Central Bank Inflation Fight To Carry On
- Central banks are set to hike policy rates this week. Markets expect rate cuts to soon follow due to cooling inflation, whereas we see central banks holding tight.
- U.S. stocks rose last week as initial earnings updates topped low expectations. We think earnings will contract in 2023’s second half as wage gains hit margins.
- The Fed and European Central Bank will likely raise interest rates again this week. We see the Bank of Japan opting to keep policy loose to sustain inflation.
The Federal Reserve and the European Central Bank (ECB) are set to hike rates again this week, yet markets have been taking this in stride. Soft June U.S. core inflation has revived hopes for rate cuts in 2024. This can fuel a bull run across assets for some time – until it runs into the disconnect between fast-falling inflation and stronger-than-expected economic activity. We look for opportunities beyond broad asset classes, such as the artificial intelligence theme in equities.
The surprising fall in June U.S. core CPI inflation was clearly good economic news. Yet how can inflation suddenly be falling if the U.S. economy is stronger than expected and the labor market remains tight? First, there’s a perception growth is strong. The reality is that the U.S. economy has barely grown over the last 18 months – despite historically tight labor markets and strong consumption. Second, the inflation story is complex. We are seeing a combination of 1) a shift in consumer spending from goods to services and 2) wage pressures from the tight labor market. The first is spurring goods deflation. The flip side is persistent services inflation, exacerbated by ongoing wage pressures. We expect core services inflation excluding housing (yellow line in the chart) to stay elevated due to those wage gains (dark orange line). The result? A rollercoaster trajectory over the next quarters before inflation likely settles near 3% – well above the Fed’s 2% target.
The U.S. dollar and Treasury yields slid after the CPI data, while stocks moved higher as markets embraced the hope of a “soft landing” – growth holding up and inflation coming down. This hope can sustain risk assets for some time even if it doesn’t pan out. A lot would need to go right for such an outcome, in our view. Activity would need to be held up even as the full force of the Fed’s rate hikes has yet to kick in. That may be possible if tight labor markets spur companies to hold on to workers after struggling to find them coming out of the pandemic. Inflation would also have to drop sustainably closer to 2%.
We expect a squeeze on corporate margins if inflation stays high – and an even larger squeeze if it falls. Tight labor markets are set to keep production costs high. A sustained fall in inflation could soften demand. Why? This would likely come from good prices falling further and/or labor markets weakening significantly. So good economic news like falling inflation is not necessarily good news for markets. Margins have already dropped, Refinitiv data show, suggesting companies are starting to have trouble passing higher costs to consumers. We are watching Q2 earnings for more signs of margin pressures.
We see most developed market (DM) central banks forced to hold policy tight to lean against inflationary pressure as they focus on tight labor markets. This is a key theme in our midyear outlook. The Fed, ECB and Bank of England (BOE) face a similar challenge: Inflation has cooled from lower goods prices, but wage gains look set to keep services inflation sticky – and overall inflation on a rollercoaster. We see them pushing ahead on the inflation fight this week, too – though growth is weaker for the euro area and the UK. The ECB and BOE have also tightened more aggressively than in the past and are still hiking. The story is different for the Bank of Japan. We think it may opt for a loose policy this week to sustain above-target inflation since Japan has fewer supply constraints.
Bottom line: Soft inflation data has rekindled hopes for rate cuts in 2024, even as central banks are set to hike more in the near term and hold tight for long thereafter. We use our new playbook to look beyond broad asset classes in this tricky macro environment. We tap into the AI mega force within DM stocks. Mega cap tech-led earnings forecast upgrades due to AI euphoria, and we’ll assess their Q2 earnings for ongoing strength. We upgrade UK equities to neutral as they better price in the weak growth outlook. We like Japanese stocks as the loose policy looks set to support earnings. We favor U.S. inflation-linked bonds as markets underestimate inflation’s persistence. Yet we prefer euro area nominal government bonds over the U.S. as they price in rates staying higher for longer.
