Lots to consider...

With interest rate cuts expected imminently in major economies, the release of the latest US Federal Reserve (Fed) minutes provided some useful insights from the biggest economy of all.

Fed officials continue to believe that the current level of rates is restrictive. Markets are currently pricing approximately1.5 US cuts through 2024, while the Fed has 3 pencilled in per their latest projections. This range doesn’t seem unreasonable to us, based on current conditions and signals.

In the last few weeks, markets have partially unwound the ‘US exceptionalism’ theme that had become so embedded in various assets, notably the US dollar. In other words, the investor appeal of the US has very slightly waned.

The combination of extremely bullish positioning, now unravelled, and softer-than-expected economic data, resulted in a weakening against various pro-cyclical and more volatile currencies, such as sterling and the euro. The increase in risk appetite within currency markets isn’t an outlier – equity, credit, and commodity markets have all gained in recent weeks too.

UK inflation for April came in hotter than expected.

The latest data? release showed that headline CPI – a key inflation measure in the UK – fell to 2.3% year-on-year, while core CPI, which excludes the more volatile components such as food and energy, fell to 3.9%. However, this figure was far higher than the 3.6% consensus was expecting.

Worryingly for the Bank of England (BoE), the upside surprise came entirely from the services sector. One data point doesn’t make (or disrupt) a trend, but they consider this to be the stickiest part of inflation, so this may their confidence in the rate at which UK price pressures are cooling (upon which they’ll make their rate cut decisions).

Investor expectations for a June cut have been pushed out from June, to July.

The recently announced election on 4th July is unlikely to materially change the inflation picture. Regardless of which party wins, there appears to be limited headroom for any meaningful fiscal spending. Any broader economic implications will become clearer once detailed manifestos have been released.

Are investors too optimistic on Japanese equities?

Japanese equities have outperformed Developed Market (DM) equities by a wide margin this year. Much of this stems from investors pricing in improvements in return on equity (ROE) given the ongoing corporate reforms.

We estimate investors are pricing in approximately11.5-12% ROE for Japanese equities. This compares to current trailing ROE of circa 9.5%, circa 13.5% for Europe and circa 18% for US equities. While some improvement in ROE should be expected – whether through returning capital to investors via dividends/buybacks or otherwise – this is a sharp adjustment in expectations without any real progress so far.

Given these corporate fundamental tailwinds, you’d be hard-pressed to find anyone who is pessimistic on Japanese equities at the moment. It’s always a reasonable starting point to assume markets have more or less efficiently priced in any and all information, but crowds are only wise if there is sufficient diversification of views. We suspect investors have succumbed to groupthink and gotten ahead of themselves a little here, even if the most-recent Japanese business reforms are hugely beneficial for the corporate sector in the long run.

In summary

Despite the global war against inflation being in its final stages, recent data releases show that prices remain stubbornly above central bank targets.

The Fed minutes confirmed a reluctance to speed up cuts before conditions merited it.? And it’s a similar story in the UK, where the BoE continues to tread very carefully. Having come this far, no central bank wants to move prematurely and risk unwinding the energy-sapping (inflation) progress that is starting to show.

And what about Japan? The economy and equity markets are clearly in robust health. But we think it’s prudent to question and scrutinise the short-term hype.

Caution remains the name of the game on a number of different investor fronts.

As usual we cover these themes and more in our weekly ‘Word on the Street’ podcast. Find out more, here .

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