Monetary policy at a turning point
- The outlook has brightened somewhat, with the USA in particular cting as a pillar of global growth.
- Inflation rates are slowly approaching the central banks' target values.
- The Swiss National Bank has already heralded the turnaround in interest rates. Other central banks are likely to follow suit in the summer.
- Equities are benefiting from positive momentum supported by an improved economic outlook and solid corporate earnings, but the upside is becoming increasingly limited.
- We consider corporate bonds in the BBB and BB segments in particular to be expensive.
- The weakness of the Swiss franc is likely to continue in the coming months.
- A sharp slowdown in China continues to pose a significant risk to global economic growth. Countries such as Australia, South Korea and Chile are particularly exposed, but growth in Europe is also likely to suffer.
- The geopolitical situation remains fragile. Further attacks on ships in the Red Sea could affect supply chains in the longer term. Both pose a risk to the development of inflation.
The economic outlook has brightened overall. However, strong regional differences remain.
Economic momentum is weak in Europe, Japan and China. Germany, the former growth engine of the eurozone, is also barely making any headway. The economy is expected to expand by a meagre 0.1% this year.
China's property crisis continues to weigh on the economy as a whole. Nevertheless, the government is still aiming for GDP growth of around 5 per cent this year. Although the latest early indicators point to a stabilisation of the economy, further massive government measures are needed to achieve the ambitious growth target.
In contrast, the USA is proving to be the driving force behind global economic growth. Forecasts for this year's GDP growth have been continuously revised upwards. Economic experts are currently forecasting an expansion of 2.2%. This is primarily due to the hitherto strong US consumer. Their spending accounts for around two-thirds of the US gross domestic product.
Savings as a result of the pandemic and the strong labour market have bolstered the purchasing power of private households. Although the unemployment rate in the US has risen slightly recently, it is still at a historically low level. More importantly, aggregate savings from the pandemic have now been used up (see chart). Younger and lower-income households are therefore finding it increasingly difficult to pay their credit card bills and car financing. The expected fall in interest rates should at least provide some relief.
Inflation
Inflation rates have slowly approached the central banks' target values. We assume that inflation in the USA and the eurozone will continue to fall towards the 2% mark over the course of the year.
However, the latest data shows that the road back is bumpy. While the easing of supply bottlenecks last year led to falling costs, the attacks on ships in the Red Sea and the low water level in the Panama Canal have led to longer delivery times and rising prices again. Energy prices also remain exposed to the uncertain geopolitical situation.
The situation in Switzerland is much more relaxed. Inflation here has been below 2 per cent again for some time. The feared rise due to the increase in VAT, rents and electricity prices has not materialised.
The unexpectedly sharp fall in inflation in Switzerland prompted the Swiss National Bank (SNB) to cut interest rates in March. In doing so, it became the first national bank among its peers to initiate an easing cycle. The central banks of the USA and the eurozone are likely to follow suit in the summer. However, inflation there is still significantly higher than in Switzerland, and the respective monetary authorities must first be able to rule out the risk of second-round effects such as sharply rising wages.
Advanced economies are thus following the lead of emerging markets central banks, which began cutting interest rates last year. Following a highly synchronised cycle of interest rate hikes, a synchronised cycle of interest rate cuts is now increasingly taking place (see chart).
In contrast to previous phases in which central banks have eased their policies, interest rate cuts in advanced economies are likely to take place only in small steps, as the economy is still largely robust. This applies in particular to the USA. We also do not expect a return to negative interest rates.
Review: The monetary authorities in the US and the eurozone clearly rejected the market's rate cut fantasies at the start of the year. This led to high volatility on the interest rate front in the first quarter of 2024.
Credit risk premiums continued to fall in the first quarter of 2024, particularly for euro corporate bonds. This applies to bonds in the investment grade segment, but above all to high-yield bonds in the BB rating segment. The spread difference to BBB-rated bonds is at its lowest level in five years.
At the same time, companies are increasingly feeling the effects of higher interest rates. The average coupon that investment-grade companies have to offer their investors for euro bonds has risen significantly. A comparison with the lowest potential yield (taking cancellation options into account; "yield-to-worst") of euro investment-grade corporate bonds shows that this trend is very likely to intensify (see chart).
Outlook: In view of the rather subdued economic outlook for Europe, the high level of geopolitical uncertainty and the election year in the USA, we believe that the recent decline in credit spreads is not very sustainable.
We consider corporate bonds in the lower investment grade range (BBB rating) and in the BB range to be expensive. Although the overall market shows a rather calm picture in terms of the development of credit risks, idiosyncratic credit events have become more frequent since this year. For example, companies in the high-yield segment are finding it increasingly difficult to service their liabilities (e.g. Atos, Atilce, Intrum) or are having to pay significantly higher interest rates when refinancing (e.g. Eutelsat).
The sharp rise in refinancing costs and the high interest rate volatility at the short end of the yield curve pose major challenges for companies. Companies that have a high refinancing requirement over the next three years are at a clear disadvantage and will have to accept reductions in profitability if the rising borrowing costs cannot be compensated for by other measures.
