Equity investors want to have their cake and eat it – Part One

Equities are pricing in a goldilocks scenario where global economic activity reaccelerates while inflation declines further, allowing the Fed and other central banks to continue to cut rates. However, we think there is substantial risk to this view. 

In this two-part report, we take a closer look at the dichotomy of the clear slowdown in global economic activity and the simultaneous rally in equities. In our view, there is no doubt that the global economy has been slowing down significantly for a while now. Oil demand has been weak in 2024 and is close to signaling a global recession. Europe’s economies have been doing particularly bad, but also China seems to have finally reached a point where the government cannot simply strongarm the economy back on track. The US has remained a bright spot in the world for most of 2024, and real-time data still doesn’t indicate it’s in trouble just yet. But the longer the rest of the world struggles, the more difficult it will be for the US to prosper on its own. Especially if now tariff wars are on the horizon. Meanwhile, equities, and particularly US equities are hovering near all-time highs. In our view, this simply reflects the markets’ expectations that the Fed, and other central banks, will continue cutting rates, while simultaneously the economy re-accelerates. While we think it’s fairly plausible that central banks will continue to cut rates, we believe it can only happen if inflation continues to decline. And, in our view, that can only happen if the US and the global economy slow down further. A re-acceleration of the economy is not just unlikely in our view, it would also push inflation up again. Hence, in our view, the markets seem to be pricing in two scenarios that are mutually exclusive.

US equity prices continue to hover near all-time highs (see Exhibit 1). In our view, assets are pricing in a medley of seemingly contractionary futures. On one hand, equity prices are supported by expectations of a reaccelerating global economy. On the other hand, equities are supported by expectations for further rate cuts by the federal reserve (and other central banks). The problem is, the latter requires a further decline in inflation, while the former would most likely lead to a reacceleration in inflation.

Exhibit 1: The S&P500 remains near all-time highs

S&P500 Index

Source: Goldmoney Research

In the aftermath of the 2020 global Covid lockdowns, the world saw very strong economic growth, which was mainly a base effect. We can see this in commodity demand. Oil demand, for example, only reached 2019 levels by the end of 2023. In 2020, demand for oil, as for other commodities, plummeted at an unprecedented rate due to global lockdowns. It took three years of extremely strong demand growth – even in excess of global economic growth - to get back to the previous highs. These were one-off effects, and growth will be more in line with normal global economic expansion going forward. 

2024 was a very different year compared to the previous three. Global GDP growth has already slowed down meaningfully to just 3% last year. For this year, economists from the World Bank, IMF and investment banks are forecasting similar GDP growth. However, we think these forecasts are too optimistic. Several regions such as Europe and China slowed down dramatically in 2024, and it is unclear to us why they suddenly should reaccelerate. Other regions such as the US still have a remarkably strong economy. But high interest rates are starting to take their toll. The two main regions of concern though remain China and Europe. 

We have discussed the Chinese economic situation in detail in our report from last year (see “China will not come to the rescue”, March 26, 2024). In a nutshell, unlike in almost all instances of a global economic slowdown over the last 25 years, China is unlikely to come to the rescue this time. We think at best; China will not drag the rest of the world down due to its own economic problems. Since we published our report almost a year ago, we saw a dramatic shift in Chinese commodity demand. Oil demand declined year-over-year for the first time in a non-COVID year. The Chinese leadership aims to see the GPD grow by 5% in 2025. However, it will be crucial that the political leadership manages to stimulate the economy without being able to rely on boosting the construction sector. The long-term goal is to stimulate domestic consumption. And while there is a lot of potential over the long run, we don’t think stimulating domestic consumption alone is enough to achieve the growth target, as that would most certainly require further substantial debt expansion, which the central government has made clear it will not allow. Hence, the most likely way to achieve the growth target is to foster export, which is what saved China in 2024. But China’s exports are somebody else’s imports. Given the outlook for the US to impose massive tariffs on Chinese imports, China will find it difficult to push exports further.                           

The other struggling region is Europe. The GDPs of European economies have been on a sharp downward trend for much of last year. Germany has been in a shallow recession for six quarters now. Other countries such as France and Italy have held up better but are now close to contractionary territory as well. The Eurozone as a whole is still showing (barely) positive GPD growth but it’s now at the lowest level since coming out of the COVID lockdowns (see Exhibit 2).

Exhibit 2: GDPs of European economies have been on a sharp downward trend

Source: Goldmoney Research

Purchasing Manager Indices (PMIs) have also been on a downward trend. PMIs indicate economic trends. They are compiled by surveying business managers in the manufacturing and surveying sectors. Participants are asked about several indicators, whether they are improving or deteriorating, or have no changes. A number above 50 means expansion compared to the previous month, a number below means contraction and 50 means no change. European composite (manufacturing and services) PMIs have been indicating contraction since the middle of last year. While the PMIs of some countries have rebounded slightly from their lows over the past months, they are still in contractionary territory, indicating continued contraction albeit at a slower pace (see Exhibit 3). 

Exhibit 3: European Composite PMIs indicate contraction

Source: Goldmoney Research

Manufacturing PMIs show an even more abysmal picture. Manufacturing PMIs showed a strong contraction last year. We believe this was mainly on the back of the European energy shock. European energy prices have sharply declined since and until a few weeks ago were close to historical levels. Yet European Manufacturing PMIs still indicate contraction (see Exhibit 4). As energy prices are rising, this trend could become even worse.

Exhibit 4: European Manufacturing PMIs show strong contraction

Source: Goldmoney Research

Interestingly, this weak economic environment hasn’t yet resulted in higher levels of unemployment. Of the largest European economies, only Germany’s unemployment rate has gone up, but it is still well below the levels following the Covid lockdowns, and much below the post-financial crisis levels (see Exhibit 5).

Exhibit 5: The weak economic environment in Europe hasn’t led to higher unemployment yet

%

Source: Eurostat, Goldmoney Research

This is not unusual for Europe. Unlike in the United States, employment is strongly lagging economic contraction, the result of much more stringent labor laws.

Importantly, we think Europe is not coming out of a recession, the recession is just starting. Arguably European gas and power prices are much lower than they were in the aftermath of the Ukraine invasion. At first sight, this might suggest that the energy shortage that led to the current economic problems is behind us. But the reason why energy prices are lower is because demand has contracted so much. While the industry sector has done a tremendous job in implementing energy efficiency measures, a large amount of this industrial energy demand destruction is due to the permanent closure of manufacturing capacity as energy intensive production moved elsewhere. Hence, the normalization of European energy prices does not mean that the European economy will also return to normal. If it did, the energy shortage would return too. In our view, it is more likely that the effect of the loss of manufacturing capacity will have spill-over effects on the rest of the economy going forward. We expect unemployment to rise going forward and we also expect a slowdown or even contraction in other sectors than the manufacturing industry. 

In the second part of this report which we publish next week, we will take a closer look at the United States, which so far has weathered the sharp rise in interest rates much better than the rest of the Western economies.