2024 Q2 Global Economic Outlook (I) - US and Europe
In our 2024 Global Economic Outlook, we made predictions about the trajectory of the global economy in the first half of 2024. Our analysis accurately highlighted the market's excessive optimism regarding interest rate cuts at the end of last year. In today’s article, we will look back and analyze key events and market dynamics in the first quarter and share our views on the economic outlook in the US and Europe.
US – A Bumpy "Last Mile" Battle Against Inflation - Rate Cuts in Q3
In early 2024, the United States experienced an unexpected surge in inflation. The Consumer Price Index (CPI) for January and February exceeded market expectations, holding steady at 3.2%, thereby delaying market expectations for rate cuts. Forecasts at the end of 2023 anticipated a 150-basis-point cut in 2024, but they have significantly decreased to 71 basis points, implying three rate cuts within the year.
The latest inflation data for February reveals that energy prices were the primary driver of the inflation rise, particularly with gasoline prices increasing by 3.8% on a month-on-month basis. This indicates that the deflationary effects of declining energy prices are nearing their end. We anticipate that energy prices will continue to push overall inflation higher in the short term and erode consumer purchasing power.
The core CPI (excluding food and energy) rose 0.4% month-on-month in February due to strong increases in housing rents and healthcare service prices. We believe that service sector inflation remains a stickier component of inflation. Given that housing accounts for one-third of the overall CPI and is a key driver of core service inflation, a significant and sustained decline in housing prices is necessary to bring inflation to the Federal Reserve's 2% target. While the trend of U.S. inflation moving towards the 2% target remains unchanged in general, the process will take longer than most anticipated and will require consistent decreases in energy and housing prices. In our view, US inflation will gradually move down to around 2.5% by the end of 2024.
In addition, the US labor market continues to show strength, with robust job growth and wage increases. In February, there were 275,000 new jobs added, exceeding market expectations. The average hourly wage growth in February reached 4.3% year-on-year, which remains at a high level from the Federal Reserve’s perspective. The strong labor market signifies that inflationary pressures may persist for a longer period. Meanwhile, thanks to high consumer confidence, low unemployment rates, and stable income growth, consumer spending remains strong. In January 2024, seasonally adjusted consumer credit grew at an annual rate of 4.7%, with revolving credit, including credit card debt, growing at a rate of 7.6% annually. This strong consumer demand keeps inflationary pressures elevated, further confirming the case of “High for Longer”.
In the March FOMC meeting, Fed Chairman Powell stated that "a rate cut is appropriate at some point this year, and most officials remain confident about inflation reaching its 2% target”. These remarks were seen as dovish by the market and further fueled expectations of a rate cut in June. The futures market is currently pricing in a 67% probability of a rate cut in June, up from the previous 50%.
However, we are in the camp of two rate cuts this year given that there are significant divisions within the Federal Reserve. Among the 19 voting members, 10 predict three rate cuts, while 9 predict two rate cuts. Although the "three-rate-cut camp" has a slight majority, their advantage is not significant. Yet, this important fact has been largely overlooked in the media. It is also worth noting that Powell's dovish remarks are not based on a guarantee of future economic trends but rather due to a lack of more effective measures. Additionally, we have observed a rebound in energy and commodity prices this month, which questions Powell's previous view that the inflation pick-up in January and February mainly stemmed from seasonal factors.
Considering the upcoming U.S. election in November, a rate cut in the summer is risky since it may raise suspicions of political intervention for the Democratic Party. This, coupled with strong inflation and labor data this year, adds to our conviction of two rate cuts within the year.
Regarding the US stock market, we recommend the "buy the dip" strategy to enter the market during pullbacks. First, the Fed's planned rate cuts are expected to provide strong support for the stock market's rise. Second, recent AI-related stocks such as NVIDIA (NVDA.US) and Super Micro Computer (SCMI.US) have continued to reach historical highs. For example, NVIDIA's financial report released at the end of February showed that AI hardware demand exceeded expectations, attracting widespread market attention. Most financial institutions are bullish on the continued market growth driven by advancements in AI technology.
Furthermore, history shows that election years usually bring favorable stock market returns. The trend could be significant given that U.S. households have up to 40% of assets in the stock market. Additionally, in eight rate-cut cycles since 1984, the S&P 500 index has, on average, risen 2% in the 3 months following the first rate cut and 11% within 12 months. The index has also mostly shown an upward trend in the first half-year before the rate cut.
