Outlook on the economy
Wages are (finally) keeping pace with inflation
It does seem clear that inflation in the eurozone and the US will continue to fall in the period ahead. Current expectations are for inflation rates to come in at around 2.5% in Europe and around 3% in the US by the end of the year. A more uncertain factor is how core inflation will evolve. This will depend partly on whether the recent cooling in services continues and how the related labour market evolves. There has so far been no sign of the feared wage-price spiral, even if the labour market tightness persists. A wage-price spiral can occur when higher wage costs are passed on in prices and those higher prices in turn lead to higher wage demands. Real hourly wages are only now rising above 0% for the first time since the COVID-19 pandemic. In other words, wages are now rising faster than prices.
Interest rate cuts not yet in sight
The risk of a wage-price spiral does not seem particularly high, despite warnings from, for instance, DNB and ECB (European Central Bank). This is because the economic outlook is moderate at best, inflation is easing and wages have not risen as much as the tight labour market might have suggested. In addition, it is likely that the effects of central banks' actions are only now starting to be felt. After all, base rates were raised substantially over the past year; in the US from 0% to 5.25% and in Europe from -0.5% to 3.5%. For the months ahead, the interest rate market is counting on further rate hikes. But what will happen after the summer? The most plausible scenario seems to be a period with interest rates remaining at stable high levels (for at least 3 to 6 months). This will give central banks the opportunity to better assess the impact of previous interest rate hikes on economic growth and inflation. If inflation does remain high, further interest rate hikes may be on the horizon. Should economic growth fall further than expected, the next step could instead be one or more interest rate cuts. But it does not seem very likely that such a move will be made this year.
Cash is king?
For now, it remains to be seen what effect central bank interest rate hikes will have on the economy and financial markets. One risk is that higher interest rates could push the economy into a deeper recession than currently thought. Another risk is that, despite higher interest rates, inflation will not be brought under control and further interest rate hikes will have to take place. Both scenarios seem unfavourable for more risky asset classes, especially equities. Central banks are expected to raise interest rates further rather than cut them, at least in the period ahead. This will favour cash and, to a slightly lesser extent, short-term government bonds.