Interest rates likely to stay higher for longer

After a differentiated analysis of inflation and its influencing factors, we expect core inflation to remain high for the time being and interest rates at a level that is likely to remain higher for a longer period of time. The banking and insurance sectors could benefit from this.

The authors

DJE's team of analysts continuously monitors and evaluates the markets using the in-house FMM method according to fundamental, monetary and market criteria. They summarise their findings once a month.

From the analyst team of DJE Kapital AG

Inflation trends and central bank policy continue to determine the stock markets. Looking ahead to the coming months, headline inflation in the US and Europe should continue to fall. However, core rates (i.e. excluding food and energy) are showing much less reassurance and underlying core inflation remains high. Pressure on core inflation rates is likely to continue in 2024, partly due to higher wage settlements. Interest rates will thus probably have to remain at a high level for longer.

So far, the US economy has shown itself to be very resilient, mainly due to the very strong labour market. Despite the Fed's monetary tightening, stock markets have performed well so far in 2023. From a monetary perspective, global liquidity has not come under as much pressure so far due to the expansionary policy of the Japanese central bank. However, this tailwind so far could start to weaken in May. Consequently, the first half of 2023 could turn out better on the stock markets than the second half of the year. Interest rates and valuations will thus be important in 2023, so stock markets in Europe and emerging markets could perform better than in the US. Europe could also show better economic growth, at least in 2023. Value stocks or favourably valued shares, e.g. from the banking and insurance sector (see also focus topic below), will remain interesting for the time being, as will selected bonds with attractive interest rates.

Fundamentally

  • 2023 Europe with stronger growth than the USA
  • Delayed effect of monetary policy may weigh more heavily in 2024 than in 2023
  • Asian investors increasingly interested in Europe
  • Stronger localisation of multinationals likely
  • Interest rate hikes do not necessarily lead to higher unemployment due to structural skills shortages

The economic outlook for Europe and Germany is somewhat better than it was at the end of 2022: due to the very warm winter so far, the situation on the gas and electricity markets has eased. The order situation for European industry should improve somewhat, as inventories are very low at many customers.

In 2023, economic growth in the Eurozone should also outpace growth in the US, which is a short-term advantage for Europe. In the medium to longer term, however, the US should grow more strongly than Europe, because Europe continues to have a structural growth problem that is likely to come to bear again after 2023. Not much is likely to be done to accelerate growth in Europe in 2023/24 either.

From a fundamental perspective (earnings performance), European companies, which are generally cheaper than their US peers, should have a short-term advantage in 2023. Looking ahead to 2024, many current growth forecasts seem too optimistic to us: the delays from restrictive monetary policy (an interest rate move usually has an impact only after a delay of up to half a year) are not yet priced into the current forecasts. Due to these timelags global growth in 2024 could generally be worse than in 2023.

Asian investors' interest in investing more in Europe is increasing, thus also supporting the euro. Singapore's sovereign wealth fund, Temasek, for example, is specifically looking to invest in companies that benefit from Europe's efforts to become more energy independent. Singapore also remains a promising region in Asia in terms of expected economic development. The rapid opening of China is positive for Chinese as well as Asian growth, but also has an inflationary effect.

In the medium to longer term, however, it remains difficult for companies in Germany and Europe. Medium-sized companies in particular are likely to have a hard time. Large, multinational companies will probably localise their resource allocation even more, i.e. invest more directly in the most important sales regions (USA/Asia). In meetings/conferences, companies with a lot of US business are confident (or happy to have a lot of US business) as US order intake is structurally better.

Compared to other cycles, the US labour market may remain tight longer than expected. The labour market in the US (similar situation in Europe) could be the big difference in this cycle: despite the Fed's massive brake policy, the unemployment rate is expected to rise only slightly as there is a structural labour deficit in very many sectors. Furthermore, many workers have become too accustomed to working from home and are only available to come to work to a limited extent (there is also talk of an unemployment rate adjusted for "working from home" (WFH) of only around 2% in the US). The price/wage negotiating power of appropriately qualified workers is high.

