capital markets primarily driven by US trends. Unlike in the spring of 2021, median inflation in the US shows that price increases have taken hold in large parts of the economy (a value of 0.6% of median inflation in January means that half of the goods and services categories recorded a price increase of at least 0.6% compared to the previous month). It should be noted that the current inflation is the result of enormous shifts in consumer demand during the pandemic, which makes it is more difficult than usual to forecast and represents uncharted territory for central banks.

In the positive case, a significant decrease in the excessive demand for goods in the US – the primary trigger of the current inflationary pressure –leads to a visible moderation of inflation in the coming months. In the negative case, inflation settles well above the central bank's target of 2%, which is an equally likely scenario, given that full employment has largely been established (full employment is supportive of corporate price increases and wage pressures).

In the medium term, we nevertheless expect inflation to be close to the central banks' targets. Depending on the course of inflation, however, a monetary policy-induced economic slowdown could become necessary in the meantime. Although an economic downturn would not be expected before 2023, it likely will already preoccupy the capital markets this year. (March 2022)

Growth vs. value shares

MSCI divides the overall market into two segments of equally sized market capitalisation. The MSCI World Value Index contains stocks with comparatively low price-to-book values, low price-to-earnings ratios and high dividend yields. The MSCI World Growth Index contains stocks with above-average earnings and sales growth (based on historical data and forecasts).

Growth stocks outperformed strongly in the 1990s (characterised by a technology boom) and moderately after the financial crisis until the pandemic. Since the first lockdowns in early 2020, the outperformance has been almost as extreme as in the 1990s. There is no clear correlation between the economy or monetary variables (e.g. interest rates, inflation) and the relative performance of growth stocks. However, growth stocks generally perform better when economic growth is rather subdued, which was the case in the years after the financial crisis (and will be the case again starting in 2023 or 2024 at the latest).

In the second half of the 1990s until the bursting of the technology bubble, the valuations of growth stocks (mainly technology at the time) increased sharply compared to value stocks. After a moderate valuation expansion until early 2020, valuation expansion has been pronounced again. Overall, there appears to be further relative correction potential for growth stocks this year, despite good medium-term prospects. (February 2022)

Medium-term inflation outlook

The fact that a structural break took place in the early 1990s and that inflation has remained low and comparatively stable since then is well documented in the literature. Inflation has also ceased to correlate systematically with the money supply over the past three decades.

Although explaining such a structural break is inherently difficult, there are a large number of studies on the subject. Among the factors often cited to explain the decline in inflation is globalisation (i.e. local bottlenecks in goods or labour markets do not drive prices if the global supply of goods or labour is sufficient). Although this argument is convincing, there seems to be surprisingly little empirical evidence in its support. Moreover, in an ageing society, more and more employees with high wages retire at the end of their working lives, while those entering the labour force have lower wages (the argument is particularly compelling when the productivity gap between older and younger workers is smaller than the wage gap). This demographic effect is small but statistically significant in the US, according to the Federal Reserve. Due to technological progress, many products (e.g. semiconductors) are becoming more efficient and less expensive, which contributes to product price deflation. In recent decades, the industrialisation of the retail sector (examples include Walmart, Zara and IKEA) has also led to lower prices for many goods.

Last but not least, central banks have made a significant contribution to low and stable inflation rates. The number of central banks worldwide that are independent of politics has increased (inflation falls with the degree of independence), and since the late 1980s more and more central banks have introduced a formal inflation target, which helps to stabilise inflation expectations.

Although the influence of the above-mentioned factors on inflation cannot be determined quantitatively, there are hardly any indications that these factors would reverse course in the future. All in all, a comparatively moderate inflation environment, as in the past decades, thus remains the most likely scenario in the medium term. (January 2022)


China: Medium-term prospects

China's 14th Five-Year Plan of March 2021 envisages a doubling of economic output by 2035. This corresponds to annual growth rate of 4.7%. Compared to over 6% in the past few years, economic growth is likely to nearly halve by the end of the decade.

Government focus is on innovation, the environment, financial stability and "common prosperity". Private consumption, renewable energies and innovation sectors (especially technology) are promoted as growth sectors. In contrast, the growth driver of the past, the real estate sector, is becoming less important (especially during the financial crisis, but also in the Corona crisis in 2020, the real estate sector was the main recipient of stimulus money from the central government).

The transformation in China will be accompanied by lower growth, with risks on the downside as long as the new growth drivers cannot fully compensate for the weaker real estate sector. In addition, the ageing of the population (despite the relaxed one-child policy) is contributing to a decline in potential growth. The world's second largest economy will nonetheless continue to grow at an above-average rate, though it will no longer be the world’s dominant growth driver as in the past 10 to 15 years.

Despite a somewhat slower growth pace, China's government will continue to steer economic activity very actively, making disorderly developments very unlikely.

Globally, the gradual decline in growth rates in China means less economic growth overall and thus low real interest rates. Nevertheless, China will remain attractive for Western companies, especially due to continued growth in consumer spending. (January 2022)

US goods demand drives inflation

In the US, the monthly price increase in October was 0.6%. Unlike in the spring, when only a few product segments saw strong price increases, the rise in October was broad based. The preliminary estimate of the monthly inflation rate in November in the euro area was 0,1% (excluding energy), with industrial goods prices up 0,5% in the month and services -0,2%.

