Eddy's Weekly Market Update

Since early 2023, many economists have anticipated that the U.S. and European economies would soon weaken significantly or even enter a recession due to sharply increased interest rates. In Europe, growth has indeed fallen to around 0% for a period, but in the U.S., it remained around 3% until last month. This growth rate is too high to structurally reduce inflation to 2%, but it has helped bring inflation down from around 7% to approximately 3% in both the U.S. and Europe over the past year. This reduction is attributed to the recovery of the supply side, which was significantly disrupted during the pandemic years. However, this process has largely run its course, so the demand side must be sufficiently curtailed to reduce inflation from 3% to a structural 2%. To achieve this, growth in the U.S. needs to fall below 1.8% soon, and in Europe, it must not exceed 0.75%.

This is not a positive outlook for stock prices. Yet, they have continued to rise. Investors expected that high interest rates would sufficiently slow growth to bring inflation back to 2%, without the need for further economic braking. This happens automatically when nominal interest rates remain stable but inflation decreases. Real interest rates then rise, which slows growth. Thus, stock prices continued to climb because:

1. Although profits may grow less rapidly with decreasing growth, lower interest rates lead to higher price-earnings ratios, which usually has a greater impact.
2. If growth does not decrease, interest rates and price-earnings ratios remain the same, but profits increase significantly, especially given the expectation that growth and inflation will eventually decline substantially.

Starting in early May, weaker economic data emerged from the U.S., while the European economy was already perceived as weak, leading to the belief that high interest rates were finally having an effect. Consequently, interest rates and the dollar fell, while stocks and gold rose. However, towards the end of this week, strong economic data resurfaced, particularly from the U.S., but also from Europe. This has led to market fluctuations between hope and fear, raising the question of why economic growth remains resilient to high interest rates and how long this will continue.

We believe the answer lies primarily in the following factors:

• When interest rates were very low, many locked in these rates far into the future. This effect will gradually diminish.
• There is still significant fiscal stimulus. However, this too is expected to taper off gradually.
• Central banks are significantly curbing the creation of new money, but there is still a surplus of money that was massively added in recent years. This surplus partly finances large government deficits, flowing into the real economy rather than staying with banks. Additionally, combined with the expectation that it’s only a matter of time before growth and interest rates decline, monetary conditions remain very loose. These conditions, encompassing asset prices, real interest rates, the availability of money, and the dollar exchange rate, have a greater impact on growth than interest rates alone.

Currently, it appears that growth in the U.S. will not fall sufficiently to bring inflation back to target, and Europe must be cautious as growth there slightly increases. Therefore, monetary conditions need to tighten, likely keeping interest rates higher for longer than many would prefer. Rates may decrease slightly but not rapidly. Consequently, we do not foresee significant increases in bond and stock prices in the near term and expect them to decline instead. The same applies to gold, albeit within the context of a longer-term uptrend (refer to our recent gold special for more details). For EUR/USD, this outlook is likely mildly negative. Only later, when growth and inflation significantly recede, will a new situation arise.

Note: Last week I released the first in a special series focusing on gold.?Lately, gold has performed much better than stocks and bonds. In this report, we ask ourselves whether this will continue... If you want to receive this report, please send me a brief DM with your email address and we will be happy to send it across to you.

Have a good week ahead.

Best regards, Eddy