The last-mile inflation challenge

• Major equity markets rebounded: The second week of 2024 saw rising equity prices after starting the year with a sharp pullback. Sector-wise, the main US technology segments rose the most, energy lagged. Japanese equities continued to rise after a strong 2023; but that’s obviously only in local currency, while their performance was lacklustre for European investors as the yen is very weak. Also continued the 2023 trend (this time of weakness), China equities lagged.
  
  
• Mixed economic data suggest caution: Resilient US jobs data and reasonable (albeit still weak) UK GDP trends helped offset higher than expected US inflation and a weak US purchasing manufacturers’ index for services. Elevated freight rates due to recent disruptions in the Red Sea also raised some concerns on the path of inflation reduction and interest rate cuts.
  
  
• Sharp and fast rate cuts look unlikely to us: US inflation came in slightly higher than expected with the annual rate ticking up rather than down, though the core measure excluding energy and food prices declined marginally as expected. Still, US bond markets were rangebound with US 10-year Treasury yields at about 4%. Taken together, we think the data are more in line with our views of rate cuts starting by the middle of 2024, later than market consensus. That said, the trajectory for lower interest rates taking a 6-12 months view and beyond remains intact.
  
  
• Q4 2023 earnings results from large US banks were mixed, too: J.P. Morgan shares were up a little post results while Bank of America shares down – both banks took some one-off charges in Q4 last year, but profits were affected much more at Bank of America. The challenge for banks is managing net margins as rates fall while pressures from credit losses and deposit rates increase.
  
  
• Bitcoin going mainstream? The other interesting development last week was the US securities regulator (the Securities and Exchange Commission, SEC) approving the first batch of proposed US Bitcoin ETFs (Exchange-Traded Funds), which boosted not only the price of Bitcoin. The key market debate is whether cryptocurrencies could in future become digital alternatives to gold. We think they may have trading value for some type of investors, but they’re also very volatile, quite correlated with risky assets and, therefore, add little diversification benefit to portfolios. We also believe that they’re likely to face formidable competition from the central bank digital currencies that are being developed.

• Maintain but moderate defensive bias: As described in our 2024 Investment Outlook, we maintain our slightly defensive positioning, with more government bonds (which should benefit from slower economic growth and inflation plus interest rate cuts) and fewer equities and credit relative to our long-term asset allocation. But we have moderated our defensive bias, as the interest rate cuts we expect remove a key headwind for equities.
  
  
• Slightly increased equities to mitigate underweight: We continue to hold low-volatility stocks and, generally, high-quality stocks with strong balance sheets. We have also increased our exposure to European equities (excluding the UK) and developed Pacific equities (excluding Japan).
  
  
• Government bonds are attractive: As evident from the last several weeks’ market movements, the expectation of interest rate cuts in 2024 has caused bond yields to fall (and prices to rise), which is positive for our overweight position. We have kept our exposure to high-quality government bonds in the Eurozone and have bought more US Treasuries.
  
  
• Reduced riskier credit: Given the lower risk yield available in government bonds, we have reduced our exposure to riskier credit.
  
  
• Added broad commodities: We are diversifying our commodity exposure into a broader allocation, which can help protect portfolios from any short-term uncertainty in geopolitics and energy prices and as capitalise on any upside surprise in growth.

• Elections in Taiwan: The vote in the island resulted in the West-leaning ruling party DPP coming back to power. As a result, geopolitical tensions between the US and China over Taiwan may continue in the medium term, although this is not different from the status quo. Markets will likely look out for any immediate commentary from Taiwan, China and US on the election results.
  
  
• Lacklustre economic growth: Even though the German economy is going through a shallow recession, several forward-looking indicators such as the ZEW investor survey (Tuesday) point to a stabilisation a low levels of activity. China GDP growth (Wednesday) is expected by the consensus to slow marginally on a quarter-on-quarter basis, but the headline year-on-year figure is projected to have accelerated to above 5% once again; the most recent data on industrial production and retail sales should confirm a degree of stabilisation, too. US retail sales figures (Wednesday) could offer some insights into the health of the consumer during the critical year-end holiday season.
  
  
• Last mile to inflation target remains tough: Inflation figures from the Eurozone and the UK (Wednesday) this week could show that, after many months of falling, inflation is stickier at current levels. Recent escalation in freight rates driven by the shipping disruptions in the Red Sea increases risks of inflation ticking up, especially in Europe. Also of interest would be Japanese inflation data (Thursday): Japanese equities rallied strongly in 2023 as inflation returned to the country after two decades of low inflation and deflation. The risk is that the Bank of Japan, which so far kept interest rates at negative levels, could raise rates when most other central banks begin to cut. This could strengthen the yen and hurt Japanese earnings growth.

Past performance is not a reliable indicator of future returns.