Will inflation settle soon?

Interest rates continue to rise in the US and UK as inflation keeps climbing, and markets have been bumpy as a result. Tough Covid-related lockdowns in China and the ongoing impacts of the Ukraine invasion have further dented the market mood.

Market conditions are very unusual right now because we have rising inflation and slowing economic growth – they usually both grow at the same time.

This means central banks are removing their support for economies to try to tame inflation, just as those economies are slowing down. Understandably, this is spooking investors and hitting market performance.

We think the immediate future for inflation is different depending which side of the Atlantic you’re on. But, crucially, it may be starting to settle in the US. And, as the world’s biggest and most influential economy, America is far more important than Europe and the UK to global investors such as ourselves.

Lilian Chovin, Head of Asset Allocation at Coutts, said: “We expect inflation in the US to fall over the second half of this year, but markets are likely to be volatile in the meantime. UK inflation, on the other hand, is likely to remain high for most of the year, and the Bank of England (BoE) has already started commenting on the challenges this could present to UK consumers.”

US inflation could be peaking

There are already signs that inflation could be peaking in the US, particularly with the latest consumer price index (CPI) figures, that came out on Wednesday 11 May, showing a slight drop. Year-on-year headline inflation was down to 8.3% from 8.5% in March, while core inflation was down to 6.2% from 6.5%. Both small declines, but they suggest US inflation might be reaching its ceiling.

The CPI numbers also showed that wage growth in the US was cooling and goods shortages were easing, which could relieve some of the pressure on the US Federal Reserve (Fed) in terms of tackling inflation.

Prior to this, investors were already encouraged by recent comments from the Fed saying a 0.75% future interest rate hike wasn’t under review, and that price pressures could be reaching their limit.

Timing is also a factor for inflation. It was around this time last year that we saw the price of energy and other goods start climbing as we emerged from lockdown.

“Now that we’re reaching the one-year point, those substantial rises should start falling out of the year-on-year inflation calculations,” explained Lilian. “For example, the jump in the oil price over the last 12 months will be smaller than the jump seen during the 12 months before that. And in time this should ease inflationary pressures on central banks and markets.”

It’s also worth noting that the US is more self-sufficient for energy than other parts of the world, so isn’t seeing the same price pressures as the UK and Europe as a result of sanctions on Russia following its invasion of Ukraine.

Lilian said: “While the exact timing is impossible to predict – with central banks opting to raise interest rates quickly, the outlook is far less predictable – we could be seeing the first signs of inflation starting to settle, at least in the US. And that should in turn eventually lead to calmer conditions for investors.”

We don’t see US recession this year

Despite the current economic challenges around the world, we don’t expect a recession in the US this year.

In fact, our recession indicator currently shows a very low probability of that happening in the coming 12 months.

There is still much to feel positive about regarding America’s economy. For example, the employment market remains extremely robust with over 400,000 jobs added each month so far this year, which supports positive economic growth going forward.

Corporate fundamentals remain healthy

From a global stock market perspective, companies are still performing well too.

The proportion of businesses beating profit expectations around the world has been above long-term averages over the last couple of months. And equity and bond market prices have been adjusting to higher expected returns in future – another encouraging sign.

Data covering global stock markets that shows how expensive a company’s stocks are – known as the ‘price earnings multiple’ – suggests shares are currently undervalued. This is a sign of good company performance and potential opportunities for investors.

How we’re managing clients’ money

We were aware of the possible challenges 2022 would bring and had already made a number of changes to our portfolios and funds to help navigate the current environment. These include:

• reducing European equities at the end of 2021 in anticipation of a tougher economic outlook for Europe and entering 2022 with an overall low exposure to equities in our multi-asset funds
• investing in healthcare and buying more UK stocks, which have both outperformed global equities so far this year
• consistently reducing our exposure to growth-style equities, such as technology, and smaller companies since the beginning of 2021 – these companies have struggled amidst rising interest rates and slowing economic growth
• having an element of stability in our investments by holding some cash, as well as a defensive allocation to Chinese government bonds – helping minimise volatility and allowing us to act quickly when opportunities arise
• holding fewer bonds that are sensitive to rate changes, which has helped cushion our portfolios and funds somewhat from bond market falls

What’s been worrying investors?

At the end of last week (6 May), the BoE raised interest rates for the third time this year by another 0.25% to 1%. Similarly, across the pond, the Fed raised its interest rate by 0.5% to a range of 0.75% to 1%.

The rate hikes were widely expected by markets, so they didn’t have a big initial impact. But concerns about the economic outlook then started to permeate an already fragile investor mood, and most markets did eventually fall.

At the same time, the BoE warned that the UK economy could shrink rather than grow in the last three months of 2022, and could contract next year. But any discussions surrounding a contraction of the UK economy are very speculative and not at all certain at this stage.

Opportunities remain despite uncertain outlook

Markets are facing some very real geopolitical and economic risks at the moment and the outlook remains uncertain.

But the signs of inflation peaking, solid company performance and no indication of a US recession are all positives worth keeping in mind.

The fact that company shares currently look undervalued is a particularly good sign of a potentially rosier long-term picture, and shows there are opportunities for investors even in difficult times.