The hoped-for glide path to inflation of 2% is not proving as smooth as expected. This month’s US CPI increased 0.4% month on month, up 3.2% 12 months. This was a smidge ahead of expectations, but the real concern was in core CPI, which was up 3.8% year on year. The chief culprits were energy and shelter, but there were also other persistent problem areas, such as motor insurance.
The problem is not as acute elsewhere. In Europe, inflation remained at 2.6% in February, with core inflation dropping from 3.3% to 3.1%. In the UK, the expectations are for inflation to drop below 2% by April, as a result of changes in the energy price cap. However, given the relative weakness of the eurozone and UK’s economies, the persistence of inflation is still worrying and gives central bankers less room to manoeuvre.
There are also some potential curve balls. Disruption in the world’s major shipping routes – from Houthi attacks in the Suez Canal and drought in the Panama Canal – saw freight prices double between December and January (as measured by the Containerized Freight index). While they have started to drop again, it remains an inflationary risk in the near-term.
To what extent is this a concern for fund managers? It is likely to defer the interest rate cuts that the markets would prefer to see sooner rather than later. Paul Niven, manager on the CT Universal MAP portfolio, is untroubled – for the moment: “Core inflation has been falling fast. There has been some data out of the US that inflation is a bit stickier than had been hoped for. Numbers are still generally heading in the right direction, but it was the second month when US inflation was slightly stickier.”
He points out that the three month core CPI is now running high on an annualised basis – the highest since 1991 ex-Covid. He says the path to 2% was never likely to be a straight line: “Inflation is coming down, but there will be some bumps along the way as we move closer to target.”
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Chris Iggo, chief investment officer of AXA IM Core at Axa Framlington, takes a similar view: “The lower inflation gets, the easier it is for rogue numbers to upset the narrative. We are now in that phase and recent US inflation reports illustrate this.
“The big picture, however, is that inflation is lower and is consistent with a soft landing scenario. In the US, growth has not slowed by as much as expected and inflation is a little sticky. That’s okay though. The risk of rates moving higher is limited. The chances of rates not being cut by as much as they could be is being well flagged.”
Outlook for cuts
Does it change the outlook for rate cuts? The US 10-year treasury yield spiked higher – from 4.08% to 4.32% in response, suggesting that the market had been hoping for better news. Nevertheless, rate cut expectations have moved out significantly, so the move was perhaps not as severe as it might have been at the start of this year.
Niven says: “There has been a lot of fluctuation in terms of rate expectations this year. Today, the expectation is that rates will come down in the US, UK and eurozone. There were bullish expectations at the start of 2024 as to where rates would land. In the US, there was an expectation that rates would fall to 3.75% by December, from 5.5% today. Central bankers pushed back on those expectations.
“Expectations now are much more reasonable and realistic. There is an expectation that short-term rates will be around 4.5% by December in the US, 4.5% in the UK and 3% in the eurozone.” Expectations of an imminent cut are probably highest in the eurozone. Niven says that central bankers have started to suggest rate cuts are likely to materialise around the middle of this year. Last week, ECB Council member Olli Rehn said that the committee were already discussing rate cuts, and implied a rate cut was possible in June.
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Maria Paola Toschi, global market strategist at JP Morgan Asset Management, says that the US central bank is in no hurry to cut rates: “This was very clear in the first meeting in January, in which Powell confirmed that there is no rush. Core inflation coming in higher than expectations has poured cold water on expectations that the Federal Reserve will cut rates in April.”
She adds: “We have continued to see a very tight, strong labour market that has continued to produce new jobs. With unemployment rate below 4% – more than 25 consecutive months. These factors are likely to support consumption.”
Nevertheless, she believes these factors should start to fade and there will be some moderation in the economy. The trajectory of inflation will be complex: “Goods prices are going down, but services – due to the huge demand – are seeing prices go down more slowly compared to elsewhere. We believe that we will continue to see disinflation in the second half of this year. We will reach a level of inflation close to the level of the central bank and that will create the environment for the central bank to start cutting rates.” She believes June is still a possibility.
The trajectory of inflation was never likely to be smooth. Most do not expect higher inflation figures to defer a rate cut significantly. Nor does it change their central expectation of a soft economic landing. However, it is clear that markets had hoped the path would be a little smoother than it has been so far.