Review: It was a strong first quarter for equity investors, even though investors increasingly had to expect key interest rates in the US and Europe to remain high for longer. Robust economic data, solid corporate earnings and optimism surrounding artificial intelligence (AI) more than compensated for this and gave the stock markets a further boost.
The S&P 500 Index reached a new all-time high and has risen by over 10 per cent since the beginning of the year. The Euro Stoxx 50 was even stronger at over 12 per cent. The Swiss Performance Index gained just under 6 per cent. Emerging market equities, burdened by the uncertainty surrounding China and the stronger US dollar, continue to lag behind with a meagre performance of 1.9 per cent.
Outlook: Do US equities still have room to rise after the S&P 500's all-time high?
Yes, although somewhat less than usual. Unsurprisingly, the upside potential is lower if you enter at the recent highs.
An analysis of the performance of US equities over the last 53 years shows that investors who bought at an all-time high achieved a maximum return of 16 per cent over three months. Buying at a lower level, on the other hand, yielded around 40 per cent. However, the median returns hardly differed. In both cases, an average return of 2.6 per cent was achieved over three months.
Of course, there were also phases in which you would have lost money. Someone who invested at the high at the end of 2019 lost around 30 per cent over three months due to the coronavirus crisis in March 2020. But in around two thirds of cases, a positive return was achieved in the three months following the all-time high. This was even more often the case over a twelve-month period.
Review: After 2023 was characterised by a strong appreciation of the Swiss franc, the wind changed in the first quarter of 2024.
The main driver was expectations of interest rate cuts. At the end of 2023, investors were still expecting up to seven interest rate cuts in 2024. In view of the robust economic data, investors now expect only half as many rate cuts. Expectations for the eurozone have also been revised downwards. The higher interest rate level is strengthening the US dollar and the euro. In contrast, the Swiss franc lost value against almost all G10 currencies due to the SNB's easing (see chart). The yen was an exception.
At the end of the first quarter, the US dollar had appreciated by more than 7 per cent against the Swiss franc. The euro appreciated by 4.7 per cent.
Outlook: Monetary policy trends are also likely to be decisive for the currency market in the coming months. For the Swiss franc, this means that there is further potential for depreciation as long as the timing of interest rate cuts by other central banks remains unclear. However, we do not expect the Swiss franc to return to parity with the euro in the short term.
The SNB intervened heavily in the foreign exchange market last year. It sold foreign currencies totaling CHF 132.9 billion. This is six times more than in the previous year. The sales strengthened the Swiss franc and thus dampened inflationary pressure from abroad. The SNB still reserves the right to intervene in the market but is likely to do so to a much lesser extent in the coming months.
Review: The SNB's interest rate cut was welcomed by property investors. In the week following the SNB's monetary policy assessment, from 22 to 28 March, the SXI Real Estate Funds Broad Total Return Index rose by 1.6% and closed the week at 489.35 points. The index closed on 28 March 2023 with a performance YTD of 5.9 per cent. The positive trend of the 4th quarter of 2023 thus continued.
According to a survey by Fahrländer Partner, the minimum discount rates for apartment buildings in Switzerland fell slightly to 2.06 per cent. This reflects the decline in long-term interest rates since the 3rd quarter as well as the above-mentioned reduction in key interest rates by the SNB.
The mortgage reference interest rate of the Federal Office for Housing remains at 1.75 per cent.
Demand for rental flats remains positive and continues to increase. This is mainly due to the continued high level of immigration. According to the State Secretariat for Migration, net migration in 2023 was around 99,000 people (+21.5 per cent compared to the previous year). Compared to the previous year, asking rents rose by 5.4 per cent in February 2024.
The supply of office space has increased and accounted for 4.7 per cent of the stock in Q4 2023 (+1.5 per cent compared to Q4 2022). The increase in space on the market is due to a slight decline in demand, with peripheral locations being significantly more affected.
Retail space remains under pressure. While demand in urban areas is stable, it is declining in rural areas.
On the supply side, investment volumes for new building permits for rental flats and office space have continued to fall in 2023. Construction prices rose by a further 1.6 per cent in 2023. In a 3-year comparison, construction prices had risen by 15 per cent by October 2023. Since then, a slight easing has been observed.
Outlook: Positive impulses can continue to be expected from an income perspective. On the one hand, the next reference interest rate increase will most likely be communicated at the beginning of December 2023 and further reference interest rate steps could follow in the next few years. Furthermore, it will not be possible to expand the supply of residential space in the short term, which is why excess demand in the residential segment can also be expected in the near future, assuming immigration remains around current levels.
The office space market is likely to cool down again somewhat in the coming months. This is a consequence of the reduced economic growth and the associated reduced employment growth.
Melanie Rama
Head of Economic Research
melanie.rama@baloise.com
Dominik Schmidlin
Head of Quantitative Portfolio Management
dominik.schmidlin@baloise.com
Dominik Sacherer
Portfoliomanager Fixed Income
dominik.sacherer@baloise.com
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Four times a year, editorial deadline: 3 April 2024
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