US inflation under control

Markets had been expecting the US’s Consumer Price Index (CPI) to creep up again in May after worrisome rises in 1Q, and a 0.3 percent increase in April. Instead, inflation growth for the month came in at 0 percent, the first time this has happened in nearly two years.

Producer prices mirrored this unexpected disinflationary trend, falling by 0.2 percent in May compared to a rise of 0.5 percent in April, due primarily to lower energy costs. These latest numbers have helped to assuage fears that US inflationary pressures had yet to be tamed. Meanwhile, both the number of jobs and hourly earnings grew by more than expected last month, suggesting still-stable economic growth, although the unemployment rate edged up slightly to 4.0 percent.

Two rate cuts on the cards

Despite easing inflation, the Fed signaled caution at its meeting last week. It noted that more inflation data was needed before a decision could be taken to cut rates, and only one rate reduction this year was a possibility. However, we continue to believe in the potential for two US rate cuts in 2024, and sustained growth over the next year or two.

Our higher-for-longer premise (details available in our whitepaper) is that interest rates will fall but not back down to the ultra-low levels seen in recent years. Already, the Fed has changed its median interest rate projection for end-2026 to a range of 3.0 – 3.25 percent, from 2.75 – 3.00 percent previously. Beyond 2026, we would expect interest rates to hover above the 2.5 percent level currently indicated by the Fed’s Dot Plot for long term rates.

Higher for longer

This premise is based on our view that inflationary pressures will remain elevated over the longer term, given a global environment dominated by deglobalisation, geo-political conflicts and climate change. This means interest rates will need to stay relatively high in order to keep these pressures in check. In addition, policy makers will be able to take comfort from the fact that high inflation rates over the past few years have not resulted in recessionary conditions or increased unemployment.

It has long been understood that the Fed’s inflation target is 2.0 percent, as measured by the Personal Consumption Expenditures (PCE) index, and that rate cuts would not be forthcoming until this target was reachable. The PCE projection for end-2024 currently stands at 2.6 percent, still some way above-target. However, in our view, the Fed is prepared to cut rates even if the 2.0 percent target is not met.

A return to “relevant inflation”

This is because, as explained previously in our whitepaper, the current inflation environment is reminiscent of the 1990s, when “relevant inflation” prevailed and the economy continued to stay strong. Unlike the stagflation of the 1970s (when inflation was high but economic growth was low), and the disinflation period of the 2010s (when inflation was low but growth was sluggish), today’s inflation backdrop suggests a period of relative economic and investment vibrancy.

In the near term, we think interest rates will fall faster than the market currently expects, thereby generating positive sentiment in both equity and bond markets. Over the medium term, assuming inflation stabilises closer to the 2 percent target rate, and despite interest rates staying sticky at above 2.5 percent, business activity should continue to improve as companies seek out real profits that are not eroded by inflation.

Similarly, investors currently obsessed with central bank policies may start to focus instead on company earnings and valuations, thereby driving forward equity and bond returns. We also see this as a more conducive environment for investors to take advantage of both income-paying and growth assets, by deploying the cash that they had parked away since interest rates started rising two years ago. In this environment, a USD risk-free rate of around 3 percent, and average global equity returns of 7 – 9 percent will become the new normal.