The Retreat of Inflation?
- Moderate recovery in Europe and continued robust growth in the USA.
- Inflation rates continue to fall but are still above the central banks' target values in the USA and the eurozone.
- The SNB and the ECB are cutting interest rates, while expectations of interest rate cuts in the US are being pushed further and further back on the timeline.
- The environment for equities is positive. However, the US elections, market concentration in the US and geopolitics pose risks.
- We consider investment-grade bonds in EUR and CHF from the upper rating segment to be attractive. USD bonds in the non-investment grade segment are less attractive.
- Property investments in Switzerland are benefiting from the lower interest rate environment.
- The potential re-election of Donald Trump in November increases the risk of a global trade conflict, which would slow economic growth and fuel inflation again.
- The geopolitical situation remains fragile. An escalation in the Middle East leading to a direct conflict between Iran and Israel, affecting oil production facilities or shipping routes, would lead to higher energy prices and supply shortages. This poses a significant risk to inflation.
Rising unemployment figures in the US triggered fears of recession in late summer. Although we anticipate a slowdown in US economic momentum, we still consider the risk of recession to be low. For the current year, we anticipate robust growth of 2.6 per cent in the US economy.
Growth in Europe is expected to be significantly weaker at 0.7 per cent. The German economy in particular is barely making any headway. In the second quarter, it even shrank by 0.1 per cent. This is not just a cyclical weakness, but a structural one. The German economy has barely grown since the pandemic (see chart). There are many reasons for this. On the one hand, the energy crisis has weakened industrial production. The gloomy consumer and business climate, higher financing costs and dwindling competitiveness in certain sectors are hampering investment. Added to this is the weaker demand from China to date.
The Swiss economy has performed significantly better since the pandemic. However, momentum has also slowed somewhat here in recent years. This is due not least to the weakness abroad. The EU and China are two of Switzerland's three most important trading partners. The weaker demand from these regions has therefore also left its mark on Swiss industry.
In September, the Chinese authorities announced a series of measures to stimulate China's economy and the domestic financial system. Interest rate cuts and new loans for companies are intended to create additional liquidity. New incentives for share buybacks are intended to support the stock markets. And the government's promise that property prices will not fall any further is intended to restore confidence in the property sector. We expect further and more concrete measures on the part of fiscal policy. This should enable the government to stimulate the economy, which would have a positive impact on the global economy and international trade.
Inflation in Switzerland has been below the 2 per cent mark since summer 2023 and is therefore within the target range of the Swiss National Bank (SNB). It therefore lowered the key interest rate for the third time in September. In its last forecast, assuming a key interest rate of 1 per cent, the SNB showed that inflation would fall to 0.5 per cent next year. It therefore held out the prospect of further cuts. The key interest rate is therefore likely to be lowered again at the SNB's next assessment in December, which would lead to a key interest rate of 0.75 per cent.
The European Central Bank (ECB), which has already cut interest rates twice this year, is expected to make two more cuts by December. According to the first estimate, inflation in the eurozone stood at 1.8% in September, putting it back within the ECB's target range for the first time since spring 2021. This gives the central bank more room for manoeuvre to stimulate the sluggish economy by cutting interest rates. However, the driving force is the fall in energy prices. Excluding energy and food prices, inflation is still at 2.7%.
In September, the US Federal Reserve (Fed) also heralded a turnaround in interest rates. It did so with an unusually sharp cut of 50 basis points. At 2.6 per cent, the Fed's preferred inflation rate is still above the central bank's target. However, as part of its mandate, the Fed must also keep an eye on the labour market. In view of the emerging weakness of the labour market, the central bank's aim is to move interest rate policy from its current very restrictive level towards neutrality in order to support the labour market and economic growth.
The Fed's economists consider further easing by 50 basis points by the end of the year to be appropriate. However, investors are speculating on up to 75 basis points.
Despite the favourable inflation trend, there are risks. On the one hand, an escalation of the situation in the Middle East with a direct conflict between Iran and Israel, affecting global oil supply, could lead to an increase in energy prices and a strain on supply chains. Secondly, the possible re-election of Donald Trump poses the risk of a trade war, which could lead to an increase in the price of goods.
Review: Hard or soft landing in the USA? This was a question that continued to move the global financial markets in the third quarter. The market has often been convinced by the narrative of a soft landing, only to put a big question mark behind this market assessment after the publication of new macro data.
