As we have moved swiftly into the second half of the year, the debate surrounding inflation, interest rates and the policies of central banks rumbles on. These are issues that have dominated the investor picture for some time.
Much of what has played out this year, particularly in regard to inflation, has been far from what was expected. It has resulted in not just a higher-for-longer outlook, but a higher-for-a-great-deal-longer position, which has created much uncertainty along the way.
Is this now changing (finally)? Inflation globally is falling, albeit reluctantly and slowly. There is a sense that it is coming under control. The fact that the Bank of England (BoE) hit its 2% target in May was welcome news and contributed to presenting a more upbeat picture going forward.
Yet, as with much of what has happened with inflation, this is not clear-cut good news. “Whilst inflation is back down to the BoE target of 2% the underlying data remains a concern,” says Paul Flood, head of mixed assets at Newton Investment Management.
“Service sector inflation remains too high at 5.7% driven by wage rises as restaurants and hotels have passed on those demands,” Flood adds. “Whilst the headline level of inflation may be down at target, it may not stay there for long.”
Even within this brief assessment there is much to cause concern.
Gradual and cautious
It has fallen to the European Central Bank (ECB) to change the narrative. The ECB was the first major central bank to act, with a 25 basis points cut in June to 3.75% – the first such cut it has made in five years.
The cut, on the face of it, looked decisive.
But when you look at ECB president Christine Lagarde’s comments following the announcement, things become less clear. She was uncommitted on future cuts and suggested the central bank would be keeping a firm eye on inflation.
In fact, the ECB has raised its inflation forecast for this year and next. And with that, an implication that this initial cut may not signal the start of a sustained easing cycle. That is not what investors want to hear, but it is what they have to live with.
“Don’t cry ‘victory’ too soon,” says Nicolas Forest, chief investment officer at Candriam. “Lagarde doesn’t want to pre-commit to further cuts. She is taking a gradual and cautious approach like the other central banks and will re-assess the situation meeting by meeting.”
As a result, Shaan Raithatha, senior economist and strategist at Vanguard Europe, holds the view that interest rates will remain higher for longer. “Part of this is because we believe the neutral rate of interest – or r-star – is higher than commonly believed. This in turn makes the current stance of monetary policy less restrictive,” he says.
The theory behind the r-star – which is the real neutral rate of interest that equilibrates the economy – suggests that if a central bank sets the rate below the r-star, then policy is accommodative.
Raithatha’s point is that a higher-for-longer interest-rate environment sets the foundation for improved portfolio returns. “As all assets are effectively priced off the risk-free rate, you can think of this as a level shift up in expected returns across asset classes,” he says.
To cut or not to cut
Nonetheless, Forest expects two more rate cuts before the end of the year, starting in September, based on inflation effects in services disappearing.
The back seat driver in all of this is the unwanted guest of inflation. If this improves, things start falling into place. If not, we have much to ponder.
Des Lawrence, senior investment strategist at State Street Global Advisors, cautions against the inflation picture.
“Although inflation expectations remain quite well anchored, recent hard data has not been entirely helpful to those of a more dovish persuasion – early estimates for the month of May showed inflation increasing by more than forecast by markets,” Lawrence says.
This was indeed a blow, even though inflation decreased in that month, but not to the low levels the market expected.
Like with a marathon runner experiencing the final miles as the toughest, we may have entered the final but tough straight in dealing with inflation. “It does remind markets that the last leg of the disinflation journey can be the most difficult – price inflation in services is still running at an annual rate of just over 4%,” Lawrence says.
Paul Jackson, global head of asset allocation research at Invesco, presents a more upbeat analysis. “Inflation is still coming down,” he says. “If you look at the background detail in US wage inflation it has been falling for more than two years, and that is an important driver of core inflation. So core inflation will keep coming down in the US. And it has already done a lot of the downward journey in many parts of Europe,” Jackson says.
Will the Old Lady act?
The ECB rate cut switches the focus to the UK and the Old Lady of Threadneedle Street. In June, the BoE was unmoved, keeping rates unchanged at 5.25%. “The ECB decision will raise hopes that UK interest rates will also be brought down sooner rather than later,” says Susannah Streeter, head of money and markets, Hargreaves Lansdown.
“The data coming in has been more positive for the Bank of England, indicating that price pressures are easing,” she adds. “So an interest rate cut in August is still a real possibility, although the financial markets have not been fully pricing in a cut until November.”
When it comes to the Fed, June’s Federal Open Market Committee kept rates unchanged. And importantly, seem in no hurry to cut. Fed chair Jerome Powell did not take the possibility of a September rate cut off the table, but he refused to say specifically how many months of good inflation data is needed to build confidence to cut rates.
All of which makes expectations for a cut, and when, difficult. “The Fed lacks guidance as it has abandoned forecast-based policy making and became extremely data dependent,” says Xiao Cui, senior economist at Pictet Wealth Management.
That said, Eric Vanraes, head of fixed income at Eric Sturdza Investments, still believes that the first-rate cut could come before the fourth quarter, in September. “We do not rule out a surprise Fed rate cut at the end of July,” he says.
