The current macroeconomic volatility has not changed. Interest rates and inflation remain elevated. At least in most markets, the inflation rate is continuously declining. In the US, inflation reached 3% and is on its way to the upper target of 2% in the short-term. Europe is following this development but still has a substantial way ahead before inflation will eventually reach those levels, as inflation remains at 6.4%. In the UK, the situation is more dire and inflation declined to 7.9% after being above 10% since August 2022. In order to bring inflation levels down, central banks have hiked substantially over the past 1.5 years. In the US, the federal fund rate is now above 5.25% with the most recent hike, which has largely been deemed unnecessary by market participants. The ECB also increased its interest rate by 25bps and is now at 4.25%. The BoE also raised its core interest rate by 25bps in their latest meeting and is now equivalent to the US’s 5.25%. The US also reached the status of positive real interest rates since the hikes started. Europe and the UK are following this trend but have not reached this territory yet. Figure 1 also shows how Europe and the UK are lacking behind the US. In the current environment, a recession is still likely. While projections have changed throughout the year, the consensus opinion remains that there will likely be a short and with a shallow to medium impact on the economy. The most notable change is that the recession expectation has pushed further and further into the future. It started with estimations that it will happen by mid-2023, then towards the end of 2023. Now, most estimates place the recession somewhen in 2024.
From a financial perspective, inflation, interest rates, and a possible recession remain the most vital topics in the short term. While inflation came down substantially in 2023, interest rate hikes have persisted thus far. In the US, the interest rate set by the Fed remains at 5% after they decided that no hike was necessary in June 2023. With the release of job data in early July, talks about further hikes have increased, as data showed that job growth has slowed. Market participants now expect further hikes in 2023. The projection from the beginning of 2023 and possible rate cuts as early as Q3 2023 seem very unlikely at this point. Figure 1 shows the expected interest rate level until 2025. Rates are expected to rise to 5.5% by the end of 2023. Based on a survey from 18 members of the FOMC, rate projections range from 5.1%-6.1% by the end of the year. In 2024 and onwards, gradual rate cuts are expected with rates around 3% by 2025. These projections are highly dependent on a positive development of inflation and job data. Recent inflation data in the US has been very promising, as inflation decreased to “only” 4%. The steep measures taken by the Fed since 2022 managed to combat inflation substantially. Excluding highly impactful developments (e.g., a steep recession or a strong escalation of war), inflation is expected to steadily decrease over the next years. By the end of 2023, inflation is expected to be around 3% ± 1% and slightly above 2% ± 2% in 2024. The expected, slowed decrease in inflation is largely attributed to the tamer measures of the Fed after their initial aggressive hikes. As these take time to become effective, the decrease should slow down. Additionally, a recession or a market correction is highly likely which may cause further issues with inflation and may slow down the effectiveness of the measure so far. Overall, the likelihood of a recession is still significantly high. The most notable differences in the expected recession compared to forecasts in early 2023 and 2022 are the recession is likely a mild one. Additionally, with the recent positive developments, a possible recession is pushed further in the future. At the end of 2022, a recession was anticipated to occur between Q3 and Q4 2023. Current forecasts expect a recession in the US in early 2024. Despite the harsh ecosystem, US equities had a great year in 2023 with a 15% return so far. On an industry level, the picture looks very different. Basically the entire gain of equities came from soaring tech stocks. On the other end of the spectrum are banking stocks, which have suffered this year, especially after the collapse of multiple large banks, such as Silicon Valley Bank and Credit Suisse. Forecasts for the value of the S&P 500 at the end of 2023 deviate substantially. In general, estimates were raised slightly compared to estimates back in 2022. On an aggregate level, investment banks expect the S&P 500 to end the year at roughly above 4,100. The highest estimates are 4,550 for the index. Contributors to these estimates are a less aggressive Fed, resilient economic growth, and the recent interest in artificial intelligence in combination with the soaring tech stocks. Bearish outlooks go as low as 3,400 points and cite a continued slide in stocks as the core reason.
Inflation remains a major concern and continues to exert pressure on markets. At least inflation is declining in most economies. In the US, inflation is declining since July 2022 due to the most aggressive measures taken by the Fed in comparison to other economies. Inflation fell from over 9% to now below 5%. The EU’s inflation kept rising until September 2022 when it surpassed the 11% mark. The more hesitant central bank interventions and higher exposure to the war led to a substantially slower decrease. As of April 2023, inflation still remains slightly above 8%. Toward the end of 2022, the UK behaved similarly to the EU, but could not maintain this trend. As of March, inflation in the UK remained above 10%. The continued struggle of the UK – in comparison to the EU – is largely attributable to a combination of its higher food price inflation, high reliability on gas, and worker shortages as well as wage rises. The latest data revealed that the UK could substantially reduce its inflation in April to below 9%. China and Switzerland were able to keep their inflation below 4% throughout this period and have achieved decreasing inflation similar to the previously discussed economies, albeit for different reasons. Japan followed this development but saw a spike in inflation in April 2023, which stems from a surge in food prices. Figure 1 summarizes the inflation rate development from the beginning of 2022. Figure 2 shows the corresponding interest rate measures the various central banks undertook. The Fed took the most aggressive measures with the current range being between 5% and 5.25%. Market participants widely expected rate hikes to stop earlier in 2023, and it seems now that during the June meeting, there will be a break. However, officials stated that the fight against inflation is not over, and further hikes are still reasonably likely. This dampened the optimism of market participants, especially considering views at the beginning of the year with fewer increases and possible cuts as early as autumn. Such a development seems highly unlikely at this stage. The BoE followed the Fed’s development most closely. Unfortunately, it did not achieve the same results, as the substantial discrepancy in inflation data shows. The ECB took almost half a year longer to implement such measures. As of May 2023, central bank rates in the EU are still 1.25% lower than compared to the US. It is also reasonable to assume that the ECB will continue hiking to offset its currently substantially higher inflation. This can be attributed to the later reaction of the ECB in comparison to the Fed. Switzerland, which had fewer problems with inflation, required less severe interventions. In total, the SNB increased its core interest rate by 2.25% since May 2022. In contrast to other Western economies, its core interest rate sits at a moderate 1.5%. Asian countries, such as China and Japan have struggled little with inflation and needed no or only minor central bank interventions. Nonetheless, the countries still did not go through the aftermath of Covid unscathed.