Monetary

  • Core inflation likely to fall less than headline inflation
  • Central banks could stabilise higher interest rates
  • ECB's inflation forecast too optimistic
  • No monetary tailwind for stock markets
  • Bonds still negative overall, but selected high-quality bonds with attractive yields

Headline inflation should continue to fall in the US in the coming months. In the eurozone, too, headline inflation should initially fall due to falling energy prices. Improvements or declines in the inflation rate take the pressure off the central banks to continue making large interest rate steps. However, core inflation is likely to fall less sharply than headline inflation. Inflation components such as rents or services are not likely to come back as quickly. If we distinguish between goods and services, we see that goods price inflation is falling. Service inflation, on the other hand, is rising. And this is a much greater threat to the achievement of the inflation target.

At the end of the rate hike cycle, market participants expect the key interest rate in the US to range from 5.25% to 5.50%. However, the Fed may be forced to go further, also because of the continued strong labour market reports. Fed Chairman Jerome Powell commented that there is still a long way to go to cool down inflation ("There is a significant way ahead to cool down inflation"). There seems to be some dissent among the voting Fed members (the same probably applies to the ECB): some members would have liked to see 50 bps at the last meeting as well. One Fed governor also believes that one will be above 5.5% in 2024/25. In general, one can say that such a wide dispersion regarding interest rate expectations in 2023/24/25 is historically unusual.

At the same time, the committee of voting Fed members is also facing new appointments or some personnel changes. There is no empirical data yet on how the new members will vote. It is possible that they will tend to be on the side of the hawks: After all, inflation should not become their problem straight away. All in all, it is not advisable to be too optimistic about rapid interest rate cuts. The Fed and the ECB will probably first try to stabilise interest rates at a higher level before considering interest rate cuts.

In Europe, on the other hand, the European Central Bank's forecasts for inflation in 2023-25 appear too optimistic: it is unlikely that price stability will be achieved by the end of 2024.

From a monetary perspective, global liquidity has so far not come under as much pressure as feared due to the expansionary policy of the Japanese central bank. It is conceivable, however, that the new governor of the Bank of Japan will cooperate much more with Americans and Europeans and thus the BOJ will act much less expansively.

The second half of the year could see another market correction. The reasons for this lie in the ongoing process of quantitative tightening, in the possible absence of interest rate cuts or in interest rates that are higher than expected. From a monetary perspective, no tailwind is therefore to be expected for the stock markets in the USA / Europe.

Historically, the development of the money supply has always been the best stock market influencing factor: The US money supply M1 is currently no longer growing and the US excess liquidity is negative, i.e. there is currently too little excess money for equity investments in the economic cycle.

Sentiment remains negative for bonds. But we see opportunities, as top-rated bonds (ex: AA or A) with attractive yields can still be found.

USD/EUR

  • Euro benefits from capital flows into the euro area
  • US dollar stronger in the medium term

The euro could initially receive further support, among other things from better growth prospects in the euro area in 2023 and increasing capital flows / investments in the euro area again. In the medium term, however, we continue to expect USD strength: The US has better structural growth in the medium term, is largely energy self-sufficient, is a technological leader in many areas, is significantly less bureaucratic and has the strongest and deepest capital market.

Focus: Banks and Insurance

Banks

The significant rise in key interest rates in the EUR and USD supports the banks' investment case into 2023. However, the deposit beta factor will become increasingly important in the coming quarters and slow the pace of profit growth. Cost increases in the context of the inflationary environment will also hit the sector in a lagging manner. There is a positive surprise potential in a positively developing credit cycle that lasts longer than expected. On the one hand, this is based on the fact that consumers are still in very good shape and hardly have to fear unemployment. On the other hand, many companies have taken advantage of the low interest rate phase to significantly lengthen their financing structure, so that the interest rate pressure from the increased interest rates will only unfold over a much longer period of time and stronger defaults are hardly to be expected in the short term. The sector's balance sheet structure is also as solid as it has probably been in any previous downturn, which will make significant shareholder returns possible in the coming years.

Insurance

The insurance sector benefits from the rise in interest rates only with a significant delay, due to the duration of the investment portfolios of 4 to 5 years in non-life insurance and approx. 10 years in life insurance. Especially non-life insurance (primary insurance and reinsurance) thus has the potential to profit from the increased interest rates in the coming years. After the strong claims years in the recent past, significant price increases can continue to be implemented in both insurance and reinsurance, even in segments where inflation should already have passed its peak (car and construction, due to delivery problems last year). In addition, in reinsurance risk capital as a price-supporting factor is only available to a significantly reduced extent. The shareholder return via dividends is similarly attractive in the insurance sector as in the banking sector, even if not quite at the same level - but the positive effect of rising interest rates should contribute positively to the result over a longer period of time.

 

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