investment insights

    Unpicking inflation trends in a changing rate cycle

    Unpicking inflation trends in a changing rate cycle
    Samy Chaar - Chief Economist and CIO Switzerland

    Samy Chaar

    Chief Economist and CIO Switzerland

    Key takeaways

    • Despite strong US consumer price index (CPI) figures, the disinflationary trend continues, as reflected in other measures of US and global inflation
    • We cannot rule out another supply shock driving inflation higher, perhaps linked to geopolitical risks. A demand-related shock seems less likely, especially outside the US
    • We see the Federal Reserve (Fed) cutting rates by 75 basis points (bps) this year, the European Central Bank and Bank of England by 100 bps each and the Swiss National Bank by a further 50 bps
    • We reiterate our strategy of locking in current attractive sovereign bond yields. We keep equities at strategic levels and retain a portfolio overweight to the US dollar.

    The US consumer price index is defying a broader price normalisation globally. We still see US interest rate cuts in the second half of 2024, with Europe, Switzerland and the UK moving first. Geopolitical risks remain high, but with limited inflationary consequences for now.

    What is happening to US inflation? A third consecutive high consumer price index (CPI) reading has delayed interest rate cut expectations further, and even raised the possibility of a hike. From pricing in six or seven rate cuts at the start of the year, markets now expect just one or two in 2024. Persistent services inflation is fuelling concerns that the headline CPI figure has stalled a percentage point above target. ‘Core’ services inflation even reaccelerated in March.


    A delayed normalisation?

    Some trends in recent CPI figures may be a delayed normalisation from pandemic-era shocks. Housing costs were slow to move up in official inflation measures after rents for new tenants skyrocketed during the pandemic. Now that inflation of rents for new tenants has fallen sharply, the change may again just be slow to show up in official inflation indices. Car prices also rose sharply as parts were hard to source during and after the pandemic. Now services costs around cars, including insurance, may just be playing catch up.

    CPI is something of an outlier among US inflation measures

    Meanwhile many other important components of US inflation, including food, are falling, and goods prices are firmly in deflationary territory. CPI is also something of an outlier among US inflation measures. The March Producer Price Index (PPI) came in slightly below expectations. Recent personal consumption expenditure (PCE) data, which is the preferred index for the Federal Reserve (Fed), has also been around a full percentage point below CPI, both in terms of headline and core measures.


    Watching wages closely

    One crucial measure being watched by developed market central banks is inflation linked to wages. Here we see a normalisation underway. While the US labour market remains very strong – with many new jobs being created and low unemployment – it is nevertheless rebalancing. Average hourly earnings are declining and the number of people quitting their jobs is holding steady slightly below pre-pandemic averages. The labour force has been expanding and productivity rising. All four indicators of US wage growth show it falling to a 3-4% range. This level is consistent with headline inflation around the Fed’s 2% target.

    Should we fear a second wave of inflation? On the demand side, this would require either persistent fiscal or wage growth drivers. The latter is slowing, and the former is unlikely to reach the heights of pandemic-era aid packages and initiatives including the Inflation Reduction Act, Chips and Science Act, Infrastructure Investment and Jobs Act and the American Rescue Plan Act.


    Assessing geopolitical risks

    On the supply side, another shock, linked perhaps to geopolitical risks, cannot be ruled out. Beyond a high-stakes scenario of broader military escalation in the Middle East, we see two obvious channels for these risks to affect inflation: upward pressure on energy prices, and additional disruptions or re-routing in global supply chains. On the former, we note that significant spare oil production capacity in Saudi Arabia and the United Arab Emirates, and more limited capacity in the US, could be deployed to offset any short-term oil price disruptions. We have previously discussed geopolitical risk scenarios for oil prices here

    On the supply side, another shock, linked perhaps to geopolitical risks, cannot be ruled out

    We also note that global supply chains are already being redrawn in a way that reflects national imperatives to de-risk, secure supplies, and to trade and invest with allies. The Middle East contains three major chokepoints for global trade: the Strait of Hormuz, the Suez Canal, and the Bab al-Mandeb Strait. While historically, conflicts in the region have had few implications for global investors, a major escalation that draws in powers outside the Middle East remains a significant risk. Yet an extension of existing conflicts and ‘bloc logic’ remains our working assumption.

    And while current rises in energy prices make headlines, unless a spike here derails consumer expectations of future inflation (which are relatively steady for now), the Fed will not be inclined to react. While we remain alert to signs of a major supply disruption or labour market reacceleration, neither is our base case.

    Solid demand in the US economy may mean stronger services inflation for longer

    Rates to fall in the second half

    Still, solid demand in the US economy may mean stronger services inflation for longer. It also reduces the urgency for the Fed to cut rates. We still see core PCE inflation falling to an average of 2.7% in 2024, allowing for some monetary easing this year. We expect as many as three cuts of 25 basis points (bps) in 2024, dependent on incoming data – not just inflation, but also the strength of the jobs and housing markets, with an eye also on any signs of strains in the financial sector. The Fed will, if possible, want to avoid cutting rates immediately prior to the presidential elections, for fear of being dragged into political arguments. This may argue for a first cut in July if the data is favourable.

    We still see core PCE inflation falling to an average of 2.7% in 2024, allowing for some monetary easing this year

    US exceptionalism also extends to inflation

    Meanwhile, the US is very much the outlier among global inflationary trends. Inflation worldwide has been undershooting expectations this year. It has gradually normalised as the world economy has recovered from a series of shocks – from supply chain disruptions to higher energy prices after Russia’s invasion of Ukraine. Trends in the US have mirrored those elsewhere but unlike elsewhere, inflation has also risen due to demand-led price pressures. The US government gave more financial support to households which then translated into stronger consumer spending.

    Inflation worldwide has been undershooting expectations this year

    In Europe, the case for rate cuts looks stronger than in the US. In its March meeting, the European Central Bank (ECB) prepared the ground for a June rate cut. Eurozone inflation came in below expectations at 2.4% in March. Growth is well below trend and the continent’s manufacturing sector is still struggling as the US recovers. Eurozone banks play a bigger role in business lending than in the US, and surveys show credit conditions for loans are still tightening and demand for credit is falling.

    In the UK, we also expect the Bank of England to cut rates in June. While services inflation remains higher than the US, in part driven by a tighter labour market and lower productivity growth, it is falling, along with headline inflation. The economy is also weak. Meanwhile in Switzerland, which has already started its easing cycle, inflation is falling fast, and we expect a second cut of 50bps in June.

    A dollar overweight serves as a useful hedge against higher-for-longer US inflation and elevated geopolitical risks

    A dollar tilt and locking in attractive bond yields

    What do changing inflation and rate dynamics mean for our investment positioning? We reiterate the argument for investors to lock in attractive yields in high quality sovereign bonds, including those in the US (which moved higher after the CPI report), eurozone and UK. We keep equities at strategic levels, as we weigh an improving economy and rate cuts against very positive investor sentiment, full valuations, and the risk of volatility and corrections ahead linked to developments in the Middle East.

    Our longstanding overweight tilt to the dollar in portfolios has been anchored in US growth outperformance and the dollar’s yield advantage. The latter will only be extended if the Fed becomes a second mover to central banks across the Atlantic. Meanwhile, a dollar overweight also serves as a useful hedge against higher-for-longer US inflation and very elevated geopolitical risks.

    Important information

    This is a marketing communication issued by Bank Lombard Odier & Co Ltd (hereinafter “Lombard Odier”).
    It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication.
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