The slowdown is underway

The US economy is slowing after a very resilient start to the year, and the European economy is stagnating. Central bankers’ concerns are shifting from inflation to employment, with the moderation of inflationary pressures becoming increasingly visible. In the eurozone, inflation has even fallen back below the target set by the European Central Bank (ECB) for the first time in over three years. In the United States, inflation is very close to the Federal Reserve’s target. These factors allow central bankers to adjust their rhetoric and give them room to lower their key rates.

Indeed, despite the monetary pivot already underway in most developed countries, the level of key rates remains high and well above their neutral levels, which in theory allows economic activity to grow at its potential, without inflationary pressure. Central banks therefore have considerable room for manoeuvre before they reach these neutral levels, and the rate cuts to be expected between now and the end of 2025 remain substantial.

Cyclical rebound remains the most likely scenario in the medium term

While the global manufacturing cycle continues to contract, the return of key rates to neutral, or even below neutral in Europe, will help to revive credit and investment in the sector from the middle of next year. This rebound in the manufacturing cycle will have a knock-on effect on the services sector, helping to sustain a new, buoyant economic cycle. Inflationary pressures should continue to moderate until the economic recovery takes hold.

This environment is likely to be favourable for risky assets over the medium term. First and foremost for equities, through an improvement in earnings. In particular, cyclical sectors and discounted stocks should do well. Small- and mid-caps should also do well, as they are highly sensitive to the global cycle and have considerable potential to catch up.

Economic activity will also provide support for energy commodities, as well as for industrial metals if China’s fiscal stimulus helps to halt the contraction in property investment. Gold should continue to benefit from the fall in real interest rates and from demand from emerging central banks, which will remain high due to global geopolitical tensions.

Within bonds, the current slowdown coupled with disinflation is favourable for sovereign assets, but in the medium term, the upturn in growth will penalise this asset class. Conversely, such an environment would be more profitable for quality credit and high yield, although credit spreads are already at low levels.

Scenario risks and potential impact of the US elections

Risks to this central scenario cannot be completely ruled out, such as a hard landing for the US economy after the Fed’s key interest rates are kept at high levels, or a scenario of a sharp pick-up in inflationary pressures should the Middle East conflict escalate and lead to a rise in the price of oil. Finally, the US elections in November make certain factors uncertain.

For example, a presidential victory for Donald Trump and Republican control of both houses of Congress could rekindle inflationary pressures, with a rise in the public deficit and an increase in customs duties. These factors could weigh on emerging assets, but potentially also on Europe if trade tensions spread to the European Union. The resumption of inflationary pressures would also be negative for US sovereign bonds and could constrain the Fed’s rate-cutting drive. The latter are already suffering in the run-up to the elections, since the odds associated with a Republican sweep have risen sharply according to betting platform forecasts. A victory for Kamala Harris coupled with Democratic control of Congress (a relatively unlikely scenario) could weigh on US equities in the event of a rise in corporate tax rates, but would be a relief for emerging market assets.

In the event of a split in the US Congress between Republicans and Democrats, the impact of the US elections on business and financial markets would be limited, allowing the medium-term cyclical recovery scenario outlined above to take hold.

This article was originally published in .