Walking the Tightrope

Debt ceiling drama
Mixed Messages from Central Banks
German Economy Stumbles

Recently, the focus has been on the debt‑ceiling, instability within the banking industry, and uncertainty regarding the Federal Reserve's (Fed) future actions. However, it is the economy that determines the trajectory of market movements. Beyond the short‑term noise of the debt‑ceiling headlines, markets will ultimately shift their attention towards evaluating the prospects for economic growth, inflation and Fed policy. These fundamental drivers of long‑term investment performance do not suggest that the view ahead is clear. Despite that, during May the developed markets stocks’ index MSCI World (EUR) has risen by 2.52% and the emerging markets stocks’ index MSCI Emerging Markets (EUR) has added 1.81%.

Debt ceiling circus captures the market’s attention

The political drama around the debt ceiling and the frequent tense negotiations resulting from a 1917‑dated law that essentially created the debt ceiling was originally intended to make Congressional leaders’ lives easier, not harder, never seems to end. The existing debt ceiling was hit on January 19, and since then the U.S. Treasury has initiated extraordinary measures to pay for the country’s bills. Those efforts were expected to have been exhausted by June 1. This so‑called "x‑date" is when the U.S. would need to raise or suspend the debt limit to avoid a default. While both parties agree that defaulting on debt is not an option, politicians appear tempted to use the process for their advantage. In the near term, we see little meaningful risk – rather, a market “noise” – which is part of investing and can result in market volatility until the end settlement is reached, for now.

Mixed messages about what's next for the Central banks

Some uncertainty surrounding prospects for a June rate hike has contributed to a rise in yields over the past month. Fed officials have shared mixed views on the need for further rate hikes. Recently, Minneapolis Fed President Neel Kashkari mentioned in an interview that a June hike is a “close call”, while other officials have adopted a milder tone focusing on the lagged effects of the prior hikes. Unless there is a major unexpected development in the upcoming inflation and employment data before the June meeting, indications suggest that the Federal Reserve is preparing to adopt a more cautious approach, as hinted in the May meeting. After a substantial rate increase from near‑zero to slightly above 5%, monetary policy is now considered restrictive.

The European Central Bank (ECB) raised its key interest rates by 25 bps during its May meeting, signaling a slowing pace of policy tightening. All ECB policymakers but one, backed the 25‑basis‑point increase in the ECB's main deposit rate to 3.25%, which follows an unprecedented series of 75 and 50 basis point increases since last July. Meanwhile, President Lagarde told a news conference that the ECB had more ground to cover and it was not pausing the rate‑lifting cycle, anytime soon.

Uncertainties Surrounding Germany's Economy

In the past, Germany has served as Europe's primary economic flagship, leading the region through various crises. However, this resilience is currently deteriorating, posing a significant risk to the entire continent. Output in Europe’s largest economy dropped 0.3% in the first three months of the year, following a 0.5% contraction at the end of 2022, official data showed.

German equities have been propelled higher by strong first‑quarter earnings from such industrial powerhouses as Siemens AG, Bayerische Motoren Werke AG and Mercedes‑Benz Group AG. But with manufacturing orders starting to weaken, there are question marks over the sustainability of those profits. The International Monetary Fund estimates Germany will be the worst‑performing economy among the Group of Seven nations this year. If it stumbles further, it may drag the entire Euro zone into recession. Germany's DAX equity index is hovering near an all‑time high, even though the country is technically in a recession, having posted two consecutive quarters of negative gross domestic product.

DAX German Equity Index

“House view” update

The investment team believes that the combination of positive and negative factors justifies maintaining a neutral risk allocation, resulting in the decision to keep the budget for neutral risk allocation unchanged.

Luminor House View

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