Asset Allocation Strategy
18 March 2024
The Global Inflation Battle
Navigating the Last Mile

The global equity market continues to keep the faith in respect of easing global inflation despite some recent signs of stickiness. 

Last week’s US CPI result for February came in above expectation. This was after an upside surprise for the January release. Despite this, the US equity market is still sticking to the lower inflation and lower interest rates narrative.

The somewhat divergent reactions from the US bond market and US equity market to the latest inflation print were interesting. US bond yields edged up in response to the higher than expected result, while equities rallied. The market’s pricing for a June Fed rate cut also eased a little (to 76%), although 3 rate cuts are still expected this year.

This still seems enough to keep equities on a glass-half-full slant, particularly with growing investor optimism towards a resilient US economy, as well as optimism toward the US tech sector’s long term growth prospects.


US Inflation – A Mixed Bag

The good news is that the year-on-year rate of inflation continues to edge lower despite progress slowing recently. US core CPI is significantly lower than a year ago (3.8% versus 5.5%) despite the lift in monthly numbers so far this year.

Figure 1: The downswing in US headline inflation has stalled out at 3% recently
Figure 2: Core CPI is still trending lower but this year’s prints have picked up – as was the case in early 2023

The specifics of the February result showed headline inflation picked up to 3.2% (previous 3.1%) on higher fuel prices. Core inflation did edge down in year-on-year terms to 3.8% (previous 3.9%) as shelter costs eased; however, the monthly print of 0.36% still surprised to the upside with non-shelter services showing some stickiness. The 3-month annualised rate of core inflation has picked up to 4.1%, after a recent low of 2.6%.

It is worth noting the Fed’s preferred measure of inflation, the core PCE, has for the most part been printing significantly lower than the core CPI recently. The core PCE currently sits 90 basis points lower at 2.9% year on year relative to the core CPI (3.8%). This is in part due to a lower housing component in the basket. The next core PCE read is due on March 29.

Figure 3: The core PCE inflation measure is trending significantly lower than the core CPI

For now, the narrative of easing inflation remains intact. The Fed will get 3 more CPI (and core PCE) prints before its “live” June 11-12 meeting. While the market has largely looked through the recent upturn in inflation, another higher-than-expected CPI read next month would likely unsettle the equity (and bond) market. Ultimately, we do believe US inflation will trend lower over the next 6 months, notwithstanding the risk of volatility near term. Measured housing (shelter) inflation should ease further over the next 6 months, as survey sampling catches up with the reality of slower rental growth.

A slower economy and an easing labour market should keep goods inflation benign and help alleviate some of the residual stickiness in services inflation via slower wage growth. As a result, we see the market’s pricing of 3 rate cuts this year beginning in either June or July as plausible.

Figure 4: The COVID goods price surge has turned to goods price deflation
Figure 5: Services inflation remains sticky
Figure 6: The market has wound back expectations for Fed cuts this year, but still expects 3

Inflation Downswing Building Outside the US

Outside of the US recent inflation trends are looking increasingly benign. China if anything is facing a deflation challenge, while the inflation pulse in Europe is now fading fairly significantly. The European Central Bank (ECB) is expected to begin cutting rates in June.

Figure 7: European inflation is falling fast

Australia’s own inflation problem is also looking more encouraging after lagging the US deceleration for some time. Australia’s headline CPI rose by 0.6% in the fourth quarter (4.1% year on year). This was below consensus expectations of a 0.8% increase. 

The RBA’s preferred underlying inflation (the trimmed mean) also came in a touch below expectations, at 0.8%. The year-on-year quarterly measure now sits at 4.3% p.a., below the RBA’s (November) forecast of 4.5% but still well above the RBA’s 2-3% target. 

More recently Australia’s (less comprehensive) monthly inflation series for January has suggested further improvement. The trimmed mean eased further to 3.8% year on year from 4.0%, the slowest pace since March 2022. While inflation is still too high, these recent inflation results are encouraging after many quarters of very high inflation.

Figure 8: Australian inflation is also finally on a clear downswing

The combination of slower economic activity and a cooling labour market should help the domestic inflation downswing over the next 12 months. The RBA should be able to ease rates in the second half of the year as inflation edges back toward the RBA’s 2-3% target.

The market’s pricing of 2 likely cuts this year seems plausible with some further easing in the first half of 2025 expected. However, we don’t believe we are on the cusp of a major easing cycle. We see the cash rate as bottoming out 100 basis points below current levels.

These moderate rate cuts along with July 1 tax cuts should encourage at least a moderate pick up in economic activity in FY25, back to at least a trend pace.

Figure 9: The market is leaning toward 2 cuts from the RBA this year

Thoughts on the Longer-Term Inflation Outlook

Beyond some additional cyclical relief, where inflation settles medium-term is still an open question. There has been quite a bit of discussion of the prospect of higher trend inflation over the next decade relative to the experience of the pre-Covid decade.

Structural forces such as supply chain reconfiguration, the energy transition and a shrinking working age population are all likely to add to medium-term inflation pressures. Conversely the AI revolution may yield significant productivity gains with resultant disinflationary impacts over the medium to longer-term.

Our best estimate is that we are likely to see a bit more inflation in the system on a trend basis, perhaps 1%, but probably less, over the next 10 years. Importantly we do not see a return to the high-inflation rates experienced coming out of COVID. We do not see the prospect of moderately higher trend inflation in itself as a headwind to equities.

Figure 10: Bond market inflation "breakeven" pricing suggests the market has a benign view of long-term inflation

Negotiating the Last Mile

The “last mile” of US inflation normalisation may prove more difficult than the significant progress made over the last year. Ultimately the market’s constructive stance on inflation and rates should be vindicated over the next 6- to-12 months, but some near-term angst is possible, particularly as US equities are priced with little margin for error near-term.

While the potential for near term volatility remains, bonds should ultimately gain some additional support this year from moderating growth, lower cyclical inflation and rate cuts. Domestically, a growth pick-up in FY25 and the prospect of only a moderate easing cycle will likely limit the downside in bond yields.

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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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