Hopes that higher US inflation in January and February would prove to be transient were thwarted as consumer prices rose strongly again in March. Expectations for interest rate cuts from the US Federal Reserve have consequently changed.
Listen to the article
Monthly inflation in the US first jumped in January, followed by a similarly higher-than-expected figure in the eurozone. This was repeated in February.
Nonetheless, the US Federal Reserve indicated that it was not worried about these figures and was still looking to cut policy rates by 75bp over the course of 2024. Now that inflation was high again for the third month in a row (see Exhibit 1), markets are no longer counting on significant cuts in the benchmark fed funds rate.
As has been the case all year, services inflation is the culprit. Goods inflation has been low (or even negative in the eurozone). But tight labour markets have kept pressure on wages, which is a key driver of services inflation. Without a more significant weakening in employment (or a sizeable increase in productivity), this may well continue.
Inflation? Oh well (when you are the ECB)
The Fed’s apparent insouciance about inflation is not necessarily surprising given its latest Summary of Economic Projections from March. Here, central bank policymakers projected core personal consumption expenditures (PCE) inflation would fall to 2.6% by the end of this year. It is currently 2.8%, so there is not much further to go over the nine months ahead.
Instead, markets are questioning whether that reduction in inflation can be achieved alongside several rate cuts. There is currently a low probability in the market’s view that the Fed will cut rates in June. A cut in September would be close to November’s US election. The Fed faces tough decisions.
The European Central Bank (ECB), on the other hand, has things somewhat easier. Eurozone growth is much weaker than that in the US, and monthly inflation dropped to 0.82% in March (annualised) from 3.31% in February (see Exhibit 1 above).
This improvement, however, is not quite as good as it seems. Goods inflation was actually negative in March, bringing the headline figure down, but core services inflation was still quite high, at 5.2%. The central bank nonetheless appears intent on cutting rates anyway in June.
Equity markets have been less sanguine
The impact of these changing expectations on equity markets have not been surprising, with US equities suffering as rate forecasts rise, and eurozone equity markets holding up slightly better.
Growth stock valuations would be expected to be the most sensitive to higher (real) rate expectations, but so far, forward price-earnings ratios have held steady at around 26 times for the NASDAQ 100 (compared to a long-run average of 20x).
Importantly, while earnings expectations have plateaued for the index overall (reflecting what has already been a significant increase over the last year), excluding the ‘Magnificent 7’, the outlook is still improving (see Exhibit 2).
The change in the outlook for central bank policy has had a bigger effect on the US dollar: it gained 2% against a basket of developed market currencies (as measured by the DXY index) last week. This strength particularly benefited the performance of Japanese equities.
Stepping back to look at Chinese data
One dampener for the market were the headlines that Chinese trade data disappointed, with exports contracting by 7.5% year-on-year compared to consensus expectations of just a 2.3% decline. At this time of year, however, there are difficulties making year-on-year comparisons due to the moving date of the Chinese New Year holidays.
Looking at the data on a seasonally adjusted monthly basis, exports actually rose by 0.4%, with growth to the European Union, Japan and ASEAN offsetting declines to the US and Latin America.
Imports fell by 1.9% year-on-year, raising questions about the robustness of the domestic economy, but on a monthly basis, they gained 1%. Following the improvement in purchasing managers’ indices for March, the data supports a view of resilient domestic growth, but at a rate which is still likely to require additional stimulus from the government.
