Asset Allocation Strategy
20 May 2024
Market Back to a Glass Half Full View for US Inflation
No Bad News is Good News

US Core CPI for April eased moderately on both a month on month (+0.3% from +0.4) and year on year basis (+3.6% from +3.8%). 

This was in line with consensus expectations but still prompted a sharp decline in bonds yields, a fall in the US dollar and a greater than 1% bounce in the S&P500 to a fresh record high.

The outsized positive reaction was likely due to some concern that the US CPI would once again surprise to the upside after three consecutive above expectations prints so far this year.

Figure 1: US Core CPI resumed its downtrend in April but remains elevated
Figure 2: Bonds yields eased and equities continued to lift

Inflation Downswing Resumes

Key drivers of the easing in core inflation were more evidence of deflation in goods prices, with core goods falling 0.11% for the month and -1.3% for the year. The decline in core goods prices was the 10th decline in 11 months. Monthly declines in new (-0.4%) and used vehicles (-1.4%) prices were a key factor.

Services inflation also eased but remains high. Core services inflation fell from last month but still rose a solid 0.4% month on month and 5.4% year on year. So, the stark dichotomy between goods price deflation and sticky services remains. Motor vehicle insurance posted another very strong increase (+1.8%). This follows last month's outsized 2.6% rise and takes year on year transportation services inflation to 11.2%. The other key driver of US services inflation remains housing. The housing or “shelter” component eased to a still sold 0.4% and 5.6% year on year.

Shelter and auto insurance (within transportation services) have prevented inflation from decelerating by much so far this year. These categories should ease in coming months. Changes in new tenant rents lead existing tenant rents and they have decelerated at a significant pace, while auto insurance prices should stabilize in line with declines in vehicle prices. So, we remain constructive on the outlook for US inflation for the balance of this year. 

While the market took the April inflation read well, further evidence of easing inflation will be required to completely ease worries of stubbornly high price pressures. Attention will now turn to the personal consumption deflator (PCE) later this month.


Don’t Mind The Gap

Over the long run the “CPI” measure of US inflation has tended to run a little above the Fed’s preferred measure of inflation, the PCE. Currently the gap is unusually large with an almost 1% differential for year on year inflation. 

This is mostly due to the larger housing weight in the CPI measure of inflation relative to the PCE. The April PCE measure is due for release on May 31.

We expect the PCE will once again print at a moderately lower level (0.25%) relative to last week’s CPI. This would imply 2.6% inflation in year on year terms. This is still above the Fed's 2% target, but it is starting to at least enter the zone in terms of the Fed contemplating policy easing in coming months.


Year-End Fed Cuts Back in View

The interest rate market seems willing to extrapolate the downtrend, with rate cut pricing back to two 25 basis point Fed cuts in September and December. The markets willingness to price two rate cuts back in has likely been helped by a softer tone in the economic activity data so far in May.

Key data points that have printed on the soft side of consensus expectations so far in May include the April employment data (non-farm payrolls), the ISM services business survey, April retail sales and April industrial production. 

The reinstatement of two rate cuts and the sharp reversal in bond yields after the April inflation scare has helped US equities quickly regain the ground lost in April and indeed push to fresh all-time highs. If this trend of weaker than expected data continues over the next couple of months it is possible that the market may begin to worry that the US economy is cooling too fast. This may cause some volatility, however, the prospects of Fed cuts coming into view should ultimately contain these fears.

Figure 3: The ECB to lead the rate cut cycle while the RBA will lag (date of first cut shown)
Figure 4: Global inflation is well down from the 2022 peaks but still above central bank targets

Buoyant US Equities on a Narrow Path

With valuations once again looking stretched, the US market is walking a somewhat narrow path between a too hot and too cold economy. We believe the path can be negotiated although volatility will likely continue. Our base case remains that US inflation will ease further over the balance of the year as will US growth. This should allow the Fed to ease later in the year supporting both equities and bonds. The next key data print is the April PCE inflation release at the end of May, followed by May payrolls in early June with the next Fed meeting scheduled for June 12.


A different Domestic Inflation Story

From a domestic perspective the easing in US rate fears and lower US bond yields has translated to the Australian interest rate markets, despite little in the way of domestic evidence to support this shift.

Local interest rate markets have priced out expectations for a potential rate rise later in the year and are now priced with a 50% probability of a cut by year end, with the first cut fully priced by April next year. This pricing seems reasonable, although the path for inflation over the coming year is looking more uncertain than the US in our view.

Australian inflation is broader than the US, albeit our economy is currently weaker. The reasonably significant fiscal stimulus coming in the 2025 financial year led by the July 1 tax cuts, also complicates things for the RBA. The RBA will certainly lag the global easing cycle due to a stickier inflation cycle and fresh uncertainty over the ultimate impact of the government’s fiscal cash injection announced last week.

Figure 5: Australia has a broader inflation pulse than the US which makes life tricky for the RBA

The next monthly Australian CPI read is due on May 29 and will be even more closely watched than usual. First quarter GDP is due on June 5. Though a lagged measure of activity, the market will be looking for confirmation that the stalling in growth evident in the fourth quarter of 2023 data has persisted into 2024.

Our domestic base case is that the economy recovers from its current below trend growth phase and picks up moderately through the back end of 2024 and through 2025. 

This view is based on the reasonably significant fiscal stimulus due in financial year 2025 and some moderate interest rate easing next year as inflation drifts back toward target. While sticky domestic inflation is still a key risk to monitor our base case macro scenario suggests a reasonable backdrop for both stocks and bonds aided by our still constructive global outlook. 

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Written by

David Cassidy, Head of Investment Strategy

David is one of Australia’s leading investment strategists.

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