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Approaching a Crossroads?

by internationalbanker

By Christian Nolting, Global Chief Investment Officer, Deutsche Bank Private Bank





Yields on international bond markets have risen again this year, driven primarily by developments in the United States, the bellwether for many other markets. Now, after sustained hikes in key official interest rates, markets reckon that the top of the current interest-rate cycle could be near. Some central banks have already paused rate rises while, understandably, leaving the door open for further hikes if needed.

But while we might appear to be close to a policy crossroads, there are good reasons for central banks to remain on guard. The International Monetary Fund (IMF) recently presented a paper examining 100 inflation-shock episodes in 56 countries since the 1970s. It shows that inflation was brought back down within five years in only 60 percent of the episodes. Even in these “successful” cases, reducing inflation took, on average, more than three years. Most unsuccessful episodes involved what the IMF calls “premature celebrations”, when inflation declined initially, only to plateau at elevated levels or re-accelerate.

One lesson from the IMF study is that countries that successfully brought down inflation had tighter monetary policies, lower nominal wage-growth rates and fewer currency depreciations than countries that struggled to achieve their goals. Successful disinflations were associated with short-term output losses but no major declines in output, employment or real wages over a five-year horizon. This underlines the value of policy credibility and macroeconomic stability.

Central banks will be well aware of these historical lessons. For industrialized countries, we expect only slight recessions or weak economic growth rates in the near future, followed by moderate recoveries. China is in a different state of the economic cycle, and we expect its economy to experience only a moderate recovery in the final quarter of this year.

Overall, sticky inflation rates will probably cause central banks to maintain tight monetary policies, restricting economic activity and keeping growth rates low. Investors should be prepared for an extended period of elevated inflation and interest rates. We expect slow and gradual normalizations of yield curves, but the slowing pace of policy-rate increases will not mean “back to normal” yet.

In the US, a significant downturn is unlikely thanks to strong private consumption and a robust labor market, meaning the US economy will largely recover by the second quarter of next year. At the same time, the ongoing threat of a wage-price spiral will prompt the Federal Reserve (the Fed) to maintain a hawkish stance despite cutting key interest rates. Meanwhile, stubborn core inflation in the eurozone will make significant easing of the European Central Bank’s (ECB’s) monetary policy unlikely.

Some short-term periods of volatility are possible, as the Fed and the ECB have repeatedly emphasized that their decisions will be data-dependent, meaning that data surprises are likely to trigger some reallocations of investments. Also in focus will be developments on the eurozone’s periphery. Here, the ECB’s transmission-protection instrument may keep the spread on Spanish bonds broadly stable, but budget struggles and worries over European Union (EU) funding could work against the Italian government’s debt.

The eventual US economic recovery will likely favor further tightening of US and euro-denominated investment-grade (IG) bond spreads. However, default rates will probably continue to rise for US dollar- and euro-denominated high-yield (HY) bonds, as some low-rated issuers struggle to refinance at higher interest rates. However, this increase should be viewed as a normalization of previous low levels rather than a significant deterioration. Fundamentals are robust by historical standards, and HY bonds will continue to carry potential for investors.

Emerging markets’ (EM) bond markets are expected to trade near current levels over the next 12 months, particularly if an eventual improvement in sentiment regarding China’s real-estate sector moves investor focus back to the strong micro-fundamentals and technicals of emerging-market corporate bonds. However, EM sovereign bonds will continue to face several headwinds from country-specific fiscal risks for some emerging markets and generally lower economic growth in China.

On equity markets, the S&P 500’s (Standard and Poor’s 500’s) performance in the first half of 2023 was largely driven by a few big-tech companies benefiting from the recent artificial intelligence (AI) boom. But overall valuations remain stretched and have already discounted much of the earnings growth expected in the next few quarters. Although earnings quality has improved in the wake of well-performing tech stocks, we see limited upside potential for the S&P 500 from current levels.

The performance of the STOXX Europe 600 was subdued in the third quarter of this year, not helped by weakening local economic indicators and an apparent stalling in the Chinese economic recovery. Significant downside risks appear to have already been factored into the prices of European stocks. However, as we expect earnings to rise slightly over the next 12 months, the STOXX 600 should offer attractive upside potential, especially if the Chinese economic recovery regains momentum.

