Economy, interest rates and shares

In May 2024, the risk of recession in the US, Europe and Japan appears low, but this has also dampened expectations regarding interest rate cuts in the US. Nevertheless, the stock markets of the major industrialized countries remain close to record prices in the hope of interest rate cuts without a recession. How realistic is this scenario and how will shares react to a worsening economy or interest rate changes?

From the movements in interest rates for 2-year government bonds compared to the money market interest rates set by the central banks, it can be seen for the USA and Germany that money market interest rates will soon fall. Yields on 2-year government bonds always began to rise (green arrows in charts 1 and 2) before money market rates were raised. Even with all interest rate cuts, the downward trend in yields on 2-year government bonds (red arrows) began before the central banks cut money market rates. So far, the yields on 2-year government bonds have therefore been an absolutely reliable early indicator for the future development of money market interest rates.

Currently, 2-year interest rates have been falling for several months - in the USA the peak was reached in October at 5.22% (currently 4.96%) and in Germany at 3.36% (currently 3.08%) in July of last year (charts 1 and 2, dark blue line).

The expectations of interest rate cuts are supported by the high probability of recession calculated by the US Federal Reserve (chart 3) and by the leading indicators for economic development in various industrialized countries (charts 4, 10, 16) and in China (chart 26).

The US Federal Reserve's recession forecast model had already reached a very high value in January 2023, without a recession having yet occurred - unlike all recessions in the last 55 years. The reason for this is the US government's enormous new borrowing (see the capital market outlook from February 2024, which you can find here ).

The Leading Economic Indicator (LEI) of The Conference Board, a forecasting institute founded in 1916, has even shown a clear downward trend since December 2021, as it has before every recession since 1970 (chart 4). The indicator fell by 4% to 7% before all recessions until they began (chart 5). This time, it has already lost 13% since its last peak, without the economy showing any signs of weakness - extremely high government spending could therefore actually delay a long-overdue recession, presumably until the election of the next US president on November 5, 2024.

The US stock market has also behaved unusually. With the exception of a brief period after the first oil crisis in 1974, when the stock market did not follow the soaring leading indicator, the movements in share prices and the leading indicator ran in parallel (chart 6, share prices and LEIs are shown here and in the following charts on a trend-adjusted basis). The upswing in share prices since September 2022 with a sharp fall in the LEI is therefore very striking. This rise can be partly explained by the euphoria among large technology stocks, especially as there was no corresponding upward movement among smaller stock corporations (small caps, chart 7).

Small caps have reacted much more strongly to the sharp rise in interest rates for 10-year government bonds since 2021 with a below-average price performance than large companies (charts 8 and 9). Should the expected decline in interest rates set in, small caps are likely to benefit more from this, as they have shown a very negative correlation to interest rates in recent years.

In the eurozone too, a suitable leading indicator, the business climate indicator calculated by the European Commission, has reliably fallen before every recession (charts 10 and 11) and is still on a downward trend after the brief recession in 2023.

Both large (chart 12) and small companies (chart 13) react similarly to US companies to movements in this leading economic indicator. Large companies have defied the downward trend of the economic indicator since fall 2022 and achieved slightly above-average price gains, while small companies have not performed as well. Accordingly, large companies are likely to underperform when a recession occurs, especially as the recent upturn in share prices cannot be explained by a strong upward trend in large technology stocks, as is the case in the US.

The interest rate sensitivity of small companies is also much more pronounced in the eurozone, as in the USA (charts 14 and 15); the negative correlation here is -0.97 and thus almost at the maximum value of -1. The rise in interest rates had hit small caps much harder, but they are likely to benefit more when interest rates fall.

In Germany, the LEI, which has been calculated by the OECD for over 60 years, has also fallen and stabilized in recent months (Figure 16). This indicator also fell significantly before every recession. Like the LEI for the eurozone, it has also shown downward movements that were not followed by a recession, such as in the mid-1980s and 1990s, but a recession has always followed such a sharp decline as in the last two years in the last 50 years (Figure 17).

