Outlook for the first quarter: economic recovery in the USA; declining key interest rates in the euro zone

Bond markets: Turbulence on the US markets could spread to Europe

The fourth quarter made up for a whole year of losses on the European government bond markets. At the end of September, prices were still in the red. From the beginning of October to the end of December, however, German government bonds rose by 6.4 percent and government bonds from the euro zone by 7.2 percent. In 2023, German government bonds thus achieved an overall positive performance of 5.1 percent – according to ICE BofA indices. Corporate bonds also had a good year in 2023. European investment-grade bonds achieved 8.0 percent and high-yield bonds even achieved 12.0 percent. The exceptionally good performance of the bond markets in the fourth quarter can be attributed to a noticeable decline in inflation and the associated expectation of market participants that key interest rates will fall in 2024. At the end of September, the financial markets were pricing in key interest rate cuts by the European Central Bank (ECB) of just 50 basis points by the end of 2024, whereas by the end of December, financial markets were already pricing in falling key interest rates of around 175 basis points.

We expect the ECB to lower the key interest rate to 2.0 percent by the end of 2024. Against this backdrop, we believe there is a good chance that yields on bonds with a maturity of up to five years will fall in the course of 2024.

In contrast, European bonds with a longer maturity are strongly influenced by the yield trend in the USA. Based on our assumption that the US Federal Reserve will lower the key interest rate less than expected, there is a risk of disappointment on the US bond market and a rise in yields. Added to this is the escalating US government debt. In 2024, the budget deficit is likely to total around USD 2.0 trillion. Investors could become increasingly nervous about financing government deficits over the course of the year and enter into a buyers' strike. A buyer's strike could be triggered by generous election promises or the implementation of election promises after the November elections. The result would be turbulence on the government bond market in the USA, which could also spread to Europe. Ultimately, the US government will then have to row back and introduce government austerity measures. The quicker the government reacts, the shorter the turbulence on the financial markets will be.

Stock markets: Artificial intelligence increases productivity and boosts share prices

The international stock markets had a strong fourth quarter. The MSCI Europe gained around 5.7 percent and closed 2023 up 15.0 percent. The MSCI World even rose by 10.0 percent in the fourth quarter and closed 2023 with a gain of 23.7 percent. The MSCI Emerging Markets Index also recorded positive performance of 5.6 percent in the fourth quarter and 10.3 percent for the year as a whole (in local currency in all cases). Prices on the international stock markets benefited from a significant decline in yields on the bond market. The noticeable fall in inflation and expectations that key interest rates could soon be lowered also ensured a positive mood. A look at corporate profits in 2023 shows that they more or less stagnated in both the USA and Europe. The positive performance on the international equity markets can therefore be attributed almost exclusively to higher valuations. Investors therefore anticipated the fall in inflation very well. Of course, artificial intelligence also fueled the imagination and led to a higher valuation of US technology stocks.

In principle, artificial intelligence is likely to become a positive influencing factor for productivity development in the next few years. Companies that utilize artificial intelligence successfully are likely to benefit increasingly. Phases with high productivity growth are generally also phases with positive performance on the stock markets.

However, this positive scenario is offset by the risk scenario of turbulence on the US bond market. Promises made during the election campaign regarding tax cuts or new spending programs could lead investors to question the financial viability of US government debt. The national debt is already at a level not seen since after the Second World War. The US government will then inevitably have to respond to financial market turbulence with austerity measures in order to reassure financial market participants. However, we see this issue only as a volatility event that may shake up the equity markets in the second half of the year but cannot throw them off their positive trajectory.  

Euro zone economy: First key interest rate cut possibly in April

Economic data in the euro zone stabilized at a low level in the fourth quarter; and according to our estimates, the economy stagnated. A significant divergence was observed between the industrial and service sectors. Industry in the euro zone has been in recession since July 2022, and this even intensified noticeably in the course of 2023. The reasons for this were weak domestic consumption dynamics, the crisis on the European property market and increasing competitive pressure from exports from China. The service sector performed better. Although the indicators for the services sector also fell from April 2023 onwards, this was only moderate in contrast to industry. The deterioration in the economic indicators for both sectors coincided with the ECB's key interest rate hikes and the transition to a restrictive monetary policy stance. It is therefore reasonable to assume that the ECB's restrictive monetary policy in particular is slowing down the European economy to a considerable extent. However, the economic weakness had the desired effect, as inflationary momentum weakened significantly. In the fourth quarter, core inflation rose by just 1.1% over three months (annualized).

