Achi news desk-
Markets have readjusted their expectations for central bank policy significantly. There is now a clear distinction between the US Federal Reserve (the Fed), the European Central Bank (ECB) and the Bank of England (BoE). As early as January this year, the market was pricing in six rate cuts by the Fed.
However, continued strength in growth data, solid labor momentum and three months of higher-than-expected US inflation have seen markets quickly price in these cuts, with US yields rising sharply as a result.
The question we are left with is whether inflation relief in the US is simply delayed or will prices re-accelerate? And what about other regions?
Rate cuts are more likely in Europe than in the US, given the different dynamics of inflation and subdued growth. In the US, inflation has been driven by demand, which has helped inflation remain sticky. In contrast, energy is a major component of inflation in Europe and the sharp drop in energy prices should allow for a return to the ECB’s inflation target over the next few months. The UK has a similar deflationary outlook to the ECB, with inflation expected to fall close to the BoE’s 2% target in April.
It therefore seems increasingly likely that the ECB will be the first major central bank to cut interest rates starting in June, followed by the BoE. The markets are currently pricing in a 0.25% rate cut in the UK by September or sooner, depending on the data. However, it is possible that the amount of cuts required will exceed what is currently priced. For both regions, the debate will turn to how many cuts can they implement while the Fed does nothing?
The main cause of the difference in policy is the different macro environment. US “exceptionalism” continues and it is difficult to see the economic growth of the region ceasing.
In the last few months, signs of global growth and global trade have come to the fore. This should not be extrapolated too far as the US is upgraded, Europe and the UK flat, and so the growth differential remains wide.
Where does all this leave markets? If feeder cuts are pushed further out this will lead to a period of instability. For equities to move significantly higher we need to see inflation fall, allowing central banks to adopt an easing bias. We also need to see a weakening of geopolitical risks as well as solid earnings and robust economic growth. The bar is set high.
Given that the trend is for US rates to be higher for a longer period, there seems to be justification for favoring high-quality, income-oriented companies with strong balance sheets and attractive dividend yields. Likewise, it makes sense to avoid the most leveraged parts of the market that have a large proportion of floating rate debt.
UK gilts are attractive, as the market is – wrongly – pricing in cuts much closer to the US, while the economy is more consistent with the rest of Europe. Corporate bonds should continue to be supported by the attractive yields on offer, but credit spreads are low, and it is difficult to see spreads narrowing further. In currencies, continued strong US growth, continued inflation and policy divergence will continue to support the US dollar.
The global economic environment remains complex and navigating the “last mile” of inflation was always going to be difficult. With ongoing geopolitical conflict and 2024 being a major election year, more surprises cannot be ruled out. Ultimately, however, current rate policies are restrictive, and inflation will eventually fall to central banks’ targets.
Meanwhile, the gap between the US and other major economies will continue, and while the Fed will remain on hold longer than other major central banks, it will only be delayed and its cuts will not be forgotten.
Gareth Gettinby is an investment manager at Aegon Asset Management
