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Des Headwinds have been mounting for the global economy since the summer, with the ongoing situation in Iran prolonging the energy shock, tighter monetary policies and a sharp rise in long-term interest rates, as well as an accumulation of political risks.
Can markets continue to withstand this growing set of risk factors? Find out with Xavier Chapard, Strategist at LBP AM, in our latest edition of Market View(s).
Since this summer, headwinds have continued to build for the global economy, with the situation in Iran remaining deadlocked and prolonging the energy shock, tighter monetary policies and a sharp rise in long-term interest rates, as well as growing political risks...
Yet economic growth and corporate earnings continue to surprise on the upside and remain very strong.
This continues to support risk appetite in financial markets, which remains high, even though some asset classes have started to come under pressure since the end of the summer
Credit markets and European equities declined in September, but global equities remain close to their summer all-time highs. In our central scenario, energy prices would begin to ease towards the end of the year, thanks to a gradual recovery in energy flows through the Strait of Hormuz, probably after the US midterm elections.
Indeed, economic pressure is mounting on the US President as refined product prices rise, while Iran has a vital need to export its oil through Hormuz, which is no longer possible due to the US blockade.
In this scenario, central banks would not need to raise policy rates significantly, although we still expect a few further hikes by early next year.
That said, we have been forced to push back our expectation of a reopening of Hormuz over time. The longer the energy shock lasts, the greater its stagflationary impact on the global economy. If tensions escalate again in the Middle East and energy prices remain even higher for longer, central banks could tighten rates much more aggressively, increasing the risk of a hard landing for the economy during 2027. The probability of this scenario, which would be very negative for markets, has declined compared with the first half of the year but remains significant in our view, at around 20%.
In our central scenario, growth would remain solid through year-end, supported by the strong momentum seen this summer, continued investment booms in AI and defence, and still substantial fiscal support, particularly in China, Japan and Germany.
However, growth would slow somewhat next year due to the delayed effects of monetary tightening, higher interest rates and still elevated energy prices. Fiscal policy is also becoming less supportive outside Asia.
Inflation would continue to rise until the end of the year, exceeding 4% in Europe. It would then decline as energy inflation eases. This is all the more likely as the pass-through of energy prices into domestic prices and wages remains limited. Inflation would finally return towards target levels in both the euro area and the United States by early 2028.
Central banks would adopt a slightly more restrictive stance in the short term to reinforce their anti-inflation credibility but would proceed cautiously given the negative impact on an economy that is not overheating. The ECB and the Fed would each raise rates once in December and probably one final time in early 2027.
Our scenario remains constructive on equities over the medium term. The market stagnation since the summer, combined with the strong increase in corporate profits, has allowed valuations to adjust and they no longer appear so stretched. Our scenario reduces, but does not challenge, the outlook for further earnings growth.
That said, we remain relatively cautious for the coming weeks. The approach of the US midterm elections and budget discussions in Europe could bring political concerns back into focus at a time when seasonality is not favourable for equities. In addition, the third-quarter earnings season could prove slightly less positive than recent ones, given that earnings expectations have been revised sharply higher.
Under these conditions, we are reducing our short-term overweight in equities, while remaining far from defensive. We remain geographically diversified, with an overweight position in Chinese equities, which are inexpensive and could benefit from somewhat stronger policy support through to the end of the year.
On the fixed income side, we remain overweight bonds, particularly in Europe and at the short end of the curve. The sharp rise in interest rates this summer, which has taken long-term yields to their highest levels in decades, appears sufficient to offer attractive carry.
The more inflationary environment since Covid, together with stronger investment needs, justifies structurally higher interest rates. However, it seems to us that markets already adequately reflect these factors. Potential growth remains limited, and inflation risks are being effectively managed by central banks, which limits the sustainability of much higher rates. Furthermore, markets are still pricing in 100 basis points of additional rate hikes by the ECB and the Fed over the next year, which we believe is excessive.
In corporate credit, we continue to benefit from the carry offered by high-quality corporate bonds, whose fundamentals should remain resilient in the face of limited additional rate increases and a contained slowdown in the macroeconomic environment next year.
The views expressed (i) are considered reliable by LBP AM and are based on, or justified by, the prevailing economic, financial, market and regulatory environment, and (ii) are provided for information purposes only.