What's next for investors as US inflation eases?

Investors in the UK and Europe are hoping the US victory over inflation will soon be repeated closer to home

There is still a high probability priced in for an interest rate increase this month as the Fed nears the end of the hiking cycle. AP

At last, inflation looks like it may be on the run. It’s the moment investors have been waiting for all year and last week they took full advantage.

Stock markets rallied hard after the US consumer price growth figure for June fell to only 3 per cent, boosting hopes of an end to the rate-tightening cycle of the past 18 months and easier monetary conditions ahead.

Many investors will be looking at how their portfolios have fared after the past few days and be feeling a little happier.

As ever, the big question with investing is what happens next. Can we now expect the rally to continue as central banks become dovish and start slashing interest rates, or is there a danger that investors are getting ahead of themselves?

Inflation is down but not out, with June’s figure a full percentage point above the US Federal Reserve’s 2 per cent target.

However, that is its lowest level since March 2021 and a long way from June 2022’s peak of 9.1 per cent. Core inflation, which excludes volatile figures such as food and energy, also fell to 4.8 per cent from 5.3 per cent in May.

Repeated interest rate rises are finally having a cumulative effect but the Fed isn’t quite done yet, says Ryan Brandham, head of global capital markets for North America, at Validus Risk Management.

“There is still a high probability priced in for a hike in July as the Fed nears the end of the hiking cycle.”

Its next meeting is on July 25 and 26 and markets still anticipate a 25-basis point increase to 5.50 per cent, but it could be a case of “one more and done”.

The high energy prices of last summer are creating a favourable base effect, which accelerates the decline in headline inflation, says David Kohl, chief economist at Julius Baer.

“This brings the Fed a big step closer to declaring victory in its fight against inflation and paves the way for one last rate hike and the end of an extraordinarily steep tightening cycle.”

Core inflation should continue to fall as post-pandemic supply chain shortages ease and labour markets cool, says Daniel Casali, chief investment strategist at wealth manager Evelyn Partners.

“This reduces the risk that the Fed overtightens and creates downward pressure to the economy and financial markets.”

As interest rates peak, confidence grows and the risk of an economic hard landing is reduced, the US dollar should depreciate against other major currencies, Mr Casali adds.

“This should provide additional liquidity, which will help equities to continue their bull run.”

It all sounds very positive but before we celebrate, it’s worth noting that inflation remains sticky elsewhere.

In the UK, consumer price growth held steady at a worryingly high 8.7 per cent in May, and the Bank of England is expected to continue increasing rates from today’s 5 per cent, with JP Morgan claiming they could go as high as 7 per cent.

Eurozone inflation did fall in May to 6.1 per cent from 7 per cent. That’s the lowest in a year but still uncomfortably high and the European Central Bank is also expected to keep tightening, even after the Fed eases off.

Yet, a growing number of analysts are questioning whether higher interest rates are the right policy, including Geoff Yu, FX and macro strategist for Europe, Middle East and Africa at fund manager BNY Mellon.

“Much to the frustration of policymakers, households across developed markets are simply not reacting to monetary tightening.”

Wages are rising, household spending is surprisingly strong, while manufacturing and other business surveys showed the economy is holding firm and policymakers are at a loss to explain the disconnect, Mr Yu says.

“The longer this situation holds, the more we expect markets to question the credibility of interest rate-based tightening.”

That didn't stop the FTSE 100 from jumping 1.8 per cent in response to last Wednesday’s US inflation figure, while the pan-European STOXX 600 index closed 1.5 per cent higher, its fourth straight day of gains.

Investors in the UK and Europe are hoping the US’s victory over inflation will soon be repeated closer to home.

Chris Beauchamp, chief market analyst at online trading platform IG, says markets everywhere are crossing their fingers and hoping for a soft landing.

“Investors are allowing themselves to contemplate the possibility that Fed chair Jerome Powell may actually achieve his goal of bringing down inflation without tipping the economy into recession.”

There is another worry, though. Monetary policy acts with a time lag and central bankers risk overdoing things as pressure grows to generate results.

Could we end up plunging into deflation instead? It seems unlikely at the moment but cannot be ruled out.

In China, consumer price inflation has fallen to zero, while factory gate producer prices have turned negative at minus 5.4 per cent, says Jim Wood-Smith, market commentator at Hawksmoor Investment Management.

As the US labour market cools, “one might argue that the two largest economies do not have an inflation issue but a deflation issue”.

It’s probably too early to start worrying about deflation before the war on inflation is won but this suggests there will be more volatility even when prices ease. There will be no easy return to the boom years of yore.

Monetarists have been calling the end to inflation, and warning of deflation, for months as the circulation of money slows, says Jeremy Batstone-Carr, European strategist at Raymond James Investment Services.

“Inflation is about to plunge even more sharply and will soon drop into central bank target ranges.”

This will leave the Fed, ECB and BoE in another sticky situation.

“For all their bluster, senior monetary policy officials will have the harder job convincing populations that grounds exist for crushing demand even more than is currently in train,” Mr Batstone-Carr says.

With inflation looking increasingly “benign”, now could be a tempting moment to invest ahead of the recovery, but investors will need to be “gutsy”, he adds.

Betting against central banks is a dangerous game, as the old financial mantra “don't fight the Fed” acknowledges but don’t rule it out.

“Is now the time to take on both central banks and the markets? There is an argument for doing just that right now,” Mr Batstone-Carr says.