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Should tensions escalate further in the Middle East, the following market reactions can be anticipated:
- Higher oil prices
- A stronger dollar, Swiss franc, and Japanese yen
- Declining yields on government bonds, but increasing credit spreads
- Declining stock prices and a rise in gold prices
An increasing oil price could push the European economy into a recession, where the ECB, given the rising inflation risk, cannot immediately respond with interest rate cuts. In the US, the economy is likely to slow down somewhat as well, but not significantly, as the country is fairly self-sufficient in terms of oil. However, history teaches us that the effects of war on the economy and markets are usually short-lived unless the conflict continues to escalate, which is not expected in our opinion due to a lack of vested interests.
Soon we expect the markets to primarily react to economic and monetary developments again. Here, it is becoming increasingly clear that Western economies are much less affected by sharply rising interest rates than previously thought. The US economy is currently growing at around 2.75%, while Europe is growing at about 1%. This means that growth in the US is above potential and in Europe, it is at potential. To curb inflation, growth needs to fall below potential. The ECB expects that with interest rates at their current level, they will slow economic growth and foresee growth in Europe falling to around 0.5%. If this is accompanied by downward pressure on wage growth and inflation, the central bank expects to be able to lower interest rates fairly quickly from June 2024 onwards.
But should Europe not learn from the US? In the US, interest rates have risen more, but growth remains relatively high. The main reasons for this are likely to be; much more immigration, fiscal stimulus, and accommodative monetary conditions. The latter are factors such as the exchange rate of the dollar, real interest rates, credit spreads, stock prices, and house prices. According to calculations by the Fed, monetary conditions are now looser than when interest rates were at 0%. All of these factors together contribute to keeping growth in the US significantly higher than expected, but many of these factors also apply to Europe. The higher-than-expected growth keeps inflation from falling or falling very slowly, and as a result, interest rates may also decline less than expected, and in our opinion also less than is currently priced into the markets.
All this is more applicable to the US than to Europe, which is why we expect the dollar to remain strong. Not only against the euro but also against many emerging market currencies. However, for them, the combination of a weak currency and high dollar interest rates is disastrous because they have borrowed heavily in dollars. It is understandable, therefore, that there are increasingly more calls to push the dollar's value down through interventions. We expect this will actually happen, but please note that interventions usually only achieve the desired result for a short period and in this case, will ultimately only slow down the pace of the US dollar's rise.
Furthermore, in this climate, we expect stock and bond prices to remain under downward pressure until economies start growing below potential. For more information, please read our latest Global Financial Markets report.