Japan’s TOPIX (Tokyo Stock Price Index) rose markedly early in 2023 before easing back in September and October. But gains could resume on the back of a pickup in nominal gross domestic product (GDP) growth, strong private-sector cash holdings and the Tokyo Stock Exchange’s (TSE’s) plans to tighten corporate governance and capital requirements for listed companies.

Since the beginning of this year, emerging-market stocks have performed significantly worse than developed-market stocks, despite some bright spots. The sluggish recovery of the Chinese economy – depressing sentiment on Chinese stock markets – has cast a long shadow, and ongoing policy measures may take time to stabilize the real-estate market and boost demand for consumer durables. Among emerging Asian economies, we continue to see the Indian market as a beneficiary of global supply-chain diversification and dynamic local-growth prospects, although there are risks, notably around US Treasuries’ yields, the US dollar and crude-oil prices.

In other Latin American and Eastern European emerging countries, such as Brazil, Chile and Hungary, where rate-hike cycles started early, central banks have already started to loosen monetary policies or are expected to soon. The implications (if major central banks stick to their restrictive monetary policies) are that these countries’ currencies could come under pressure, dampening stock-market performances for international investors in the short term. Putting these exchange-rate risks aside, Latin American energy and materials stocks may be attractive due to their low valuations and expected high dividend yields over the next 12 months.

On commodity markets, oil prices rose after Saudi Arabia voluntarily cut its oil production, Russian oil exports declined and geopolitical events in the Middle East kept prices high, with perceived risks around future supply. On the demand side, oil prices continue to be supported by high apparent demand from China, although this has retreated from its April peak. We expect oil prices to remain high over the next 12 months.

Although key interest rates will likely stay higher for longer, the risks of a recession and expectations of future interest-rate cuts are expected to drive gold prices slightly higher by the end of the forecast period.

Higher interest rates and marked rises in construction costs are straining the real-estate sector. However, most countries and real-estate segments have coped well thanks to solid fundamentals. The few exceptions include markets characterized by the excessive indebtedness of private households and predominance of variable-interest real-estate loans. The office segment has continued its downward trend due to declining demand related to digitalization and the coronavirus pandemic. However, many premium office properties that meet high environmental standards continue to enjoy robust demand and rental growth.

Against this background, subtle shifts in direction rather than dramatic changes in strategy are required in investment management. As inflationary pressures are unlikely to subside fully, bond yields are unlikely to decline substantially, although yield curves are expected to become less inverted. Corporate fundamentals will probably remain solid despite temporary economic weaknesses, so we do not expect bond spreads to widen significantly.

Stock markets will also likely weather any downturns relatively well, as corporate profits are expected to increase again soon. This development will be primarily driven by strengthening technology and communications services (TCS) sectors in the US and other regions. The relatively modest 12-month total-return targets for most equity markets may hide several other specific opportunities, including the likely narrower valuation discount for European stocks relative to US stocks. Potential price declines could be viewed as buying opportunities.

Commodity prices remain, as always, vulnerable to uncertainty about economic growth. However, as noted above, oil and energy prices have already risen due to supply concerns as winter approaches in the Northern Hemisphere. Copper prices could be supported by continued activity in the e-mobility and renewable-energy sectors. Gold could also be in demand among investors wanting to protect themselves against supposed recession risks in the coming months.

We also look beyond immediate monetary-policy developments to continuing profound real-world changes, analyzing investment implications through nine long-term investment themes grouped into three areas: next-stage technology, resource transition and population support.

We are already seeing technologies that can solve many environmental problems and improve how we live. What is less clear, however, is how markets can evolve to better channel capital to these areas and what impacts this will have on investors, not only for opportunities but also valuations and risk assessments. This argues for a measured investment approach that combines investments for the longer term with a sound risk-management approach.



Christian Nolting is the Global Chief Investment Officer for Deutsche Bank Private Bank. Christian began his career at Deutsche Bank in 1991 and has held senior roles in Singapore, London, New York and Frankfurt.

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