At the beginning of August, surprisingly weak economic and labour market data in the US led to fears of recession. At the same time, many investors were surprised by the Bank of Japan's interest rate hike. This increased uncertainty was also reflected in a brief rise in credit spreads.
For years, investors had taken advantage of the Japanese monetary authorities' clear commitment to a low-interest rate policy for carry trades. In a yen carry trade, you borrow in yen at low interest rates and invest the money in a higher-yielding currency to thus benefit from the interest rate differential but run the risk of exchange rate losses.
Towards the end of the third quarter, however, fears of recession in the US faded, solid labour market data and a 50 basis point interest rate cut in the US strengthened the market's confidence in a soft-landing scenario. In addition, China sent a strong signal to the markets with the announcement of generous measures to support the weakening economy. As a result, credit spreads for non-investment grade bonds fell significantly. In the investment grade rating segment, on the other hand, this sharp decline in EUR and CHF bonds could not be observed.
Outlook: The expected "soft-landing" in the USA and the monetary and fiscal policy support in China offer a positive market environment. Europe should also benefit from this. However, there are increasing signs of a sustained economic slowdown in Europe. Companies in key sectors such as the automotive, chemical and construction industries are hardly expecting any positive surprises in the coming months.
In view of the low credit spreads in the non-investment grade segment in EUR and especially in USD, we currently consider this rating segment to be less attractive. However, high yields can still be bought here with new issues. However, fundamental credit analysis is essential for this. Despite the very likely continuation of the economic downturn in Europe, we rate investment-grade bonds in EUR and CHF in the higher rating segment as attractive.
Looking back: In the first seven months of the year, the stock markets knew practically only one direction - up. Volatility returned in August. Concerns about an impending recession in the USA, disillusionment about the trend towards artificial intelligence (AI) and the interest rate hike in Japan fueled panic on the markets. As a result, the stock markets in the US and Europe lost around six per cent in the first three trading days of the month. In Japan, the Topix index recorded its sharpest one-day fall since 1987 on 5 August, falling by 12%.
The panic did not last long. At the end of August, most stock exchanges were back in positive territory, with the exception of Japan. However, the start of September was subdued. Historically, September is a weak month on the stock markets. In the last four years, the global stock market has always lost more than 3.5% in September. This negative trend was broken this year thanks to the recovery that began in the middle of the month.
Despite the more volatile environment, the global equity markets recorded a positive performance at the end of the quarter. The S&P 500 Index rose by 5.5 %, the EuroStoxx 50 by 2.2 % and the SPI by 2 %. Emerging market equities once again rose significantly at the end of the quarter, achieving a performance of 7.8 %.
Outlook: In principle, the equity markets in the fourth quarter should expect a positive environment, not least thanks to monetary easing. However, risks associated with the US elections, market concentration around AI stocks and geopolitics could lead to greater price volatility.
When central banks cut interest rates, but the economy is not yet in recession, this has been very positive for the stock markets in the past. For example, the S&P 500 Index rose by a median of around 14% twelve months after the Fed's first interest rate cut, when there was no recession.
The economic stimulus measures in China have already boosted the Chinese stock market at the end of September. We expect further fiscal policy measures to be announced. These should continue to support equities in China and the emerging markets in general.
The corporate results of AI companies were viewed with greater skepticism in the last quarter, which led to share price losses for these stocks. However, recently the prices of the "Magnificent 7" (Apple, Microsoft, Google, Amazon, Meta, Tesla, and Nvidia) have risen again. Valuations and the concentration risk on the US equity market therefore remain high. These seven companies account for over 30% of the market capitalisation of the S&P 500. This makes the market more susceptible to price corrections in the event of disappointing earnings reports.
On 5 November, US citizens will go to the polls. In the past, this has meant more volatility for the stock markets (more on this here). Everything currently points to a close race. There is therefore a risk that the election result will be contested by the losing party. This was last the case in 2020 and before that in 2000. In both years, however, other issues took centre stage, namely the pandemic and the dot-com crisis. However, we do not expect this to have a significant impact on the equity markets in the medium term this year either. The Fed's interest rate path is likely to be more decisive.
Review: While the Swiss franc depreciated against the euro and the US dollar in the first half of the year, it appreciated significantly in the third quarter. The franc gained almost 3 per cent in value against the most traded currencies during this period.