“American banks, including the largest, are more heavily exposed to commercial real estate loans than anyone thought. Rates, short and long, are not falling fast enough to dismiss this concern,” Vanraes adds. “And if the commercial real estate debt wall appears in 2025 while rates are still too high, we risk a Silicon Valley Bank-style crisis at large scale.”
This presents another potential layer of concern.
And despite the Fed’s prevarications, Xiao Cui also says investors should still expect rate cuts from the Fed later this year. “We maintain our call for two rate cuts this year in September and December,” she says.
A crucial indication of how things will progress is that there will be three more inflation reports before the Federal Open Market Committee meeting on 18 September, which should give some clearer semblance of where the US economy stands, and the opportunity, or not, for the Fed to go for cuts.
“We expect continued good readings on inflation to enable the Fed to start cutting then, but the risk continues to be that the disinflation path is bumpy and a cautious Fed might need to see more months of good readings to start cutting in December,” Cui adds.
The next cut
So who will cut next – the BoE or the Fed? “The ordering [of cuts] is not what I was expecting six months ago,” Jackson says, adding that he believes the Bank of England will be cutting in August and for the Fed it could be earlier.
The election will play its part for the Bank of England. “The BoE does have capacity to cut rates with inflation coming down, but with the UK election in mind they will likely delay any decisions until September, when they will also have more data on whether service sector inflation abates further,” Flood adds, when speaking ahead of July’s election.
But Flood also adds another interesting contextual and historical point. “Most likely the Fed will be first to cut, since the BoE was made independent they have always followed the Fed.”
So how many rate cuts can we expect? “I would expect the ECB to cut maybe two to three times this year, the Bank of England perhaps twice and the Fed maybe once, possibly twice,” Jackson says. “But if we look 12 months ahead, I wouldn’t be surprised to see four to five amongst those major central banks.”
This presents a pretty compelling picture: one where inflation is duly put back in its box.
Tactical opportunities
Jackson is not alone in seeing light at the end of the tunnel. Pictet Asset Management’s chief strategist, Luca Paolini, is a half full glass type of guy. He notes that the prospects for the world economy have improved and interest rates are, he believes, set to fall, which is a positive backdrop for stock markets, at least in the near term.
On this basis, he therefore remains overweight equities, neutral bonds and underweight cash. Pictet’s business cycle indicators are sending positive signals about emerging markets and Australia, he says. Emerging markets, not least China, are at the vanguard of the easing cycle, and that is set to support growth.
On the other hand, developed economies are showing more muted economic performance, he adds. “But the eurozone and the UK are showing an improvement in activity,” Paolini says. “For now, our signals are neutral for the US economy, which will slow from around a 3% rate of growth to closer to 1%, before recovering back towards potential by the end of the year.”
A point worth considering is that in contrast to the decade after the 2008/09 crisis, some, like Vanguard’s Raithatha, expect real rates to be positive over the long term, and with it have implications for investors. “This return to sound money provides a solid foundation for equity and fixed income returns over the coming decades,” he says.
There are other signs for investors. Daniel McCormack, head of research at Macquarie Asset Management, sees the BoE cutting rates, which means there could be a tactical opportunity in European and UK assets. “Our expectations for the Bank of England suggest gilts could be in for a period of strong relative performance,” he says.
“The combination of falling interest rates and an improving economic cycle is likely to be positive for European and UK equities, particularly in contrast to the US where interest rates are likely to stay higher for longer and growth concerns are coming to the fore again after a period of remarkable resilience,” McCormack says.
Fiscal support
Outlining other areas for investors to follow, Flood notes the outlook means some long-term structural themes will remain, and beneficiaries of the spending on infrastructure and decarbonisation will continue. “We see companies tied to these themes continuing to benefit from fiscal support for many years to come,” he says.
Alongside that, Flood cites bond yields as being more attractive than they have been for much of the last decade, offering a reasonable return as well as diversification from equities in a downturn, helping to provide a balanced portfolio.
“With fiscal spending forecast to continue for a number of years we see valuations in the bond markets as fair, so there remains the risk that yields continue to rise if the US bond market takes fright at the amount of issuance to fund the fiscal largesse,” Flood says. “For that reason, we favour other government bond markets, such as Australia, New Zealand and the UK.”
There is more to explore when it comes to the yield curve factor. Possibly an obscure element to trot out, but the yield curve tends to steepen during cutting cycles, which can have an impact on investors.
Mauro Valle, head of fixed income at Generali Asset Management, is positive on the short–medium maturities of the euro-yield curve. “As inversion of the yield curve is quite significant and we don’t see conditions for a further inversion in the next future, we continue to be positive on peripheral countries, as carry trades and search for yields will continue to be a driver for investor preferences, considering that in the future the euro rates could be lower,” he says.
Ultimately though, the picture, it is safe to say, is far from clear. “There are still many questions to be answered and investors will have to continue listening to the data,” says Jamie Niven, senior portfolio manager at Candriam.
“We believe the signals are there that we are nearing a more positive path for rates markets, but there are still plenty of bumps which need to be navigated first,” he adds.
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