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Investors may be placing too much confidence in a combination of resilient economic growth, contained inflation risks and manageable supply disruptions, according to Deutsche Bank, which believes today’s market backdrop is unlikely to remain in equilibrium indefinitely.
Macro strategist Henry Allen said global equities are trading at record levels while expectations across rates markets suggest central banks have almost finished raising interest rates. Commodity pricing, meanwhile, indicates investors are largely assuming that existing supply disruptions will remain contained.
“This goldilocks window isn’t a sustainable equilibrium,” he wrote, adding that markets are “pricing a near-immaculate scenario where basically everything goes right.”
Deutsche Bank sees two broad ways in which that optimistic backdrop could unravel. The first involves economic growth remaining stronger than expected while increasingly loose financial conditions make central banks more concerned about inflation.
Bloomberg’s measure of U.S. financial conditions recently reached its most accommodative point since 1996, according to the bank. That easing comes while headline and underlying inflation rates remain above target across many of the world’s major economies.
Such a combination could force policymakers to tighten monetary policy more aggressively than investors currently expect. Markets are pricing just one Federal Reserve rate increase, but Deutsche Bank noted that historically, tightening cycles have rarely consisted of a single hike followed by no further action.
The second possibility is that growth weakens. In that scenario, the economic resilience currently helping to sustain elevated risk-asset valuations would begin to disappear.
Allen stressed that an outright recession would not necessarily be required to produce meaningful market declines. Deutsche Bank cited the 2015-16 corrections and the 2022 bear market as examples of episodes in which economic slowdowns were enough to force investors to reassess asset prices.
Commodity markets could add another layer of risk. Oil remains below its recent peaks and futures prices decline further along the curve even though the Strait of Hormuz remains blocked.
Deutsche Bank believes another significant supply disruption could therefore present a particularly difficult outcome for investors. Such a shock could simultaneously undermine equities and bonds, leaving markets exposed after pricing in an economic environment where relatively little is expected to go wrong.