Inflation Remains Sticky: April 24

One of the major narratives in April was the hawkish repricing of the chances that the US Federal Reserve (the Fed) will cut rates, with market confidence eroding from last month’s highs. As a result, the S&P 500 fell 4% and the US 10-year treasury rate rose 48 basis points. The Fed left the policy rate unchanged at its May FOMC meeting and announced it would slow the pace of quantitative tightening from June 1, from the current $60 billion to $25 billion per month for Treasuries redemptions. Chairman Jerome Powell highlighted that the Fed officials are “prepared to maintain the current target range for the federal funds rate for as long as appropriate” as he acknowledged that progress towards bringing down inflation to its 2% goal had stalled. March CPI rose 3.5% year-over-year, up from 3.2% in February, which landed above economists’ estimates and further dampened sentiment. Local equity markets also came under pressure, with the S&P ASX200 down almost 3% (Chart 1).

Economic data suggesting stubborn inflation and mixed perspectives on the overall economy also garnered much attention this month. With March headline and core CPI printed above consensus and March nonfarm payrolls rising sharply, analysts are concerned inflation will take longer to fall to target and may further push out the prospect of Fed rate cuts. In the Euro area, the preliminary year-on-year core CPI decreased; however, it still ended above expectations, as preliminary GDP estimates also surprised on the upside. Global central banks continue to closely monitor economic data and will only begin to cut rates when they believe the risk of a second wave of inflation is minimal. As long as there is strength in the economy, it will be too early to cut rates as it may further stimulate growth and put upward pressure on CPI.

However, the odds of rate cuts in September and November improved slightly following the Fed’s meeting on the 1^st of May, which may help support US equity markets heading into the new month. Tighter lending standards widened corporate bond spreads and the general negative sentiment saw bond yields increase and the Bloomberg Barclays Global Aggregate Index move almost 3% lower in May (Chart 2).

Bleak Inflation Outlook for Australia

Australia’s inflation rate slowed less than expected in the March quarter as cost of living pressures continued to weigh on consumers, dimming hopes that there would be a cut in the official cash rate this year. The March quarterly inflation rate was 1%, compared with the 0.6% pace in the December quarter, coming in higher than analyst expectations (Chart 3). “It’s higher than we were expecting, higher than what the market was expecting and higher than what the RBA would be expecting, so that 1% number will be something that they’ll be alarmed about,” said Madeline Dunk, an economist at ANZ that tipped a first rate cut in November. Service inflation is the main culprit for holding back progress, as is rent, which advanced 2.1%, lifting the annual increase to a whopping 7.8%. This is the fastest pace in 15 years amid very low vacancy rates.

The Reserve Bank’s board will analyse the latest data closely when it meets on the 6-7^th of May to determine the most appropriate course of action. If we do not see services and rent driven inflation decelerate in Q2, rate cuts will likely get pushed out to next year. Due to the slower progress on disinflation and a healthy labour market, Westpac revised its forecasts for rate cuts from September to November. It has been frustratingly slow to reduce inflation in Australia; however, with signs the US Fed may begin to cut rates earlier than Australia, support may re-emerge for the Australian Dollar.

Portfolio Positioning

As market sentiment fluctuates each month with policymakers carefully observing economic data to determine monetary policy, investors should remain focused on long-term investment objectives. Preserving capital by maintaining a multi-asset class portfolio that is sufficiently diversified across all asset classes, regions, sectors, and fund managers is imperative.

The yield curve displays normal convexity in the long-term vs short-term maturities (10Y vs 2Y) however it remains inverted in short-term maturity bonds (2Y vs 1Y) which has been viewed as an indicator of pending economic recession. It becomes particularly important for investors to maintain a well-diversified portfolio when it comes to various risk and return factors. Constructing a portfolio that derives its return from various factors (equity, currency, momentum, value, growth, and interest rates) will perform more robustly during periods of economic recession and heightened volatility.

LBP therefore maintains its slightly defensive positioning, seeking relative value in private debt to provide investors with a good income stream given the current level of global yields. We also consider other alternative investments such as royalties that focus on the top level to provide stable income. Private markets also typically have a lower sensitivity to market movements that can help smooth returns. There remains a meaningful allocation to listed and private equities, and real assets while we continue to explore divergent and convergent strategies in alternative investments to provide further portfolio diversification.

LBP continues to stress that a robust investment framework, and remaining invested through the cycle are integral to preserving wealth, and that investors should emphasise the long-term goals of income generation and capital appreciation. With markets unable to remain consistent, it is best to avoid trading on short-term movements as time has shown that the greatest threat to real wealth comes from being underinvested in the long run.