We do not expect the European economy to pick up significantly in the first half of 2024 and anticipate inflation to remain weak. In our opinion, the ECB is therefore likely to cut its key interest rate for the first time as early as April. The key interest rate is likely to fall from 4.0 percent to 2.0 percent by the end of the year. Nevertheless, we believe there is a good chance of a stronger euro exchange rate in 2024, as European consumers have not yet spent the surplus savings they built up during the pandemic. They have also tended to increase their savings rate over the course of 2023 due to the attractive interest rates on savings. Against this backdrop, the key interest rate cuts we expect should noticeably dampen the propensity to save and boost consumer sentiment, especially as we also anticipate low inflation.

The euro zone therefore has good prospects for a dynamic economic upturn in 2025. The unfavorable interest rate differential for the euro is likely to be more than compensated for by better growth prospects and falling government debt, boosting the external value of the euro exchange rate. 

US economy: Economic recovery likely in the first quarter of 2024

The US economy proved resilient despite the Fed's aggressive interest rate hikes in 2023. The rising key interest rates had the usual effect on the credit cycle: commercial banks tightened their lending standards noticeably and the growth momentum of bank lending slowed considerably as a result. At the beginning of 2023, bank lending to the private sector was still up 11.8 percent on the previous year. At the end of the year, the growth rate was then only 2.2 percent compared to the previous year. This would normally have been accompanied by a pronounced economic downturn. However, the markets for corporate and high-yield bonds did not follow the developments in the banking system and bond spreads even narrowed over the course of the year. Companies were therefore able to turn to the financial markets for financing. However, companies' financing requirements were rather low, as they were able to significantly strengthen their balance sheets during the pandemic and used the long period of low interest rates to take on debt with a long maturity.

Basically, it can be said that the financial markets were able to decouple themselves from developments in the banking system during this cycle, thus ensuring favorable financing conditions for the US economy. One reason for the decoupling of the financial markets was certainly the generous provision of liquidity by the US Federal Reserve during the banking crisis in March. Another reason was the euphoria of investors with regard to the opportunities that could arise from artificial intelligence (numerous studies confirm great potential here). The development of prices on the US stock markets was reminiscent of the mid-1990s when investors anticipated a noticeable acceleration in productivity growth.

The very positive performance on the financial markets in November and December 2023 in particular means that financing conditions have improved considerably, making an economic recovery more likely in the first quarter of 2024. In this environment, the US Federal Reserve is not likely to lower the key interest rate – even if inflation has recently fallen significantly. We do not see a key interest rate cut until June and expect interest rates to fall by a total of 100 basis points by the end of the year. 

Asian economy: Falling inflation in Japan; China's economy continues to weaken

There were increasing signs of a slowdown in inflation in Japan in the fourth quarter. In October, inflation still stood at 3.3 percent, but it fell to 2.6 percent in December. At the same time, wage growth slowed again. The previous surge in inflation in Japan was only a consequence of sharply rising import prices. As recently as September 2022, they climbed by 48.7 percent compared to the previous year. In December 2023, however, this increase was reversed and import prices fell by - 4.9 percent. The surge in import prices therefore did not trigger a domestic inflation process in Japan. Ultimately, however, Japanese households suffered a loss of income in real terms that was not offset by higher wages.

One reason for the sharp rise in import prices was the weak yen exchange rate, which should have improved the competitiveness of the Japanese export industry. In reality, however, exports hardly picked up at all. Japanese companies mainly produce locally in foreign markets, meaning that exports have become less important. However, the weakness of the yen means that Japanese companies recorded an explosion in profits last year, as profits generated abroad are converted at a favorable exchange rate. The high profitability of Japanese companies offers the opportunity to significantly increase investments in 2024 and thus make a positive contribution to economic growth.

China's economy remained weak in the fourth quarter. A crisis on the property market and a continuing low propensity to consume had a negative impact on the economy as a whole. The Chinese government is not dependent on foreign investors as it has a trade surplus and large foreign assets. It could therefore fire up the printing press at any time to stimulate the economy. Debt would then rise – but without macroeconomic relevance, as the Chinese government could print the money needed to service the debt at any time.

Due to ongoing economic weakness, pressure on politicians appears to be increasing. New government stimulus measures could therefore be adopted in the first quarter. However, the crisis on the property market is structural in nature. This means that new stimulus measures will boost the economy for one to two quarters, but then fizzle out again. The construction sector is still oversized and needs to shrink. In 2023, residential property construction accounted for around 6.6 percent of gross domestic product (GDP) compared to a normal level of around 4.0 percent. The Chinese economy will only be able to return to dynamic growth once this contraction process is complete, which is likely to take another two to three years.