Impact of AI remains to be seen
Ms. Petersen, let's first look at the market environment. What are your expectations for the ECB and the Fed in the second half of this year and in 2025? To what extent do you expect them to cut interest rates?
We anticipate that both central banks have limited room for interest rate cuts. Therefore, we foresee more of a „gentle rate change“ rather than a comprehensive rate-cutting cycle as seen in the past. Specifically for the ECB, which has already started with its rate cuts unlike the Fed, we realistically expect two more rate cuts, which aligns more or less with the current ECB communication. For the Federal Reserve, we anticipate one to two rate cuts still this year. The Fed is likely to get started with its rate changes, but in a cautious manner.
A major issue is political uncertainty. We have seen elections in France and the UK, with France now having a parliament without clear majorities. What impact does this political uncertainty in Europe have on the markets?
The political developments in France need to be seen in a broader context. We are experiencing a global super election year, and governments are grappling with many challenges following the cost-of-living crisis in recent years, the aftermath of the pandemic, and in Europe, the energy crisis – all amidst the limited fiscal space of current governments. This has put pressure on several governments, including in France. With regard to the French bond market and stock market, the future government's direction is relevant for investors. This also concerns the increased fiscal risks in France. The fact is that the new government inherits a debt-to-GDP ratio that exceeds the Maastricht criteria of 3%. The EU Commission has already issued warnings to France, Italy, and other member countries. It's also a fact that S&P downgraded France's rating at the end of May. Thus, the new government faces a challenging fiscal situation.
What consequences could this have for the bond market?
It's possible that the spread, which is the risk premium of French government bonds compared to German Bunds, could settle in a slightly higher range than before the announcement of the elections. Previously, the spread was around 50 to 55 basis points, which was considered relatively narrow from a fundamental perspective. We will likely see somewhat higher levels now. Bond investors will certainly be keeping an eye on this.
What does the current political situation mean for the French stock market?
The situation in the stock market is different because the CAC 40 and the MSCI France are heavily influenced by multinational companies. Only about 15% of the revenues of French blue chips are directly connected to the domestic economy. Over 80% are generated internationally. This is a different starting point compared to the bond market, where fiscal risks play a bigger role. Nevertheless, multinational companies located in France will generally look at the direction in which the overall economic conditions in France are developing. Like many other countries, France has significant structural issues to address.
What are these issues?
In addition to geopolitical fragmentation globally, demographic change is a major structural shift, which also applies to France. One related question is how France's immigration policy will be shaped in the future, whether there will be enough local labor available, and how expensive this labor will be. For example, will there be an increase in the minimum wage? Which sectors will be more promoted and which less under the new government? These conditions play a role. But – as mentioned – the stock market in France is very internationally oriented.
Let's look at the stock markets in general. Where do you see opportunities in the second half of the year and beyond?
We see the greatest opportunities over the next 6 to 12 months primarily in the US stock market, driven by the advancement of artificial intelligence and the beneficiaries of artificial intelligence. We also remain optimistic about the Japanese stock market. In Japan, corporate governance reforms have convinced us, which have already increased earnings expectations and will continue to develop positively. While the Bank of Japan is normalizing interest rates because Japan has managed to dispel the specter of deflation, it is proceeding very gently. Therefore, we still expect negative real interest rates in Japan. In our strategic perspective, which means five years or longer, Japan is also one of our favourites among industrialised countries.
What are your assessments for the emerging markets, especially regarding China?
Tactically, we are neutral on emerging markets. Regarding China's medium-term growth prospects, we have a cautious view on the country and see challenges including a shrinking working-age population, issues in the real estate sector, and concerns about the debt situation in certain segments of China.
Where do you still see issues?
There is still uncertainty among Chinese consumers, which has prevented a catch-up effect in consumption that could have been expected after the end of lockdowns. Additionally, geopolitical risks are playing a role for us. From our perspective, Chinese assets carry a geopolitical risk premium. This is one of the reasons why we are cautious in our outlook on China, both tactically and strategically.
Are you also cautious about other emerging markets?
We like a number of emerging markets. We believe that countries like India and Mexico will benefit from structural changes. This includes demographic change, as both countries will have a young and growing working-age population over the next 20 years, whereas China is expected to see a decline in its population by about 140 million over the next 20 years. This contrasts with a rise of approximately 120 million in India's working-age population. We also favor Mexico and India in the context of the global reshuffling of supply chains. The Mexican manufacturing sector benefits from the so-called „nearshoring“ by the US. Generally, we are tactically neutral on emerging markets. However, strategically, we are overweight because emerging markets trade with a valuation discount not seen in four years.
The keyword AI has already been mentioned. Are these legitimate hopes or just temporary phenomena and therefore market exaggerations?
