Between AI euphoria and recession worries: which scenario will prevail?

Generally speaking, the rising share prices and high valuations on the market are currently being driven by three things:

• a good story (artificial intelligence)
• solid profits (which are above expectations and show increasing growth)
• favorable financing (a monetary policy that is not restrictive for the market).

In such a scenario, the positive trend usually continues until really bad news arrives. This could be the case if a recession becomes apparent or bond yields rise sharply due to the high level of US debt. On the other hand, the rapid development in the field of artificial intelligence could actually boost economic growth in the US.

Risks currently pointing downwards

A look at the current news situation reveals “only” downward risks:

• News such as “Donald Trump fires labor statistics boss after weak jobs reports” is worrying. This is because the high level of trust in the quality of US data could be damaged. However, such developments have no immediate impact on corporate profits.
• US economic growth has slowed. Real GDP growth in the first half of the year was 1.3% on an annualized basis. This is below potential (estimated at 1.8%), but is not a recession. Addendum: Some people speak somewhat luridly of a growth recession.
• The US labor market is weakening. Employment growth in the non-agricultural sector is down to a three-month average of just 35,000. In the manufacturing sector, employment has fallen by 37,000 jobs in the last three months. The question is whether the slowdown can be attributed primarily to lower demand (companies need fewer workers) or to a falling labor supply (due to the mass deportations in the USA). The more the latter is true, the less the unemployment rate will rise (and point to a recession). To summarize: Employment is not (yet) shrinking.
• The decline in the global purchasing managers’ index for the manufacturing sector in July (49.7) indicates a slowdown in global production towards stagnation. In contrast, however, the global purchasing managers’ index for the services sector has risen. Overall, the report counters expectations of a slowdown in economic growth in the second half of the year.
• Consumer price inflation in the USA rose by 0.2% month-on-month and 2.7% year-on-year in July. The decline in inflation in the services sector remains very sluggish (3.8% year-on-year). At the same time, the effect of the tariff increases is already visible: goods price inflation is at 1.2% year-on-year. A short time ago, it was still at zero percent.
  The tariff increases will probably lead to even higher goods prices and a temporary rise in inflation. However, this increase is not particularly large in our base scenario (4th quarter: 3.6% p.a.) and is temporary. The assumption is that there will be no pass-through and secondary round effects and that inflation will fall next year.
• The effective tariff rate on US imports is hovering at 20%. Although a trade war has been avoided, a negotiation result with China is still pending.
• The US government is exerting great pressure on central bank members to cut key interest rates significantly. Interest rate cuts would immediately support the markets and economic growth. In addition, interest payments on government bonds, at least those with a short maturity, would also fall. However, in the medium term, key interest rate cuts that stimulate demand without increasing supply would lead to higher inflationary pressure.
• In fact, some recent speeches by Fed members have argued in favor of lowering key interest rates. One reason for this is the slowdown in the labor market. However, the “dovish” tone could also have something to do with the immense political pressure. In any case, a series of Fed rate cuts starting in September has become more likely.

Wide range of possible scenarios

The combination of US economic policy, economic indicators and the market environment opens up a very wide range of future scenarios:

• On the negative side is the “recession” risk scenario. After all, employment growth has already weakened significantly. In addition, higher inflation and general uncertainty could further worsen sentiment among consumers and companies.
• On the positive side is the “exceptionalism” scenario. Here, the revolution in the field of artificial intelligence leads to a massive increase in productivity in the USA. Permanently higher economic growth of 3% suddenly seems possible.
• Our base scenario “weakening” lies in between. The expected impact of the unilateral US tariff hikes has a stagflationary effect in the US (higher inflation, lower growth) and a dampening effect on growth in the rest of the world (deflationary).

Conclusion

Overall, the indicators in the current base scenario do not point to a recession, but to growth below potential. However, this environment is not necessarily negative for equities. The question is whether and to what extent companies’ profit margins will be affected by this phase.

A “soft patch” – i.e. weak growth in the second half of the year – would probably be ignored. However, a longer phase of a stagflationary environment in the USA and a more deflationary environment in the “rest of the world” would leave its mark. In any case, the high valuations argue against a particularly risk-averse positioning. At least until it is a little clearer whether the boost from AI on economic and earnings growth or Donald Trump’s policies will dominate.

 

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