As Q2 kicked off, we were expecting both short yields and equity prices to rise. This more or less panned out. But what happens now?
Overall, our main message is that the global expansion remains intact. We expect growth to continue at a slow but positive pace in the coming quarters and inflation to ease but remain above central bank targets.
Ever since US recession fears ramped up last summer, we have consistently taken a contrarian view against this being the most likely scenario to play out. Naturally, we acknowledged the risk, but our assessment was that an extraordinary shock to the economy would be needed to trigger a recession – basically because the US economy is not fundamentally imbalanced. Households and corporates have neither spent nor invested too much (borrowed) money, which makes it less sensitive to credit and monetary policy shocks.
And this remains our main argument for why the economy, despite the historical tightening of monetary policy and stricter credit conditions, will not tip into recession.
This scenario unfolding could cause euphoria in global equity markets and thus a situation were equity risk premiums basically collapse in a way similar to previous, bubble-like situations. Bo Bejstrup Christensen,
Head of Macro & TAA at Danske Bank Asset Management
READ the full AM Quarterly View Q3 2023 report here.
If our expectations hold, global equities should be capable of rising moderately over the coming 6-12 months.
Following the latest price rises in Q2, we now assess equity valuations to be expensive. Naturally, this tends to curtail future return potential. However, in light of our moderately optimistic expectations for global growth, we estimate these expensive valuations can be sustained and risk premiums on equities fall a tad more. This is our main scenario.
However, given the high valuations, a recession could potentially trigger a significant increase in equity risk premiums and put equities on the ropes.
Conversely, we would stress there is a considerable probability that equity risk premiums could fall further and thus send global equities into even more overvalued territory. This scenario could materialise if we are right about expecting low but positive growth in the coming quarters, followed by a modest acceleration in growth in H1 2024. If inflation also fell significantly, the Federal Reserve and the ECB could potentially begin to air the possibility of modest monetary policy easing later in 2024 or 2025. This scenario unfolding could cause euphoria in global equity markets and thus a situation were equity risk premiums basically collapse in a way similar to previous, bubble-like situations.
BONDS: We expect stable to slightly declining bond yields
With the latest increases in bond yields in mind, market pricing of short bond yields now makes more sense to us. We remain at odds with the market on the potential for both the Federal Reserve and the ECB to cut rates noticeably from H2 2024 onwards, but our distance from each other is much less pronounced now compared to earlier. Meanwhile, we continue to view long yields in particular as fair. We therefore estimate that bond yields overall are now at an appropriate level, and we expect stable to slightly declining bond yields on a 6-12-month horizon.
Should inflation prove more sticky than we estimate, the need for monetary policy tightening would increase – and the Federal Reserve and the ECB would doubtless deliver, as they have clearly communicated they must rein in inflation again. Such actions would likely push short yields further up, but long yields would remain stable in this scenario, in our opinion, as inflation risk premiums would probably fall, and the market would price in monetary policy easing further out in the future.
EMERGING MARKETS: We expect the worst in China is behind us
Disappointment about China’s economy floundering in Q2 hit Chinese equities hard, which in turn pulled the broader emerging markets index lower. However, we expect the worst is behind us. Not only should Chinese growth stabilise in the coming quarters, but stability and later a modest acceleration in US and European growth should also assist China and the broader emerging markets index – especially if inflation eases and monetary policy tightening is soon a closed chapter. We therefore expect emerging market equity prices to increase moderately over the coming 6-12 months as well as favourable conditions for bonds issued by emerging market countries.
In addition to the obvious risks, such as a US recession and the potential need for even tighter monetary policy, the long-term geopolitical situation of course casts a shadow over Chinese equities in particular. This could hamper how expensive the market is capable of pricing equity risk, even in the global scenario outlined above with equity euphoria.
Photo: Spencer Platt/AFP/Ritzau Scanpix.
DISCLAIMER: This content is based on Danske Bank’s macroeconomic and financial market expectations. Developments deviating from our expectations could potentially affect the return on any investments negatively and result in a loss. This material has been prepared for information purposes only and does not constitute investment advice. Note that historical return and forecasts on future developments are not a reliable indicator of future return, which may be negative. Always consult with professional advisors on legal, tax, financial and other matters that may be relevant to assessing the suitability and appropriateness of an investment.
