Central Bank Inflation Fight To Carry On

Transcript

Soft inflation data has rekindled hopes for rate cuts in 2024, even as central banks are to hike again this week as they remain in inflation fighting mode.

This week, I’ll be discussing an apparent disconnect in the economy: how can inflation appear to be falling quickly back to 2%, and yet the U.S. economy be stronger than expected at the same time?

1) A strong U.S. economy?

There’s a perception that growth is strong, but the reality is that the US economy has barely grown over the last 18 months, and that is despite historically tight labor markets and strong consumption.

2) The inflation story

The inflation story is also more complex. We are seeing the combination of 1) a shift in consumer spending from goods to services and 2) the pressures from the tight labor market. The first is finally spurring the expected goods deflation. Yet, the flip side is persistent services inflation, exacerbated by ongoing wage pressures from labor market tightness. The result of all this is a rollercoaster trajectory over the next quarters for inflation before it likely settles closer to 3%.

3) Profit margin squeeze

Companies are already facing higher production costs while margins have dropped, suggesting they are losing their ability to pass on higher costs to consumers.

We use our new playbook to look beyond broad asset classes in this tricky macro environment. We tap into the AI mega force within developed market stocks. We upgrade UK equities to neutral as they better price in the weak growth outlook. We like Japanese stocks, U.S. inflation-linked bonds and prefer euro area nominal government bonds over the U.S.

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The Federal Reserve and the European Central Bank (ECB) are set to hike rates again this week, yet markets have been taking this in stride. Soft June U.S. core inflation has revived hopes for rate cuts in 2024. This can fuel a bull run across assets for some time - until it runs into the disconnect between fast-falling inflation and stronger-than-expected economic activity. We look for opportunities beyond broad asset classes, such as the artificial intelligence theme in equities.

Wage-inflation connection

The chart shows U.S. core services inflation, excluding shelter, using the Personal Consumption Expenditures (PCE) price index, relative to hourly earnings based on the Employment Cost Index (ECI). The data is in three-month-on-three-month annualized terms.

The surprising fall in June U.S. core CPI inflation was clearly good economic news. Yet, how can inflation suddenly be falling if the U.S. economy is stronger than expected and the labor market remains tight? First, there’s a perception growth is strong. The reality is that the U.S. economy has barely grown over the last 18 months - despite historically tight labor markets and strong consumption. Second, the inflation story is complex. We are seeing a combination of 1) a shift in consumer spending from goods to services and 2) wage pressures from the tight labor market. The first is spurring goods deflation. The flip side is persistent services inflation, exacerbated by ongoing wage pressures. We expect core services inflation excluding housing (yellow line in the chart) to stay elevated due to those wage gains (dark orange line). The result? A rollercoaster trajectory over the next quarters before inflation likely settles near 3% - well above the Fed’s 2% target.

The U.S. dollar and Treasury yields slid after the CPI data, while stocks moved higher as markets embraced the hope of a “soft landing” - growth holding up and inflation coming down. This hope can sustain risk assets for some time even if it doesn’t pan out. A lot would need to go right for such an outcome, in our view. Activity would need to hold up even as the full force of the Fed’s rate hikes has yet to kick in. That may be possible if tight labor markets spur companies to hold on to workers after struggling to find them coming out of the pandemic. Inflation would also have to drop sustainably closer to 2%.

Margin squeeze

We expect a squeeze on corporate margins if inflation stays high - and an even larger squeeze if it falls. Tight labor markets are set to keep production costs high. A sustained fall in inflation could soften demand. Why? This would likely come from good prices falling further and/or labor markets weakening significantly. So good economic news like falling inflation is not necessarily good news for markets. Margins have already dropped, Refinitiv data show, suggesting companies are starting to have trouble passing higher costs to consumers. We are watching Q2 earnings for more signs of margin pressures.

Holding tight

We see most developed market (DM) central banks forced to hold policy tight to lean against inflationary pressure as they focus on tight labor markets. This is a key theme in our mid-year outlook. The Fed, ECB and Bank of England (BOE) face a similar challenge: Inflation has cooled from lower goods prices, but wage gains look set to keep services inflation sticky - and overall inflation on a rollercoaster. We see them pushing ahead on the inflation fight this week, too - though growth is weaker for the euro area and the UK. The ECB and BOE have also tightened more aggressively than in the past and are still hiking. The story is different for the Bank of Japan. We think it may opt for loose policy this week to sustain above-target inflation, since Japan has fewer supply constraints.

Bottom line

Soft inflation data has rekindled hopes for rate cuts in 2024, even as central banks are set to hike more in the near term and hold tight for long thereafter. We use our new playbook to look beyond broad asset classes in this tricky macro environment. We tap into the AI mega force within DM stocks. Mega-cap tech led earnings forecast upgrades due to AI euphoria, and we’ll assess their Q2 earnings for ongoing strength. We upgrade UK equities to neutral as they better price in the weak growth outlook. We like Japanese stocks as loose policy looks set to support earnings. We favor U.S. inflation-linked bonds as markets underestimate inflation’s persistence. Yet, we prefer euro area nominal government bonds over the U.S. as they price in rates staying higher for longer.

Market backdrop

U.S. stocks edged up on the week as early earnings updates, mostly from financials, topped low expectations. We expect Q2 results to be similar to Q1 - flat to slightly negative. We see a contraction later in the year as wage gains erode profit margins. Treasury yields steadied as markets eyed the signal from major central banks. UK markets breathed a sigh of relief on soft CPI data: stocks climbed and 10-year gilt yields fell sharply on the week as markets priced in a lower peak in BOE policy rates.

The Fed and ECB are set to hike rates again this week, while the BOJ may keep policy loose to sustain inflation. U.S labor cost data is likely to reinforce the tight job market is fueling wage gains and inflation pressures. Global PMI data will help gauge how much rate hikes are dampening activity. We see major central banks holding policy tight even as activity slows.

This post originally appeared on the iShares Market Insights.