According to UBS's data, retail investors have accumulated a staggering $962 billion in cash over the past 94 weeks since May 2022. Once rates are cut, these funds are expected to flow back into the stock market, further driving index gains. Further factoring in the upcoming easing cycle, robust GDP growth, low unemployment rates, and close-to-target inflation, we hold an optimistic view on the performance of the U.S. stock market this year. We reckon that by the end of this year, the S&P 500 index could reach levels of 5500-5550 points, corresponding to a 15% annual increase.
Due to the unexpected rise in recent inflation data, the yield of the U.S. 10-year Treasury bond has climbed from 3.8% at the beginning of the year to 4.2%. This reflects a downward revision in market expectations for rate cuts. However, due to the sticky inflation, the Fed may need more time in the "Last Mile" Battle Against Inflation. Therefore, in the short term, bond yields may continue to rise. Nevertheless, as the Fed is highly likely to initiate a rate-cut cycle this year, bond yields will eventually start to decline. From our perspective, 4.3% 10-year Treasury yield will present a good buying opportunity to lock in long-term high returns. Investors can consider adopting a Barbell strategy, which combines the allocation of short-term and long-term bonds to achieve a balance between risk and return. Alternatively, they can directly invest in US long-term Treasury bond ETFs (such as TLT.US) to have a larger capital gain when the bond prices rebound.
Europe - Lack of Momentum - Rate Cuts in Q2
The latest CPI data indicates that year-on-year inflation in the Eurozone dropped from 2.8% to 2.6% in February. Although this figure still exceeds the 2% target, the ECB maintains a dovish stance. In our previous analysis of the European market, we pointed out that the ECB's tightening cycle had come to an end and predicted an interest rate cut in the second quarter. Considering the downward trend in inflation and the fragile economy in the Eurozone, we maintain our previous conviction that the ECB will cut rates in the second quarter of this year, ahead of the US. The market is predicting an interest rate cut by the ECB in June.
Geopolitics will continue to be a major factor that influences the Eurozone economy in the next one to two years. In that, the Energy sector remains an unavoidable topic. Due to a mild winter and increased natural gas reserves, the price of natural gas in Europe has been consistently declining in recent months. The Dutch TTF index, which serves as the benchmark for European natural gas prices, has significantly dropped to around €25 per megawatt-hour (MWh), a nearly 50% year-on-year decrease. The decline in natural gas prices will further drive down inflation. However, despite the improvement, Europe has not fully resolved its energy crisis. The structural issues concerning European natural gas persist as the increased supply of liquefied natural gas has not completely offset the loss of Russian gas imports. Thus, European natural gas prices remain susceptible to supply disruptions or surging demand, especially during the winter. Another factor to watch out for is the worsening Red Sea crisis, which may increase the transportation costs of liquefied natural gas and impact European energy supply and, therefore, prices.
Unlike the robust US economy, the Eurozone's GDP growth in 2023 Q4 remained stagnant at 0%. Five consecutive quarters of low or even negative growth rates show that the Eurozone is still in stagnation. Although the recent unemployment rate has fallen slightly, productivity in the Eurozone is constrained by various factors. For instance, employment growth is primarily concentrated in low-productivity service industries, while the manufacturing sector has started downsizing amid industry downturns. Along with this, we observe that the Eurozone's job vacancy rate has continuously declined to 2.7% over multiple quarters. This suggests a gradual shift in labor supply and demand, weakening workers' bargaining power for wage growth against their peers in the US. Consequently, we believe that wage growth in the Eurozone will decelerate, and that the sticky inflation in the service sector will also decline.
The European Stoxx 50 index reached the 5,000-point milestone for the first time in 20 years. As a benchmark index for European stocks, the rally of the European Stoxx 50 index is primarily driven by ASML, SAP, and LVMH, with these three stocks accounting for nearly half of the index's year-to-date gains. Moreover, a dovish central bank and relatively cheap valuations have also boosted the European stock market. For sectors, we believe that AI-related stocks like ASML will continue to thrive on the wave of AI's rapid development and grow to even higher valuations in the future. In addition, stocks in the aerospace sector, such as Airbus, will continue to benefit from increased demand for aircraft.
Across the English Channel, the UK's GDP in the previous quarter continued to contract, entering a technical recession. Much like the Eurozone economy, the UK economy remains fragile and lacks growth momentum despite minor improvements in the consumer sector. We are convinced that the sluggish economy with declining inflation will prompt the BoE to cut rates ahead of the US.
