The escalation in the Middle East as well as the sell-off on the bond markets weighed on investors' nerves in October. Despite the escalation, government bonds, which are considered safe havens, failed to provide protection in many places. Other factors, such as persistently high fiscal spending and still above-target inflation, weighed on bond prices (see FOCUS). In the United States, the budget deficit is set to double year-on-year from 1 trillion to 2 trillion (fiscal year 2023). Interest costs now account for almost 20% of increased spending. Suspended taxes for crisis-stricken regions, especially California, which was hit by historic floods, are also having a negative impact. US inflation was a negative surprise. Consumer prices rose more strongly than expected. PCE inflation, monitored by the FED, rose at the fastest rate in 4 months. However, the trend in core inflation (PCE Core) continues to decline on a yearly basis and was quoted at 3.7% for September. Increased patience will be required in moving inflation toward the 2% target. Even if the FED wants to claim the first decline in core inflation as a success, the average American is suffering from elevated inflation. A basket of essential consumer goods costs them about $700 more per month than it did two years ago, according to Moody's calculations. U.S. economic growth showed surprising strength in Q3 despite all the warning calls from higher interest rates and defaults. Quarter-on-quarter, the economy grew by a whopping 3.9%, as strong as the last time it grew two years ago - an unsustainable growth rate. The concert tours of stars like Taylor Swift and Beyonce as well as blockbuster movies ("Barbenheimer"), which gave a real boost to consumption, had a supporting effect. The 4th quarter is thus likely to deliver a less distorted picture of the US economy. In Europe, inflation is falling in tandem with economic activity. As a result, the ECB did not raise interest rates in October and advocates keeping them elevated for the time being. The FED is expected to do similar this Wednesday. Meanwhile, the Bank of Japan has abandoned the target range for long-term interest rates. Equity markets were weak, and the weakness was partly reinforced with earnings disappointments in large blue chips.
Losses on the global markets affected all regions. Unusually weak was the Swiss stock market, otherwise considered defensive, which was at the bottom of the ranking (-5.2%). Despite the weak markets, there was hardly any panic in sight. The fear gauge VIX rose to just above 20, although panic is only spoken of at values of 30-35. In Swiss francs, the annual gains have shrunk again significantly after the very weak October. Some leading indices are even in negative territory. The reporting season has so far provided positive surprises in terms of earnings, but has been largely disappointing in terms of sales. This is true for the US, and even more so for Europe. We are also seeing more negative revisions for 2024, which do not surprise us in view of the tighter financing conditions. For 2024, analysts still expect 11% earnings growth in the US market. Meanwhile, we believe this is overly optimistic given the tight financial conditions and weakening economy. In the short term, however, the stock markets are heavily sold off and countermovements cannot be ruled out based on the very negative sentiment.
Bond yields have recently risen sharply globally. In mid-October, U.S. government bond yields at times reached levels above 5% - a level last traded in 2007. At the same time, the U.S. yield curve has steepened significantly from its extreme inversion. The yield differential between ten-year and two-year government bonds was -1.1% in June and is now only -0.2% (see FOCUS). The rise in yields was accompanied by declining core inflation, rising real interest rates and slightly higher inflation expectations (market-based inflation rate in five years for the following five years). In Europe, the yield differential between Italian and German government bonds widened significantly, reaching over 2% for ten-year maturities in the course of the month. The jump in Italian bond yields followed the announcement by Prime Minister Giorgia Meloni of significantly higher deficits for the coming years. Movements in the Swiss bond market were much less pronounced, with ten-year yields oscillating at the low level of 1.05%. We consider the current yield levels in the U.S. and Europe to be attractive and have taken advantage of the recent rise in yields to increase the bond ratio and duration.
The Middle East conflict exerted upward pressure on oil prices and the gold price temporarily climbed to USD 2,000 per ounce. Diplomatic efforts to postpone a ground offensive by Israel and keep the war regional resulted in a countermovement in oil prices. The softening of monetary policy yield curve control in Japan, with the BOJ now accepting yields north of 1%, weakened the yen. As the central bank declared its willingness to intervene in the currency, the yen was able to move tentatively away from its lows for the year. No more interest rate hikes are likely to be expected from the major central banks as inflation continues to decline. We assume that the cycle of interest rate hikes in Europe and the USA has reached its peak and that key interest rates will be kept at restrictive levels for several quarters. We prefer the Swiss franc, especially in uncertain times.
The newly opened geopolitical front in the Middle East is causing further uncertainty. Increasing escalation could further complicate the already difficult task of fighting inflation. While further escalation is possible, it is not in the interest of Israel, Iran or Lebanon. Meanwhile, after the sell-off in October, the mood of market participants is extremely negatively colored. We have taken advantage of this and unwound some of our equity hedges to participate in a possible countermovement in equities. In particular, declining market interest rates could again lead to easing in the market into the end of the year. Nevertheless, the investment ratio in equities remains in an underweight. Our negative outlook for the coming year has not changed. Macroeconomic developments are in line with our expected scenario of a recession in 2024.