By: Peter McLean
For most of this year, investors have been in a jubilant mood. Fears of a US recession, which dominated in 2022-23, were replaced with the hope of a ‘goldilocks’ economy, with growth remaining firm and inflation gradually easing.
Furthermore, indications from the bond markets in January suggested that the Federal Reserve would cut interest rates soon and potentially as many as six times in 2024 alone. As the positive sentiment spread, stock market record highs became a regular occurrence.
Unfortunately, though, the economy didn’t follow the script. Consistently higher-than-expected inflation and employment figures ignited fears of an overheating economy. Perhaps more interest rate hikes might be needed to cool animal spirits and get inflation under control once and for all? Equity market momentum paused in April, and bond investors signalled that only one or two rate cuts were now more likely this year.
While some elements of inflation have proven stubbornly high, there is little evidence of an upward inflation spiral. In mid-May, when core US inflation fell to 0.3% for the month of April, and 3.6% year-on-year (the lowest annual reading in three years) investors and policymakers breathed a sigh of relief. Since then, equity markets have re-accelerated to new highs, while declining interest rate expectations have supported returns for bond investors.
The path of inflation is a key indicator in the setting of investment strategy as it underpins interest rate policy and can have a meaningful impact on capital markets. Drivers of price pressure, such as inflation expectations and wage growth can be used to indicate inflation’s next move. Currently, neither is trending convincingly higher. It is worth noting that some components of US inflation experience an annual price adjustment in the first quarter of the year, such as healthcare, auto insurance, and financial services. These lagged elements have seen meaningful increases and caused most of the recent inflationary scare.
In addition, longer-term inflation drivers continue to ease gradually. Importantly, the labour market is not in the same place it was two years ago. Since March 2022, job vacancies have fallen by 3.5 million, while the labour force (including those in work and those looking for employment) has grown by about 4 million. This has weighed on wage growth. As time passes, the ratio of labour demand to labour supply will likely fall further. Savings accumulated during the pandemic have been exhausted by most measures, and interest rates remain at the highest level since 2007, making it less likely for consumer spending to re-accelerate.
Consumer resilience supported the economy for longer than most expected, staving off a US recession in 2022-23, something that many feared was inevitable. Our multi-asset portfolios have benefited from our fully engaged position in equities. However, as the consensus has shifted towards this constructive view, sentiment has rallied, and market valuations have re-rated to higher levels.
With growth moderating gradually, lower inflation lies ahead. In due course, this will support lower interest rates with fewer reasons to retain a ‘restrictive policy.’
While there is little evidence for an imminent US recession, should growth continue to slow gradually over the coming months, it may lead to rising unemployment, which in turn could lead to declining consumer spending and corporate profits.
With some perhaps distracted by the bumpy path of inflation and worries of economic overheating, investors would do well to watch these developments closely, ensuring a well-diversified and robust investment strategy for the long term.
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