The environment for the financial markets remains fraught with heightened uncertainty. This is because the further development of several negative trends is not sufficiently foreseeable. This applies, among other things, to the development of inflation and real economic growth. There will probably be no foreseeable positive trends with low fluctuations. This speaks in favor of high fluctuations in asset prices.
Falling inflation rates
Indications of falling inflation rates in the coming months increased further last week. In the eurozone, the flash estimate for consumer price inflation in the eurozone for the month of November showed a 0.1 percentage point drop in month-on-month terms to 10.0% year-on-year. In October, inflation had still risen by 1.5% month-on-month. The main reason for the decline in inflation was the fall in energy prices.
In the US, the deflator for personal consumption expenditures excluding food and energy prices (the core rate) rose by only 0.2% month-on-month to 5.0% year-on-year in October (after 0.5% p.m. / 5.1% p.a. in September). In Germany, import prices fell for the second month in a row on a monthly basis (-1.2% p.m. / 23.5% p.a.). In the global manufacturing purchasing managers’ report, selling prices show falling inflationary pressures, while delivery times have continued to fall. And in the US ISM Purchasing Managers’ Index for the manufacturing sector, purchase prices have retreated to a very low level (43.0).
Scope for pause
After all, the declining inflation momentum increases the scope for central banks to reduce the pace in the rate hike cycle as well as for an early pause (probably in Q1 2023) on already restrictive interest rate levels. Central banks are aware of the lagged effect of monetary tightening on economic activity. This was also the picture painted by U.S. Federal Reserve Chairman Powell in a speech last week.
Low unemployment rates
However, uncertainty about the extent of the decline in inflation next year remains considerable. First-round effects are diminishing, but the risk of possible secondary-round effects remains. This is because inflation expectations or inflation persistence may already have risen permanently. Above all, the firm labor market could be a source of increased wage inflation. In the OECD area, the unemployment rate for the month of October was 4.9% (close to the all-time low). In the eurozone, the unemployment rate fell to just 6.5% (all-time low) in October. In the USA, the rate for the month of November was 3.7% (close to the cyclical low of 3.5% in September).
Falling inflation without recession?
Hopes that inflation can fall sufficiently without a recession (rising unemployment rate) triggered by the central bank were dampened last week. This is because the labor market report in the U.S. showed a further decline in the participation rate (share of the labor force in employment or in unemployment) to 62.1%, strong employment growth (+263,000) and, above all, an acceleration in the growth of average hourly wages (0.6% p.m. / 5.1% p.a. after 0.5% p.m. / 4.9% p.a.).
Since mid-October, rising hopes for continued falling inflation rates have supported both stock and bond prices. However, the tight labor market means increased risks of secondary round effects. To contain these, central banks could raise key interest rates further after the pause in the rate hike cycle. This would increase the risk of a recession in the medium term (H2 2023 to 2024). Relying on the rosy scenario of persistently falling inflation (disinflation) would be bold.
Imminent recession risks
The theme of the transition phase from inflation as the dominant factor to at least also economic growth also received confirmation last week. The global Purchasing Managers’ Index for the manufacturing sector continued its downward trend in the month of November (overall figure: 48.8). The subcomponent production (47.8) indicates a contraction in the global manufacturing sector. The ratio of new orders (falling trend) to inventories (rising trend), which continued to fall, has reached a very low (recessionary) value of 0.92.
The key question for the immediate growth outlook is how resilient private consumption and the services sector are. After all, in the U.S.A., growth in real personal consumption expenditures has increased in recent months (October: 0.5% p.m.). The global purchasing managers’ index for the service sector on Monday will provide an important update in this regard.
Higher risk premiums
In technical terms, in an environment where liquidity is no longer abundant because central banks are raising policy rates and uncertainty is kept at a high level by multiple drivers (geopolitics, economy, climate), the (required) risk premium for different asset classes is likely to be higher than in the past. Even though the outlook for some asset classes seems favorable next year (for example for bonds), the higher expected volatility will reduce the price appreciation potential.
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Prognoses are no reliable indicator for future performance.