Despite a stubborn January inflation report, we see inflation trending down gradually. We also think the U.S. Federal Reserve will not cut interest rates as quickly as markets expect.
U.S. equity markets rallied in the first six weeks of 2024. After rising over 24% in all of 2023, the widely followed S&P 500 index, rose another 5% to an all-time high in early February. The tech-heavy Nasdaq Composite index jumped over 7% in the first six weeks of 2024. Markets were initially buoyed by expectations that the U.S. Federal Reserve (“the Fed”) will start cutting interest rates as early as March 2024 as inflation slowed. Markets were also boosted by strong jobs growth; the unemployment rate was just 3.7% in January, near all-time lows.
However, January’s inflation figures surprised markets: the U.S. Consumer Price Index (CPI) rose 3.1%. While this was the slowest pace of inflation since June 2023, it exceeded forecasts of 2.9%. That threw doubts on expectations that the Fed will cut interest rates in March 2023.
We were not surprised by the stubbornness in inflation. We predicted that the last stage to lower inflation back to the Fed’s target of 2% was going to be tough. January’s price gains played to our views. However, despite the inflation surprise, we still believe price growth will continue to slow in the coming months barring geopolitical risks. We also believe that central banks will be wary to rapidly cut interest rates. After January’s surprise inflation, markets now expect the Fed to cut interest rates in June, more or less in line with our views.
On the other hand, despite inflation-induced volatility, markets resumed their rise. That’s because the U.S. economy is signaling that it is neither too hot nor too cold. Retail sales and industrial production data in early February cooled, reassuring markets that interest rate cuts may not be too delayed.
While the U.S. economy has held up remarkably well under the weight of high interest rates, other economies around the world are struggling. Growth rates were muted in the Euro zone and Canada. Japan unexpectedly slipped into a recession in Q4 2023. China is trying to break free from the grip of deflation.
As for positioning, we are neutral towards equities across all geographies. While U.S. equities are seeing upward earnings revision on the back of resilient consumer spending, we feel they have run up too far too quickly. Given current elevated valuations and the dominance of a handful of stocks driving U.S. gains, we think equity markets will struggle to increase a lot from here. On the other hand, any U.S. interest rate cut may boost equities everywhere else.
Within fixed income, we are overweight Canadian investment grade bonds that are dominated by high-quality issuers. Further, as the Canadian economy slows in the wake of higher interest rates, we expect interest rate cuts to come sooner to Canada. This should broadly help performance of Canadian bonds compared to other regions. We are underweight both high-yield bonds and emerging market bonds as the effect of high interest rates continue to play out with a lag.