Outlook on the economy

Rate hikes set to accelerate

Given the unfavourable pattern of inflation, the European Central Bank (ECB) has no choice but to further raise its policy rates in the coming months. The July hike will probably be by a relatively small increment of 0.25%, but larger steps could be on the horizon. It remains to be seen whether the ECB will keep pace with its US counterpart (the Fed) in raising its policy rates. Unlike the Fed, the ECB also has to consider the impact that higher interest rates will have on the eurozone’s stability. But all in all, the policy rates of central banks in developed countries all seem to be heading into the same direction, and that is up. The uncertain factor is how far up they will go, especially next year. This will depend mostly on the impact that the first rate hikes will have on inflation. This impact is as yet difficult to predict. Central banks’ plans will presumably be much more clearly defined towards the end of this year as those plans will be modified at that time.

More risks than opportunities

With higher interest rates and lower equity prices, financial markets seem to have been anticipating a stagflation scenario in the past six months. This is a scenario of low economic growth combined with high inflation, and it already seems to be factored in. Financial markets must now predict what comes next. A return to the pre-COVID situation of low growth / low inflation? Or, conversely, a scenario of high growth / high inflation, fuelled by large scale government investments in defence and the energy transition?

For now, we believe the most likely scenario will be a combination of moderate economic growth and a persistently high level of inflation – higher than central banks’ 2% inflation target, that is. That scenario would also leave some slack for even higher market rates, which have already risen considerably in recent months. This is an unfavourable scenario for the expected price development of government bonds. For equities and other riskier asset classes, too, such a scenario is not necessarily good news. There will be some considerable uncertainty for quite a while yet as to which scenario will eventually materialise. That argues in favour of exercising restraint in respect of equities, in our view. Corporate bonds might perhaps be a somewhat safer choice but we are not counting on high returns for this asset class either in the time ahead as interest rates continue to rise. Overall, the old adage ‘cash is king’ may still ring true in the months ahead. Accordingly, we will maintain our above-average cash position (money not earmarked for investment) and our underweight position in government bonds.