Share prices in Germany show the same behavior in relation to the LEI and interest rates as in the US and the eurozone, namely a positive correlation with the LEI and a negative correlation with interest rates. What is special about large companies, however, is that, unlike in the US and the eurozone, they have not ignored the decline in the LEI in recent years with above-average share price performance (chart 18). A recession should therefore come as no great surprise to investors. German small caps, represented here by the MDAX stocks (MDAX: index of medium-sized companies), have accompanied the decline in the LEI with a very weak price performance, meaning that the residual risks here should not be particularly high. In Germany, falling interest rates - a very likely side effect of a recession - will help small caps in particular, which have long shown a negative correlation with interest rates (chart 21), but also large companies (chart 20).

In the UK, the LEI has even risen significantly recently, while share price performance has been below average at the same time (chart 22). This means that the equity market should currently present few risks, especially as UK equities should also benefit from falling interest rates - their correlation with interest rates has been negative again for the past two years (chart 23).

The Japanese equity market presents a picture that differs significantly from that of Western industrialized countries. Although the usual and economically sensible positive correlation between the LEI and share prices exists here too in most cases (chart 24), the positive correlation between shares and interest rates (chart 25), which has existed without interruption for 35 years, is unusual and requires explanation.

Until 1989, Japanese shares had a similar reputation among investors as the major US technology companies currently do. It was firmly believed that high-tech products could only be manufactured in Japan in the future, as Japan had the best engineers, scientists and skilled workers. The management boards of major Western companies traveled to Japan to learn how to run industrial production in a modern way. At the height of the Japan euphoria, Japanese stocks had risen eight times as much as the global stock market over the previous 20 years (chart 26). In 1989, the dividend yield reached an all-time low of 0.4%, which had never been seen before or since (chart 27). When this bubble burst, large losses by Japanese investors led to a long period of stagnation in Japan's economy; the Japanese Nikkei share index did not return to its December 1989 level until 2024. Since that time, however, falling interest rates in Japan have been seen as a sign of a continued phase of economic weakness and have therefore not encouraged investors to buy shares, while the slight rise in interest rates in recent years (chart 25) is seen as a sign of economic stabilization and tends to help the stock market. This resulted in the aforementioned decades-long positive correlation between equities and interest rates in Japan.

Even in the economic miracle country of China, there is usually a positive correlation between the LEI and share prices (chart 28). However, the development of the LEI is not very encouraging (chart 29), which has shown an upward trend for almost 40 years, interrupted only briefly by the coronavirus crisis (2020). Since February 2022, the trend has been just as consistent. China is facing major problems and will no longer be the driving force for the global economy as it has been in recent decades (see capital market outlooks from November 2021(here), September 2022(here) and June 2023(here)).

Conclusion: Some stock markets, particularly the large companies in the USA, but also to a lesser extent in the eurozone, have achieved significant price gains in the last year and a half despite weak leading indicators for the future development of the economy, which is not in line with normal behavior. However, falling interest rates will also help these stock markets in the event of future economic weakness, as has been the case everywhere except Japan in recent decades. There is little risk in the German and UK equity markets and smaller companies everywhere, as they have not ignored the weakness in LEIs and are likely to react particularly positively to interest rate cuts, as has been the case in the past. China needs strong support from the government and the central bank to help Chinese equities overcome their weakness. The first signs of this support can be seen, but so far it is by no means sufficient.

Incidentally, this was the 50th FINVIA Capital Market Outlook. I am already looking forward to seeing what the 100th will contain.

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As usual, we will provide the key messages from our capital market outlook from 3 years ago here so that you can get a feel for our long-term forecasts.

You can find the Capital Market Outlook from May 2021 here. In it, we have compiled in detail all the arguments in favor of sustainably rising inflation rates:

• Rising government debt for consumption purposes
• Demography
• Deglobalization
• Money printing and economic stimulus programs due to corona

This was not a consensus opinion at the time. The US Federal Reserve raised interest rates for the first time in March 2022, i.e. 10 months later. It took the ECB until July 2022 to get around to its first rate hike from 0% to 0.5%.

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You can also download the capital market outlook here.