Inflation remains the key

Equity markets have had a somewhat choppy start to the new year following their strong gains late last year. They retreated 1-1.5% in the first week, only then to recover these losses last week, and end little changed year-to-date.

Bond yields have followed a similar pattern, reversing some of their sharp decline at the end of last year and then falling back again last week. Year-to-date, this has left US Treasuries and UK Gilts down 0.3% and 2.2% respectively.

The key question now is whether the market’s newfound optimism on the economic outlook is justified. Most importantly, whether interest rates will be cut this year by as much as the market is now assuming.

The latest US economic data briefly caused a few wobbles on this front. Payrolls posted a larger than expected gain in December, raising some doubts as to whether the labour market has weakened enough to be compatible with a further decline in inflation.

The December US consumer price numbers also came in a tad higher than expected. Headline inflation rebounded more than anticipated to 3.4% from 3.1%, while the core measure declined only slightly to 3.9% from 4.0%.

The conflict in the Red Sea has also started to stir up fears that the diversion in shipping away from the Suez Canal, which is pushing up shipping costs, could boost inflation and cause some supply shortages. That said, the impact has so far been very limited with the Brent oil price still a bit below $80/bbl, well below the highs of $95 last autumn and $120 in 2022.

Despite these concerns, the market is currently assuming interest rates will be lowered by year-end in the US from 5.25-5.5% to 3.7%, in the Eurozone from 4.0% to 2.5%, and in the UK from 5.25% to 3.9%.

These expectations look on the optimistic side if economic activity and corporate earnings remains as resilient as equities appear to be assuming. The US fourth quarter earnings season kicked off on Friday with the big banks and was a mixed story with JPMorgan posting stellar results but Citigroup posting a loss. Overall, S&P 500 earnings are forecast to be up 4.4% on a year earlier and earnings growth is projected to strengthen to a high 18% over the coming year.

The Fed is undoubtedly keen to minimise the risk of a recession ahead of the November elections and is forecasting rates to be cut 0.75% this year. But this decline is 1% less than the market is now pricing in. In the UK, the market’s view that rates will fall 1.4% this year is also at odds with the guidance from the Bank of England which remains cautious.

The optimism is being fuelled by the unexpectedly sharp decline in UK inflation seen in November. Indeed, there is increasing speculation that inflation could fall back to the 2% target over the summer, much sooner than the Bank has been forecasting. The December data out on Wednesday will be examined closely to see whether or not they validate this optimism.

On the growth front, the latest UK numbers showed GDP regaining in November the 0.3% drop seen in October but remaining down 0.2% over the last three months. The coming year should see growth edge back into positive territory, helped in part by tax cuts, both those announced in November and those looking almost certain to feature in the Budget on 6 March.

Overall, as we highlighted last week, the global economic backdrop is looking distinctly better than it was a few months ago. Activity has held up surprisingly well, inflation has fallen back faster than expected and rates now look set to be cut significantly over the coming year. While much of this good news is priced in, we believe there are still opportunities to exploit – particularly in the cheaper areas of the markets.

Rupert Thompson – Chief Economist