U.S. stocks edged up on the week as early earnings updates, mostly from financials, topped low expectations. We expect Q2 results to be similar to Q1 – flat to slightly negative. We see a contraction later in the year as wage gains erode profit margins. Treasury yields steadied as markets eyed the signal from major central banks. UK markets breathed a sigh of relief on soft CPI data: Stocks climbed and 10-year gilt yields fell sharply on the week as markets priced in a lower peak in BOE policy rates.
Core inflation across developed markets (DM) is falling from last year’s highs. That’s good news. But we think the journey back to the central bank’s 2% policy target remains bumpy.
The sharp rise in core inflation was driven by two shocks. The first: A massive swing in spending toward goods and away from services during the pandemic. Demand surged and businesses couldn’t keep up, creating bottlenecks and soaring prices. See the chart. The second: labor shortages. Smaller workforces have created tight labor markets, with unusually low unemployment rates and companies struggling to fill job vacancies.
The good news? Spending is shifting back towards services, so goods inflation is falling. But labor markets are still tight. That will stoke wage gains and feed into services inflation. Core inflation seems set to ride a rollercoaster — dipping before climbing up again — but staying above 2%. We think that compels central banks to keep policy tight, with little room to cut rates as quickly as markets expect, especially in the U.S.
1 Holding tight
- Markets have come around to the view that central banks will not quickly ease policy in a world shaped by supply constraints – notably worker shortages in the U.S.
- We see central banks being forced to keep policy tight to lean against inflationary pressures. This is not a friendly backdrop for broad asset class returns, marking a break from the four decades of steady growth and inflation known as the Great Moderation.
- Economic relationships investors have relied upon could break down in the new regime. The shrinking supply of workers in several major economies due to aging means a low unemployment rate is no longer a sign of the cyclical health of the economy. Broad worker shortages could create incentives for companies to hold onto workers, even if sales decline, for fear of not being able to hire them back. This poses the unusual possibility of “full employment recessions” in the U.S. and Europe. That could take a bigger toll on corporate profit margins than in the past as companies maintain employment, creating a tough outlook for DM equities.
- Investment implication: Income is back. That motivates our overweight to short-dated U.S. Treasuries.
2 Pivoting to new opportunities
- Greater volatility has brought more divergent security performance relative to the broader market. Benefiting from this requires getting more granular and eyeing opportunities on horizons shorter than our tactical ones. We go granular by tilting portfolios to areas where we think our macro view is priced.
- We think dispersion within and across asset classes – or the extent to which prices deviate from an index – will be
higher in the new regime amid the various crosscurrents at play, allowing for granularity. That offers more ways to
build portfolio “breadth” via uncorrelated exposures, in our view.
- We think it also means security selection, expertise and skill are even more important to achieving above benchmark returns. Relative value opportunities from potential market mispricing are also likely to be more abundant.
- Investment implication: We like quality in both equities and fixed income.
3 Harnessing mega forces
- Mega forces are structural changes we think are poised to create big shifts in profitability across economies and sectors. These mega forces are digital disruption like artificial intelligence (AI), the rewiring of globalization driven by geopolitics, the transition to a low-carbon economy, aging populations, and a fast-evolving financial system.
- The mega forces are not in the far future – but are playing out today. The key is to identify the catalysts that can supercharge them and the likely beneficiaries – and whether all of this is priced in today. We think granularity is key to finding the sectors and companies set to benefit from mega forces.
- We think markets are still assessing the potential effects as AI applications could disrupt entire industries.
- Geopolitical fragmentation, like the strategic competition between the U.S. and China, is set to rewire global supply chains, we think.
- We see profound changes in the financial system. Higher rates are accelerating changes in the role of banks and credit providers, shaping the future of finance.
- Investment implication: We are overweight AI as a multi-country, multi-sector investment cycle unfolds.
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