Investors are likely to be surprised by a shift toward lower interest rates in the US later this year. In response to the jump in headline inflation due to the energy crisis, the market now expects one 25 basis point rise in US cash rates in the next year. But two cuts are more likely as the Strait of Hormuz is finally reopened, allowing energy costs to decline, while underlying price pressures continue to subside.
The recent bond selloff provides the opportunity to increase weights to enhance running yield while positioning the portfolio to benefit from price appreciation should growth disappoint on the downside.
The shift toward US monetary accommodation will allow bond yields to modestly fall, prices rise, and in so doing, support a broadening of equity performance away from the recent concentrated gains mainly in technology.
Global economy holding up well
The global economy has been holding up reasonably well. Growth in the US is slowing through softer consumption but remaining solid, helped particularly by AI infrastructure spending supporting industrial businesses as reflected in the 8% year over year rise in durable goods orders. Earnings have been remarkably strong, rising more than 25% over the last year, helped especially by strength in technology.
In Europe, a new energy shock compounds lingering effects from the Ukraine crisis and trade headwinds, but strong household finances and rising fiscal spending limit the downside. China keeps delivering robust growth through exports and high-tech manufacture, tempered by consumer weakness and a fragile housing market. Australian expansion is being restrained by rising costs, tax changes and proactive RBA tightening, but there is underpinning from strong public spending and capital investment.
CHART 1: US DURABLE GOODS ORDERS
Source: US Census Bureau, Assureinvest
Inflation is spiking but should ease relatively quickly as pressures disperse. Underlying inflation is unlikely to jump in the way it did after the pandemic and Ukraine war shocks. Scope for companies to pass cost increases on is reduced by looser jobs markets, low confidence and less capacity for government handouts.
US consumption growth is being supported by tax refunds and the rebounded share market but will likely moderate this year through softer wages growth, higher energy costs and the rundown in household savings. Real income growth is actually falling slightly now, compared with 3.1% growth a year ago. The savings rate of 2.6% is below normal levels of 4.9%, so buffers are lower at a time when consumer sentiment is at the weakest level since the University of Michigan data was first captured in 1978.
The jobs market remains soft. Job openings are declining while the number of unemployed people is rising. The fall in small business optimism is weighing on hiring plans. Approximately 70,000 new jobs are being created each month, which is below the number required to keep unemployment from rising from the current 4.3%. It is likely to exceed 4.5% in the next few months.
The US Federal Reserve is likely to seize on the softening in the labour market and relatively contained core inflation to reduce rates by 50 basis points by the end of the year from the current 3.50-3.75%. New Fed chair Kevin Warsh sees productivity benefits of AI implementation that will allow supply to increase and thereby maintain inflation within an acceptable range. He has also indicated a wish to move away from bond purchases, or ‘quantitative easing’, as a policy tool given its potential to distort financial markets and exaggerate wealth inequality.
In terms of the method used to estimate inflation, Warsh prefers a ‘trimmed averages’ approach where the high and low outlier items are removed from the calculation to arrive at an indication of the longer-term trend. By contrast the core personal consumption expenditures (PCE) approach currently favoured by the Fed strips out the same items each time, being food and energy. Interestingly, the trimmed averages approach produced by the Dallas Fed is significantly lower than core PCE. It has also been trending down in recent months. A Fed focused more on this measure will be more inclined to reduce rates.
CHART 2: US INFLATION MEASURES
Source: Federal Reserve Bank of Dallas, US Bureau of Economic Analysis
Portfolio positioning
The case remains for diversification across equity markets. Our overarching focus on high quality remains but we have a greater than usual weight to ‘value’ style and European stocks which are relatively attractively priced. We have recently increased weights in sustainable higher yielding stocks which provide more certain returns with less volatility and should gain if US rates drop later this year as we expect.
Lasting investment success is built on balance and foresight, not reflexive responses to the news of the day. Over a full market cycle it is thoughtful positioning, unwavering discipline and clear-eyed perspective that determine outcomes. The AI revolution provides exciting opportunities for profit expansion across a range of industries but buying during periods of market exuberance can meaningfully erode long-term returns.
