After rain the good weather ?

After rain the good weather ?
After rain the good weather ?

First, the conflict in the Middle East has been a Source of volatility. Although markets believe that a head-on war between Israel and Iran can be avoided, the price of oil has approached its highest level in a year and the price of gas has surged. In a region that produces 35% of the world’s exported oil and 14% of the world’s gas, the effects of possible production disruption are a major concern. However, unlike previous episodes, and even if prices fluctuated sharply in response to geopolitical events, oil producers could exploit the abundant spare capacity to restart production without delay, which would help to mitigate the impact of this situation. Our central scenario is that a major escalation of tensions in the region and a sustained increase in oil prices appear unlikely. We expect the oil price to stabilize, around $91/barrel in September 2024 and at $87/barrel in December.

Figure 1. Geopolitical risk supported the rise in oil prices

Oil price in dollars/barrel

Second, in a context of generally high inflation, markets are wondering about the consequences of an increase in oil prices on the economy in general. In addition to geopolitical risk, there is therefore economic risk. Investors have begun to factor in the possibility that the American economy could face a stagflation scenario, a scenario which would be synonymous with high inflation and sluggish growth. This scenario seems unlikely to us. Examination of all the data since the end of the fourth quarter of 2023 shows an economy that is recovering and not stagnating. Although US growth slowed in the first quarter, US GDP stood at 1.6% annualized, compared to 3.4% in the fourth quarter of 2023. Details of the report show that growth is much stronger than the figure suggests. Consumer spending rose 2.5%, less than expected, but still a solid increase. Consumption of services increased by 4%, its highest level since Q3 2021, while consumer goods fell by 0.4%, penalized by lower vehicle sales. Non-residential investment and residential investment also grew at a good pace. On the other hand, inventories and net exports had a negative impact on quarterly growth. Public spending also slowed to 1.2% compared to 4.6% in the previous quarter.

Lately, rising oil prices and higher-than-expected inflation figures have contributed to the recent rise in rates. Investors are no longer expecting rate cuts in the United States this year. US Treasuries are now trading at 4.6%, 70 basis points higher than at the start of the year. Once again, investors are worried that the rise in rates could have a negative impact on investments and household consumption. In reality, the American economy is today less sensitive to interest rates. Unlike most economies in Asia and Europe, the American economy is essentially a service economy. Sectors such as information technology, travel, healthcare, entertainment, financial services, logistics or e-commerce are less capital intensive than manufacturing. Service providers need fewer factories and machines financed by debt. In this respect, the American economy differs from that of China or Germany, or even from the American economy of the period of the first rate reversal of 1979-1980, which was then more capital intensive.

As a result, even after a return of market volatility, our baseline scenario of a soft landing for the US economy remains unchanged with a probability of occurrence of 60%. Economic growth is expected to slow this year, and inflation to gradually return to a downward trend. We do not see the US economy going into recession. The Federal Reserve (Fed) should therefore be able to start reducing its rates in September. As for the conflict in the Middle East, it should, in our opinion, remain contained. In this scenario, the S&P 500 could, in our opinion, reach 5200 at the end of the year and the yield on 10-year Treasury bonds return to around 3.85% as investors integrate a cycle of falling bond rates. More substantial Fed next year. Under these conditions, quality bonds should display an attractive risk-return profile.

A bearish scenario (20% probability) could materialize if investors fear overheating of the American economy. In this scenario, “too strong” growth in the American economy and concerns about US fiscal policy would push the yield on 10-year Treasury bonds towards 6%. In this case, the S&P 500 would fall, according to our estimates, to 4400 and an allocation to alternative assets would then undoubtedly be essential to stabilize portfolios.

Our bullish scenario (20% probability) corresponds to a situation of marked disinflation in the United States and positive expectations regarding the growth of artificial intelligence (AI). This scenario assumes some investor optimism about AI’s prospects, continued strong U.S. growth, and inflation returning to a downward trajectory. In such a scenario, the S&P 500 could rise to 5,500 (even with 10-year Treasuries at 5%) on the back of better-than-expected earnings growth.

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