Over the next 6 to 12 months, we expect a focused, concentrated group of AI winners to drive returns. The hope in the medium term is that there will be a productivity boost at an aggregated macroeconomic level that also boosts economic growth across sectors. However, the scenario of widespread productivity gains in the short term is just one of several possible scenarios. In our view, the scenario of a group of concentrated AI winners is more likely in terms of tactical investment horizon. These are the large technology companies, chip manufacturers, as well as energy and utility companies. But the extent and speed of productivity gains through artificial intelligence across the board remain uncertain.
Why is that?
Estimates of how much US growth could be lifted by the advancement of artificial intelligence range from 0.1 percentage points of additional growth per year to 1.5 percentage points per annum. From our perspective, the lower range is more realistic. The question is also when these benefits will actually materialize on an aggregated level. If we think about the steam engine, it took 100 years. And the internet revolution, which began in the 1970s, took several decades for the productivity gains to materialise.
Why does the energy sector benefit from the AI boom?
AI data centers are very energy and resource-intensive. That is one reason why we believe AI could be inflationary in the short term and not deflationary as hoped, before cost-cutting effects are realised in the medium term.
Let's briefly look at the bond markets in the context of declining interest rates. Where do you see opportunities for investors there?
In the segment of government bonds, we still like the shorter and medium maturities. At the longer maturities, we make a clear distinction, viewing this segment neutrally from a tactical standpoint for industrialized nations, except for Japanese sovereign bonds. We are, for example, overweight in short-term US government bonds.
Why?
We believe that the issue of interest income remains relevant due to structurally higher interest rates currently. We have already talked about the limited room for interest rate cuts in the US. At the same time, investors should bear in mind that in the key markets for government bonds, such as US Treasury bonds and German Bunds, we still have an environment of inverted yield curves. Over time, we expect a normalisation of yield curves, meaning an increase in term premiums. Therefore, we are strategically underweight in US government bonds. We think that term premiums, which compensate investors for holding long-term bonds, will rise.
Is this especially the case in the US?
This is especially the case in the US, where we expect a more unfavourable fiscal environment compared to Europe. When we look at the current deficit-to-GDP ratios as a key driver of debt dynamics and compare Europe with the US, it appears that the debt-to-GDP ratio in the US is expected to move towards 150% of GDP by the end of the decade and towards 200% by 2040. In contrast, in Europe, fiscal rules have been reinstated since the beginning of the year, although there will be individual countries that will not be able to comply with the 3% deficit rule this year. In Europe, the deficit ratios are expected to narrow, and the overall debt-to-GDP ratio for the euro area as a whole is expected to stabilize sideways to slightly downward – unlike the US.
Let's go back to the deteriorating fiscal environment in the US. Do you expect this for all possible election outcomes in the US?Is this especially the case in the US?
Yes, we expect the deficit-to-GDP ratio to remain high in historical comparison under both a Democratic president and a Republican president. Currently, the Congressional Budget Office in the US estimates a budget deficit of around 6% over the medium term, only slightly lower than the 6.5% we saw on average in 2023. At the beginning of 2024, it was even at 7 to 8%.
Are there any other aspects that bond investors should consider?
There are two more reasons why we are less optimistic about the long end in the strategic perspective. First, we see persistently high and volatile inflation, and secondly, the fact that central banks are withdrawing from the market – cue, quantitative tightening.
Let's briefly consider the foreign exchange markets. Do you expect significant shifts in currency exchange rates in the near future?
We do not forecast significant shifts. For instance, looking at the Euro-Dollar currency pair, there are two major influencing factors: firstly, the transatlantic interest rate differential, and secondly, the risk environment. Generally, the fact that the Fed has not yet initiated a rate hike and is therefore expected to implement only one or two rate increases this year has supported the dollar. However, looking ahead, this interest rate differential is likely to narrow as the Fed begins to lower interest rates.
And what about the risk environment?
This naturally depends on the extent to which geopolitical risks actually materialise and how much the dollar functions as a safe haven. Looking at the performance of global stock markets since the beginning of the year, we find ourselves in a generally venturous environment, which could continue.
Finally, looking at alternative asset classes, where do you see interesting opportunities for investors?
We anticipate that demand for certain commodities, including industrial metals, will remain structurally higher in the long term. This is due partly to the transition towards a lower carbon world and also the advancement of artificial intelligence, which as mentioned, requires significant resources and energy for the establishment of data and computing centers. These markets currently experience some supply scarcity. Moreover, the expected investment boom is likely to benefit the infrastructure asset class.
Meet the person
Ann-Katrin Petersen is Head of Capital Market Strategy for Germany, Austria, Switzerland, and Eastern Europe at the Blackrock Investment Institute (BII). In the region, she assumes the role of thought leadership at BII on global economic and investment themes. Petersen is also a member of the global tactical asset allocation team and co-leads the European allocation team. She began her career in 2010 in the economic research department of Allianz SE and subsequently worked as a capital market analyst and investment strategist in the Global Economics & Strategy division of Allianz Global Investors before joining Blackrock in 2022. She completed her economics studies at the University of Bayreuth and the University of Nottingham. In addition, she holds a Bachelor of Arts in Philosophy & Economics and is a CFA charterholder.
