Dear Investors,
Where is core going? – BlackRock (10 Volatility Updates)
Yield swings
The plunge in long-term US Treasury yields on news of slowing US inflation shows volatility is persistent in the new regime of greater macro uncertainty.
Compounding this is a disconnect between the latest cyclical market narrative of a strong expansion – and the reality we have just climbed out of a deep economic hole caused by the pandemic.
This disconnect risks obscuring the new regime’s opportunities – a key conclusion of our 2024 Outlook Forum last week.
Where is core inflation going?
We see core inflation hitting the Fed’s 2% target in the second half of 2024.
Inflation is falling because rapid rate rises to combat it have pushed US growth trend below pre-Covid levels.
We think more of the same is needed to keep inflation down as price pressures resume amid slowing labor force growth and geopolitical shocks.
Markets appear to miss this bigger picture, and we see more volatility ahead as they swing between hopes for a “soft landing” and fears about higher rates and recession.
Inflation in retreat
The US economy has made major progress recovering from massive pandemic shocks that caused such a historic shift in spending, and that’s why inflation is falling.
Consumers are spending more on services again after mostly buying goods during the pandemic. Mismatches in the labor market are also easing.
The ongoing unwind of both shocks should help drag down goods and services inflation further.
Wise Investors Should Pay Close Attention to Falling Inflation – Citi (15 Inflation Updates)
How markets are reacting to inflation evolution
Investors tell us that they will not allocate more to bond investments because rates will stay higher for longer.
They also say they will not allocate more to equities because of an impending recession. The inconsistency of these two views is obvious.
Markets are responding quite positively to reported declines in inflation with the S&P 500 gaining 7.6% in the month to date.
The 10-year treasury yield has fallen 44 basis points over the same period.
Why investors should pay close attention to inflation
Is Inflation Here to Stay? No.
Inflation peaked in the US at 9.1% in June 2022 and in the Eurozone at 10.7% in October 2022.
These amounts were several multiples of the respective central bank’s 2% inflation target.
We see the Fed effectively reaching its inflation target by end 2024 and likely easing before the ECB does.
Of course, there remains a risk that shocks emerge separately in the two regions. There is a possibility that higher lagging shelter inflation measures will cause the Fed to wait too long before easing monetary policy.
But there are numerous signs in markets and Fed commentary that the narrative is shifting.
When could the fed begin to protect the labor market?
Many investors mistakenly believe that an economic collapse is a prerequisite for Fed easing. But that is not true.
Since 1980, the Fed has begun cutting rates while US employment was rising, at times when average employment growth of 146K jobs per month were being added in the prior six months.
We believe the Fed will see materially slower job growth during the year ahead. Job gains in 2022-23 exceeded GDP growth by the most since 1974.
This is unsustainable and likely to reverse.
As US employment gains fade in the face of restrictive monetary policy and slowing inflation, we also believe the Fed will change course and seek to protect the labor market from an unwanted contraction.