Particularly in view of the panic at the beginning of August, the franc once again proved to be a safe haven. The Swiss franc between the end of July and 6 August appreciated by around 3 per cent against the US dollar, which was plagued by fears of recession,
The US dollar became even less attractive in view of the interest rate turnaround in the USA. It fell by 6.5 per cent against the Swiss franc in the third quarter.
Outlook: Falling interest rates and a slowdown in the US economy speak in favour of a weaker US dollar. Although a significant trend reversal is not to be expected, the US presidential elections could cause short-term fluctuations. For example, hopes of an expansive fiscal policy could suddenly strengthen the US dollar again.
The prospects for the euro are also modest. Although the fall in inflation is likely to have a positive effect, it is questionable whether the economic outlook will brighten sufficiently to significantly strengthen the euro.
The strength of the Swiss franc is therefore likely to continue, which should prompt the SNB to cut key interest rates further. This is because the appreciation of the Swiss franc is one of the main reasons for the SNB's significantly lower inflation outlook. Also, it is still prepared to intervene in the foreign exchange markets.
Review: In the week of the Swiss National Bank's third interest rate cut between 23 and 27 September, the SXI Real Estate Funds Broad Total Return Index rose by 2.8% and closed the week at 509.01 points. The positive trend that has been in place for around a year thus continued.
The interest rate trend also has already an impact on the expected discount rates. According to a survey by Fahrländer Partner, the minimum discount rates for apartment buildings in Switzerland have fallen further to 1.99%. This reflects the decline in long-term interest rates since the third quarter of 2023 as well as the above-mentioned reduction in key interest rates by the SNB.
The SNB's interest rate cuts are also having a gradual impact on the mortgage reference rate. After the average interest rate for domestic mortgages rose steadily in recent quarters, the average interest rate stagnated for the first time with effect from 4 March 2024 and was quoted 5 basis points lower again for the first time with the publication on 3 September 2024 at 1.67%. The reference interest rate of the Federal Office for Housing thus remains at 1.75%.
The high excess demand for flats is reflected on the one hand in the further decline in the vacancy rate, which has reached a 10-year low of 1.08%. From a historical perspective, however, the vacancy rate is at a moderate level. In the 1980s and early 1990s, the vacancy rate was between 0.43% and 1.00%. On the other hand, according to the Swiss Marketplace Group, asking rents have risen by 2.2% across Switzerland since the beginning of the year. Regionally, particularly in Central Switzerland and the Zurich region asking rents have risen sharply.
The Swiss economy remains robust, resulting in a high demand for labour. As a result, net migration is still clearly positive at around 50,000 people (as at August) - albeit not quite at the same high level as the previous year (-15%).
The increasing shift towards home ownership due to falling (mortgage) interest rates is also likely to have a moderating effect on demand for rental flats. The number of search subscriptions for residential property increased significantly again in the first two quarters of 2024. Hence prices continue to develop positively across Switzerland. According to Fahrländer Partner, prices for condominiums rose by 1.2% and prices for single-family homes by 4.7% year-on-year.
According to the Federal Statistical Office’s latest figures construction investment by private clients fell by -1.9% overall in 2023. It is striking that investment in new buildings fell significantly by -4.8%, while more was invested in existing buildings (+3.9%). The construction index of the Swiss Federation of Master Builders also indicates a reduction in construction activity for 2024. This is despite largely stable construction prices.
The supply of office space in Switzerland has decreased slightly compared to the second quarter of a year ago. Wüest Partner reports a supply ratio of 6.3% for the 2nd quarter, which corresponds to a reduction of 0.6 percentage points compared to the 2nd quarter of 2023. Employment in Switzerland has developed positively across the board in the last three years, which is supporting demand for office space.
Outlook: The structural supply deficit in the rental flat market will not be resolved in the short term, which will result in further increases in asking rents. This in turn is likely to lead to further increases in rental income from new lettings. With significantly lower interest rates and the associated more favourable mortgages, there are signs that the reference interest rate will be lowered in 2025. This is likely to lead to a slight decline in existing rents.
No major shifts are expected in the office space market. On the demand side, there are regional differences as well as differences between city centre and peripheral locations.
The SNB's interest rate cut should again somewhat increase the relative attractiveness of property and property products and thus tend to have a positive effect on market values.
Melanie Rama
Head of Economic Research
melanie.rama@baloise.com
Dominik Sacherer
Portfolio Manager Fixed Income
dominik.sacherer@baloise.com
Four times a year, editorial deadline: 1 October 2024
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