Significantly Higher Volatility Ahead
In recent months, financial markets have traded within relatively narrow ranges. The S&P 500 has fluctuated between approximately 6,800 and 7,000, the yield on 10-year U.S. Treasuries between roughly 4% and 4.3%, and the EUR/USD exchange rate between 1.17 and 1.20.
As we have noted on several occasions, this reflects a broad range of uncertainties that are preventing markets from taking a clear directional stance. Key concerns include:
- The risk of a potential military conflict between Iran and the United States, which could trigger a sharp increase in oil prices.
- Uncertainty surrounding the large-scale implementation of AI. Will it lead to lower prices and strong economic growth, or to higher unemployment and social unrest? The outcome depends on two critical factors: the extent to which AI drives economy-wide productivity gains and the number of new jobs created in parallel.
- For now, markets are pricing in a rapid acceleration in productivity growth, leading to rising unemployment and downward pressure on wage growth and inflation. As a result, expectations still include at least two 25-basis-point rate cuts this year by the Federal Reserve.
However, many experts expect U.S. economic growth to remain relatively strong, while productivity gains increase only gradually. At the same time, labor force growth has largely stalled due to demographic aging, a sharp slowdown in immigration, and the expulsion of foreign workers. Consequently, a growing number of economists believe that rate cuts may not materialize at all and that rate hikes could instead become necessary.
The recent ruling by the Supreme Court of the United States, declaring many previously imposed import tariffs under Donald Trump unlawful, raises further questions. Will previously collected tariffs need to be refunded? What are the implications for trade agreements concluded under the threat of elevated import duties that may ultimately prove unenforceable?
In the meantime, Trump has announced a general 10% import tariff, with the intention of increasing it to 15% as soon as possible. However, this measure is valid for only 150 days, after which Congressional approval will be required—approval that is highly unlikely to be granted. This raises the question of what follows. Without tariff revenues, the U.S. budget deficit would widen significantly. What would this imply for interest rates, and could it trigger a renewed tariff escalation or trade war?
From a technical perspective, our chart analysts expect the S&P 500 to edge somewhat higher before entering a bear market. This scenario appears plausible. NVIDIA reported excellent earnings this week, yet the stock declined thereafter. The most likely explanation is valuation: the company is priced for near-perfection. Given the numerous uncertainties outlined above, it seems unlikely that all variables will evolve favorably. Even minor disappointments could exert substantial downward pressure on the share price. The same applies to many other equities.
This could quickly become problematic, as credit spreads remain exceptionally tight and a significant amount of financing has been structured through private debt. Once equity markets begin to decline, this could easily trigger a broader chain reaction.
Naturally, we do not possess a crystal ball that reveals how these uncertainties will ultimately unfold. Nevertheless, we consider the following developments likely:
- Tensions between Iran, the United States, and Israel are, in our view, likely to culminate in a limited military conflict, pushing oil prices higher. This would be negative for equity markets, though probably not catastrophic. Europe would also be adversely affected, and we would expect the EUR/USD exchange rate to decline under such circumstances.
- We expect the U.S. economy to continue expanding at a solid pace in the near term, while productivity growth falls short of current expectations. As a result, we anticipate increasing signs of accelerating wage growth and inflation in the second half of the year, particularly in the United States. The Federal Reserve would then need to reconsider its easing bias and potentially contemplate rate hikes. This would be negative for equities, bonds, and credit spreads.
- We believe markets underestimate the extent to which AI will intensify both national and international competition. As a result, returns on AI-related investments may disappoint. The recent performance of NVIDIA’s share price may already be signaling this risk.
IIn our research reports, we take a closer look at what all this means for price movements in the major currency, interest rate, and equity markets over the medium term (3 weeks to 1 year ahead).
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