For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
In this cycle, the market has believed on a number of distinct occasions that the US Federal Reserve is about to pivot towards a more dovish stance. Each time there has been a clear response by markets. Each time the market has ended up being disappointed.
Understandably, each time the market’s pivot belief is driven by weak data, whether that in turn was driven by a specific event or not, for example the invasion of Ukraine or the regional bank crisis. This time, the market has again become turbo charged by lower than expected US inflation data.
Obviously at some point the Fed will pivot towards a more dovish approach but why has the market been so consistently wrong? In part, it’s perfectly understandable to try to anticipate the peak in the cycle and also markets know that lower rates are generally good for markets, so there’s a wishful element to their thinking.
However, it’s also evident that the Fed’s work is incomplete (see graph). Compounding that, the market’s response to the belief that the Fed will become more dovish and loosen policy, in fact loosens policy itself, for example by US Treasury yields moving lower. This sometimes unhelpful feedback loop is something the Fed is very aware of.
Core inflation metrics are heading towards central bank targets but remain someway off
Source: Bloomberg, data from 30.05.2018 to 17.11.2023
It’s generally been stubborn inflation and hawkish Fed comments, which are clearly closely related, which have put paid to the previous convictions around a dovish pivot in this cycle. That said, the day the Fed pivots is coming ever closer: inflation is falling, unemployment is rising and the clamour for keeping inflation under control is fading, while concerns about over-tightening are growing.
To that end it’s worth thinking about where inflation goes from here. In the short term, the lower oil price will be applying cyclical pressures for disinflation, as will slowing economic growth. In the medium term we believe that structural factors like deglobalisation, resource constraints and very loose fiscal policy will apply powerful upwards pressure on inflation. At the minimum, we expect inflation to be more volatile and to be an uncomfortable force for central banks.
As a result of our higher for longer inflation base case, we expect bonds and equities to continue to be positively correlated. So, when thinking about portfolio construction, we look beyond bonds for diversification of equities, for example gold, the US dollar and Japanese and Indian equity.
