Inflation Picture Comes into Focus

Only a year ago, markets were focused on recession risks. Now, the consensus view sees a soft landing for the U.S. economy. Still, the Federal Reserve (Fed) remains on hold and may keep rates higher for longer. A closer look at the inflation picture may shed some light on what could be ahead for the macroeconomic outlook, Treasury yield curve, currencies, and global economies.

Inflation picture comes into focus

Despite some upside surprises in the first quarter, significant progress has already been made against U.S. inflation. Furthermore, April’s reading showed some moderation, which we expect to continue in the coming months. The first quarter increases were concentrated in service sector prices, like rent and auto insurance, where lags are particularly long and not necessarily reflective of current economic conditions. Meanwhile, goods price inflation is already low, and there is scope for further declines going forward.

Jobs versus growth

Progress on labor market rebalancing is beginning to appear. At the same time, solid economic growth has been supported by strong population and productivity growth. Despite this attractive gross domestic product (GDP) growth, the unemployment rate has actually moved up slightly. This trend suggests that strong growth can exist without putting upward pressure on capacity and inflaming corresponding inflationary pressures.

Going forward, we do expect some moderation in U.S. growth along with rebalancing of some of the drivers, like consumption. While we have seen weakness in manufacturing and housing activity over the last two years, these sectors likely will be less of a drag on growth. At the same time, private service consumption and government spending have made outsized contributions to growth, which we expect to slow in the future.

Soft landing or something harder?

Monetary policy is restrictive and a headwind to economic growth, in our view. Signs of these tight conditions can be seen in weak private sector credit growth, commercial real estate market stress, credit card delinquencies, and soft small business confidence survey readings. Meanwhile, the consensus has shifted toward a soft landing view, and that is probably the more likely scenario, particularly if the Fed is able to cut rates later this year. But at the same time, it is important to recognize that this has been an incredibly unusual economic cycle with no obvious historical comparisons. We remain open-minded about the possibility of recession risk. Ultimately, we are watching economic data very closely. If we see a larger slowdown in consumption or in service spending, maybe together with more fiscal drag, we could see a deeper retrenchment in labor demand and a more significant increase in the unemployment rate, potentially taking the economy down a more recessionary path.

The Fed’s reaction function

While we expect inflation to continue to subside, it may not go back to levels seen before the pandemic. In the decade before the pandemic, the Fed was persistently missing its inflation target with inflation running too low. Going forward, it may be more realistic to expect that inflation will be more in line with the 2% target, if at times a little bit above. The Fed likely will not wait for inflation to fall below target and instead will ease once they are confident inflation is on the right path.

If we generally are correct with our view of inflation, we expect at least two 25-basis points cuts this year, even if the economy remains resilient. Rates are restrictive and still at elevated levels. If inflation is progressing toward target, the economy does not need the current degree of restriction. Additionally, the Fed is forecasting the unemployment rate will be at 4% by the end of this year. It will not take much to finish the year above that target. If we see even a moderate increase in unemployment, we could potentially also see more aggressive policy easing.

In favor of fixed income

We believe 10-year Treasury nominal yields around 4.5% are attractive given that it is unlikely the Fed will need to hike rates again. Instead, we do see a number of plausible scenarios in which rates are cut more than current market expectations for about 150 basis points of rate cuts over the next three years. So, bonds may offer investors an attractive asymmetry. Going into a policy cycle, investors may want to be a little closer to the short end of the yield curve. But from a longer-term perspective, 10-year real yields of 2% to 2.25% are quite compelling and generally consistent with the underlying trend growth rate of the economy. At the same time, U.S. equities are expensive on a wide range of valuation measures, and the equity risk premium is around its lowest level in 20 years. Over a medium-term perspective, when looking at a plausible real U.S. equity return estimate over the next 10 years, we see the spread as effectively favoring fixed income. For investors with a medium-term horizon or longer, we believe now is a good time to shift some of the risk away from equities toward fixed income.

Looking beyond the U.S.

Compared to the U.S., other developed economies generally have experienced weaker economic growth over the past two years. In some countries, like Canada, Australia, and New Zealand, the pass-through from monetary tightening to higher mortgage costs has caused a quicker and larger drag on growth. In Europe, some of the growth underperformance was due to a massive terms of trade shock after Russia invaded Ukraine. Differences in fiscal policy responses to the pandemic are also important considerations. Since its fiscal response to the pandemic was much more aggressive and enduring compared to other developed market economies, the U.S. potentially faces a greater payback.

Signs of improving growth are beginning to emerge outside of the U.S. Falling inflation is boosting real incomes, which is supporting stronger consumption. Business confidence surveys are showing gradual improvement. Now, several central banks outside of the U.S., such as the Swiss National Bank, Swedish Central Bank, European Central Bank, Bank of England, and Bank of Canada, are either cutting policy rates already or poised to start soon, which should be supportive for economic growth in these countries going forward.

Investment implications

From a medium-term perspective, we believe the dollar is expensive versus both developed and emerging market currencies. At the same time, the U.S. risk-free rate is still very high, particularly compared to other G10 economies, which means the dollar may remain expensive for a while longer. However, signs that a more aggressive Fed easing cycle may be warranted would also signal an opportunity to be short the dollar on a broader basis. While the focus currently is on the U.S. inflation trajectory and timing of the first Fed rate cut, attention will shift toward the elections by August or September. The outcome of the November elections could lead to significant changes in U.S. trade, fiscal, and other policies, which could trigger extreme currency market swings.

Our focus has been on Latin American currencies, which generally offer a compelling mix of favorable valuations, high real rates, and decent economic fundamentals. Fixed income assets in these markets also are attractive, with countries like Mexico and Brazil offering investors 5 to 6% real yields on local currency government bonds. Generally, we see a supportive backdrop for U.S. fixed income, including Treasuries and agency-backed mortgage securities. We think the Fed policy easing cycle would provide a supportive backdrop to these assets.