Weekly market update - Jenkins' Ear

The lesson here is simple: wars are not predictable, either in how they start or how they proceed.

The plan was to talk about US core inflation this morning. However, this weekend’s fresh tensions are forcing a discussion about headlines instead. Energy has stopped dis-inflating since autumn 2023. In March, energy prices were 22% higher year-on-year.

At the back of every trader’s, investor’s, politician’s, central banker’s and consumer’s mind right now, there is but one question: what if oil starts another inflationary wave?

For the last two years, one of our key calls was that the era of macroeconomic stability, known as the Great Moderation, was over and we should expect more economic volatility, i.e. it was always going to be a bumpy road towards structurally lower inflation. Global economic and political centrifugal forces persist, causing supply chain and energy oscillations which are not too difficult to translate into harder wage negotiations.

For the moment, let us assume that geopolitical tensions don’t escalate much further and that energy prices do not cause another inflationary wave. At the time of writing (Monday morning, too early to gauge proper market reactions), oil prices hadn’t moved much. 

That means that the EU and the UK would, all other things being equal, be on their way to 2% inflation and summer rate cuts, albeit with bumps on the way, while the US would be left fighting an overhang of money supply, higher inflation and higher interest rates until next year.

Last week’s US CPI announcement tells much of that story, registering 3.5%, up for the second month in a row.

Following the announcement, equities tumbled -1.5% and bond yields rose, with the US 10y back at 4.5% for the first time since November. Year to date, global equities are up +6.1% while bonds are having another bad year, down -3%.  Various Fed officials took the podium last week, mostly suggesting that they are in no hurry to lower rates.

The market is now pricing in less than two rate cuts in the US, solidly below the Fed’s latest expectations for three cuts (although this may not necessarily be reflected in the latest statements by officials). However, they are pricing in two-plus cuts for the UK and three for the EU.

Back to the basics then. There are two major types of inflation. One that starts from supply chain dislocations (supply side inflation) and one that starts from an excess amount of money in the economy (demand side inflation).

Those two are not mutually exclusive. They can run concurrently and even affect each other. Monetary policy can have a much bigger effect on the latter type, rather than exogenously generated inflation cycles. Interest rates going up or down do not help much if oil taps are shut or ports are blocked. Most importantly, the timing of their cycles can’t be predicted. Past data are scant and involve very different economies and demographics than what we have today. I am sure hindsight will prove an excellent helper for future academics, but for the time being the collective output of consumer psychology regarding inflation lies beyond our modelling capabilities.

What we know is that American inflation has not been tamed. Every Fed official has told us as much. To some extent, this may reflect the US administration’s practice of sending cheques and increasing monetary supply significantly back in 2020 to fight Covid-19. So, supply chain disruptions were aggravated by excessive money supply.

European nations, who chose to subsidise employment rather than unemployment, seem to be getting out of this inflation wave more easily (again, no telling what happens when and if the next one hits).

So what does it all mean for investors?

For equities, geopolitical tensions have been a large part of the risk for some time, along with sticky inflation. So what is happening is not new, and should be somewhat priced in. So far, investors have chosen to look away from these and ride the tech-driven rally. Apart from possibly a renewed focus on the energy sector, which is up +19% since February but trading at a 53% discount versus its own average, and some money-shifting ahead of May (algorithmic trading reinforces past trends), we wouldn’t be too surprised if the equity market reaction, bar some volatility, remained muted. Outside tech, valuations aren’t high enough to cause a rout.

The main problem is with the bond market. As inflation expectations rise, bond prices fall. So far, for the year, global bonds are down -3.7%. It is the third year in the last four where bond performance is negative.

Since mid-2020 a theoretical defensive 80% bond, 20% equity portfolio (USD, no fees or costs) has been nearly flat (+1%). A more aggressive 80% equity, 20% bond portfolio has gained +45.5%, more than 10% per annum. This is not what one should expect during turbulent times.

However, the more important point here is one of diversification. A 100% allocation in mid-duration bonds would have resulted in a whopping -14% net loss for investors. Adding just 20% equities at least resulted in capital reservation (although not in real terms as inflation soared).

It’s not too long ago when the investing world lost trust in professionals. DIY low-fee investing was all the rage. This is easy when we are in a QE-fuelled bull market. Times, however, are now different. This is not the time to be picking single assets. It’s a time to diversify, rely on long-term return and risk trends, and wait. Strategic Asset Allocation is a narrow path, with some obstacles to be sure. But outside it, the dangers are exponentially higher.

George Lagarias – Chief Economist

Market update

All eyes were on US inflation last week, as a hotter than expected figure led to a sharp drop in share prices in most major markets on Wednesday. In the US, stocks fell by around -1% following the release of the inflation report, while similar drops were also seen in the UK, EU and Japanese markets. A partial recovery was seen in a few markets on Thursday when US producer price inflation came in slightly softer than expected, although geopolitical concerns, and a weaker than expected US consumer confidence number, weighed on sentiment on Friday.

US stocks ended the week down by -1.5% in USD terms, but were only -0.2% down in GBP terms, as the USD rallied following the inflation report. In GBP terms, EU stocks ended the week down by -1.4%, while UK, EM and Japanese stocks finished higher, rising by +1.2%, +1.1% and +2.6% respectively.

Yields on US treasuries and UK gilts spiked on the inflation surprise. US 10-year treasury yields rose by 11 basis points to 4.5%, while 10-year gilt yields rose by 5 basis points to 4.12%.

Gold rose by +5.9%, while oil fell by -0.1% over the week in GBP terms.

Macro news

The US Consumer Price Index (CPI) ticked higher in March, raising fears that interest rate cuts by the Federal Reserve may be further out than previously anticipated. The year-over-year rise to 3.5% came in slightly higher than consensus, partially driven higher by a rise in the price of medical services. With monthly CPI figures having now risen for a fifth consecutive month, traders pared back their expectations to just two interest rate cuts by the Fed by the end of 2024. Bond yields rose sharply following the CPI announcement, with the 10-year yield on US Government debt rising back above 4.5% for the first time since last November.

Even more concerning US inflation news came in the form of the ‘super-core’ inflation figure, which excludes energy and housing costs. This measure of inflation was noticeably stronger in March, rising 4.8% YoY. This, in combination with a general sense of reluctance to cut interest rates amongst Federal Reserve officials, suggests that rate cuts may still be a way off in the US. This puts additional pressure on other developed central banks to consider the timing of their interest rate cutting cycles, as opting to reduce interest rates before the Federal Reserve could contribute to additional imported inflation thanks to interest rate differentials.

The week ahead

Investors will be analysing the inflationary outlook on the other side of the Atlantic this week, with March inflation prints for the UK being released on Wednesday. The UK economy has been less resilient than the US in the face of higher interest rates, putting pressure on the dual-mandated Bank of England to consider earlier cutting interest rates earlier. A robust inflationary print would make this prospect significantly less likely.