With inflation remaining high, rates are trading higher than at the beginning of the year. While the view for 2023 is still largely pessimistic, in January the view shifted to more optimism, when most assets posted strong gains. However, this optimism faded to some degree again in February 2023. With inflation only going down slowly, more and more market participants expect rate cuts later than previously expected. This stance is also further supported by the central banks, especially by the Fed and ECB recently. In the US, this led to a substantial rise in longer maturity yields. Nonetheless, the yield curve inversion is still severe. Over the past weeks, yields on 6m- and 1Y-Treasuries have surpassed the 5%, whereas the 10Y-Treasuries are close to the 4% mark. The current yields also are also alarming for the real estate market that now sees a crisis ahead. House prices plummeted since 2020. At least, the impact is not that large as it has been during the global financial crisis, but it could still reach those levels with more time. The now high mortgage rates lead to a strong decrease in home construction. The last time it was this low was back in 1995. The particularly alarming thing is that this is despite the already strongly decreasing house prices. With rates unlikely to go down substantially any time soon, the industry is under significant pressure, which is likely to persist for a while. While the decreasing house prices are substantial, compared to its history, this decline is very small. Since the global financial crisis, the median house price in the US has doubled. In this context, the affordability of housing and in particular construction is at a very low level.
2022 was a year that tested the worldwide economy. The highest inflation in 40 years, unprecedented interest rate hikes, and the invasion of Russia into Ukraine were only some contributors to the hugely difficult year of 2022. In the US, inflation started soaring during 2021 and peaked in the summer of 2022 at 9.1%. Thanks to the central bank’s quick response, inflation has since continuously slowed down and is currently at 6.5%. Europe had significantly more issues handling the inflation crisis. The EU started the year at an inflation rate of slightly above 5.5% and it continued to soar until October 2022 when it reached its peak at 11.5%. The UK was similarly affected, despite the BoE being the fastest-acting central bank to raise interest rates. However, its inflation behaved like the EU’s and soared to its peak at 11.1% in October 2022. Both economies have not been able to reduce inflation below 10% so far. In contrast to the US, European countries were much more affected by the direct impact of the war between Russia and Ukraine. Soaring energy and food prices, for both of which Russia and Ukraine are crucial suppliers, were the main constituents causing the high inflation. Additionally, the ECB did not enjoy as much freedom as the Fed had when raising interest rates. This is in large part due to the high indebtedness of certain European countries that would have gone bankrupt if interest rates would have been raised as much as the US did. Other countries, such as Switzerland, Japan, and China stand out in this discussion, as those countries managed to keep their inflation relatively low. Switzerland managed to avoid such high inflation due to its strong currency, and a limited dependency on fossil fuels. Japan avoided high inflation through the continued quantitative easing by the BoJ. However, in contrast to the other countries, Japan’s inflation is still soaring and poses substantial issues to the country. China avoided high inflation through its rigorous Covid policies and its limited governmental support when Covid emerged. The source of this soaring inflation is a combination of the war but is largely based on unprecedented central bank intervention to save the economy during the early Covid days when large parts of the economy were completely unable to function. Figure 1 shows the inflation levels of the previously mentioned countries during 2022.
With the currently pessimistic view of 2023, markets are under substantial pressure. Most market participants are expecting a recession in 2023/2024. High inflation, steep interest rate hikes, and historical yield curve inversions are just a few indicators that suggest tough times ahead. However, there are some indicators that provide hope that a larger crisis can be avoided. While inflation is high, it has been steadily decreasing, at least in the US. Rate hikes are also expected to increase only slightly in 2023. Nonetheless, this provides little help in avoiding a recession, as it is still unclear how fast inflation will drop down to the acceptable 2% and below range. Furthermore, interest rates will remain high for 2023 with a low to moderate probability of rate cuts in 2023. These still pressure businesses that are expected to earn less in 2023, as consumers have exhausted most of their resources in dealing with the impact of inflation. The biggest saving grace currently is the labor market, which functions very well. In Western countries, the unemployment rates are close to record lows of the past few decades. In the US and the UK, the unemployment rate is 3.7%. In the EU, the unemployment rate is 6%, while Switzerland sees an unemployment rate of 2.2%. Figure 1 shows the jobless claims in the US in 2022. While there has been some variation during 2022, these were small and at very low levels historically. It is even more promising when addressing the private sector. Since early 2021, the private sector in the US is adding jobs at a constant pace. Figure 2 shows this development.