The enormous increase in demand for goods is a phenomenon that is largely confined to the US, so inflationary pressure is likely to remain highest there. Nevertheless, the resulting pressure on commodity prices, supply chains and transport also has global impacts. In addition, some bottlenecks in the labour market (for example, in the hospitality industry) are leading to some wage pressure.

We expect the imbalances in the goods markets to gradually reduce, though this process may not start before the spring 2022 if the omicron variant requires meaningful social distancing in the winter months. During that process, monthly US inflation rates will remain higher than usual. (December 2021)

Equity markets: Fundamental sensitivities

We have analysed how the MSCI World, its sectors and key market segments are performing in different fundamental environments.

The overall market rises when the economy is growing, but, on average, also when bond yields or inflation rise, and monetary policy is tightened. Financials are the best sector when inflation and interest rates rise. Industrial stocks also perform comparatively well in a rising yield environment. Conversely, consumer staples, healthcare and quality growth stocks are the preferred market segments when the economy is growing only slowly, and interest rates are low, which remains our base case for the medium term. (December 2021)

China: Tighter regulation of the economy

This year has seen tightening of the regulation of internet companies in China, with Alibaba (the world's largest e-commerce company with annual gross merchandise value of over 1 trillion US dollars, more than twice as much as Amazon), Tencent (social networks with over 1.2 billion active users, payment services, mobile games, news content, videos and music) and Meituan (the world's largest delivery service) among the most prominent targets. What started with the cancellation of the Ant IPO (Alibaba's payment service) in November last year has expanded into a comprehensive set of measures focused on competition, but they also include restrictions in areas such as online games. Separately, academic tutoring – a boom sector in recent years – has been banned for for-profit organisations. In August, China also passed one of the strictest data protection laws in the world, curbing the collection and use of data by tech companies (but not by the government). The latest regulatory efforts are part of the 2021-2025 plan released in August, indicating that regulation of the economy will be a greater governmental focus than in recent years.

More competition tends to lower the profit margins of monopolists and benefit consumers and smaller merchants (who use the large platforms to distribute their products), with strong network effects (which promote monopolistic market structures) likely limiting the impact on profitability. We also believe that the regulatory measures do not go so far as to negatively affect overall economic growth. (September 2021)

Is «market breadth» a good stock market indicator?

In recent months, the equity bull market has broadened visibly, with almost all sectors and an unusually large number of companies seeing rising prices. There is an often-cited rule that a high market breadth bodes well for future returns.

As an indicator of market breadth, the proportion of shares reaching a new 52-week high is most often used (the difference between the number of new 52-week highs and new 52-week lows can also be examined. To analyse future returns we grouped market breadth into four equally sized buckets (quartiles), with the fourth quartile representing the best market breadth (i.e. the highest proportion of new 52-week highs). This year, the market breadth has been mostly in the third or fourth quartile.

We conclude from our analysis that market breadth does not give reliable signals for market direction. In particular, the share of positive stock market periods is largely independent of market breadth. Contrary to what is often portrayed, high market breadth is associated with below-average returns. High market breadth thus appears to be an indication of an advanced bull market rather than a signal for high returns or a particularly high probability of achieving positive returns in the future. The conclusions are the same if we analyse only positive market periods. (April 2021)

Interest rates and equities: Conceptual framework

In a simple earnings discount model, the relationship between the stock market value and its determinants can be represented as follows: P = E / (r + z - g). P is the price (the present value of future earnings), E the earnings of the current year (or a multi-year average, as used in the Shiller-Cape ratio), r the risk-free interest rate, g the earnings growth rate and z the equity risk premium. The risk-free interest rate r and the growth rate g are strongly correlated, both conceptually and empirically. Interest rates are high when real or nominal economic growth (and thus growth in corporate profits) is high and vice versa. If r and g are the same, the formula shortens to: P = E / z. The fair value of an equity index equals the underlying profit level divided by the equity risk premium. If the risk premium is high (i.e. uncertainties are high), P is low and vice versa. As indicators of the risk premium, inflation (i.e. current inflation and not inflation expectations as implied in longer dated government bonds) and the frequency of recessions have been empirically shown to be very important in the long term. In the short term, economic momentum plays a role, while changes in monetary policy have less influence. We conclude that a connection between stock markets and interest rates is conceptually far less compelling than often assumed. Empirically, it can be shown that both a decline and an increase in the returns of the 10 year US-Treasury of the past 20 trading days lead to an above-average stock market performance in the following 20 and 60 trading days (especially a strong increase of more than two standard deviations). In contrast, an increase in yields by one or two standard deviations indicates a slightly below-average, but by no means strongly negative, performance in the month immediately following the increase in yields. (March 2021)

Equity regions: Risk and return profiles

The US stock market is by far the largest, followed by emerging Asia, Europe and Japan (while Latin America and emerging European markets lag far behind).

With a view to returns and risk measures, it is striking that the US market enjoys a top rank for returns in each period and is also among the markets with the lowest risk (standard deviation, semi-deviation). Consequently, portfolios optimised for risk and returns have a very high US-weighting, with some allocation to Emerging Asia and Japan for diversification purposes. European investors, therefore, should hold a high share of equities outside their home region (primarily in the US and, to a lesser extent, Asia). In contrast, the case for international diversification for US-based investors is much less compelling. (January 2021)

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