Backdraft

Best laid plans…

Markets gasped this week on US data showing (dis)inflation not quite playing ball. Best laid plans based on a summer start to the interest rate cutting cycle were upended. Fixed income investors endured another painful (mark to market) slap, with bonds selling off as stubborn inflation potentially reigns back the scale and frequency of imminent interest rate cuts – particularly in the US.?

The question for investors here is whether the news of this week changes the range of probabilities sufficiently to act. We explore below and in this week's Word on the Street podcast .

Is inflation back?

The familiar warning here is that the more strident the answer to this question, the more untrustworthy the source. The fact that we are in the middle of another terrifying, tragic and confusing time on this planet increases our vulnerability to the false reassurance offered by overconfident soothsayers. This goes for inflation forecasting as much as other areas of crystal balling of course.

For the moment US disinflation seems to have paused. (Figure 1). That fact may conceivably tell us very little about what is going to happen in the months ahead. Nonetheless, in the context of that necessary humility on the outlook for inflation, it is worth exploring what a continuation, or even worsening, of that trend would mean for the economy and asset markets.

The first and most obvious point surrounds the path of interest rates. With inflation loitering unhelpfully above target and the economy still seemingly humming, we should expect less from the US Federal Reserve. Markets have already moved a long way. At the beginning of the year a rate cutting bonanza was pencilled to begin in March. That expectation has largely fizzled out, with many now seeing US interest rates on hold for the whole of 2024. Some are even warning of more interest rate rises .

At the same time, a divergence is emerging between the major central banks which have recently been moving in lockstep with one another. While the European Central Bank was previously expected to cut rates in sync with the Fed’s timing, it may now make the first move as eurozone inflation cools faster than in the US.

Does this increase risk of a crash?

The US economy continues to motor on according to most credible measures. As we pointed out last week , we are even seeing manufacturing revive a little. Nonetheless, the step change in interest rates this last couple of years is obviously putting huge strain on certain segments. Rising delinquencies in auto loans and credit cards speak of the stress on certain lower income houses. Meanwhile, the crash in the office real estate space is being held in suspended animation for now.

The longer interest rates remain at these levels, the more these actors and their creditors are going to struggle to kick the various cans down the road – ‘extend and pretend’ as this is often less charitably labelled. It is worth also pointing that there may be other sectors, hitherto unnoticed, that are finding their business models unsustainable amidst the current constellation of interest rates.

So, the risks of a financial accident would probably increase if the last half mile of inflation continues to prove stubborn.

So how does that change my investments?

The difficulties here are several.

First, the stall in disinflation could simply be temporary - the statistics still have room to catch up with reality in some areas, such as property. In any case, the US private sector remains in robust health , benefitting from a strong employment backdrop characterised by rising real incomes across all income segments . The bar to bet against the US economy should be high in such a context, even if interest rates stay higher for longer.

Second, it may simply be that US interest rates are not as restrictive at current levels as thought. Perhaps the policy rate that is supposed to hold the economy roughly in balance has risen . There are certainly a number of plausible reasons why that might be the case, from trends in productivity to the green transition. That may not change the risk of an accident. However, it should raise the cost of disinvesting or turning overly defensive in your investments.

The dangled investment carrot remains centred around the unfolding industrial revolution. This is front and centre in how the strategic weights are allotted between and within the various assets in our multi-asset class funds and portfolios. This is not an ‘all in’ bet of course, but a carefully calibrated, constantly optimised package.

This week’s inflation news from the US doesn’t materially change that main portion of the multi-asset class funds and portfolios are invested. There is more debate in the team on the package of (short-term) tactical investments sitting on top of that (long-term) strategic allocation. The range of futures reflected in markets looks to have invested sufficiently to reveal a few more tactical opportunities. More on that next week. For now, the message remains that the team is watching developments closely on your behalf.

And don’t forget, we cover these themes and more in our weekly ‘Word on the Street’ podcast. Find out more, here .

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*This article is for information purposes only. It is not intended as a product offer or investment advice