All eyes on inflation

Central banks around the world have waged an aggressive policy war to fight the stubborn inflation experienced in the aftermath of the pandemic and the war in Ukraine.

The resultant higher interest rates continue to weigh on economic activity and stifle growth, affecting developing and emerging economies to differing degrees.

While a cooling in energy prices is helping to bring down headline inflation, and tighter monetary policy by central banks is starting to filter through markets, inflation is moving back towards targets slower than initially anticipated.

With global headline inflation expected to fall from 8.7% in 2022 to 6.8% in 2023 and 5.2% in 2024, the IMF forecast in its July World Economic Outlook that global growth would fall from an estimated 3.5% in 2022 to 3% in both 2023 and 2024.

“We have seen only a moderate slowdown in economic activity so far, which has helped bring inflation down from peak levels,” affirms Justine Cousins, Portfolio Manager at Peregrine Capital.

“While we could still experience a recession in the next 12 months, the odds of this seem lower given the resilience of the global economy in the face of the very rapid rate hikes seen over the last 15 months, which has increased the probability of a soft landing.”

Cousins believes that global markets have priced in the reduced risk of a recession quite accurately over the last six months, with most global indices making back a portion of their 2022 losses.

While it remains unclear whether inflation will trend all the way down to 2% in the developed world, Cousins cautions that it remains possible that interest rates will rise further and stay higher for longer.

The consensus view is that the rate-hiking cycle is nearing an end. Ratings agency Fitch Solutions stated that the hiking cycle has reached its apex, and that most policymakers will either maintain current rates or cut them during the latter part of the year to stimulate growth.

Renzi Thirumalai, Chief Investment Officer at FNB Wealth & Investments, highlights that emerging markets that hiked interest rates before the developed world, like Chile and Brazil, have already started their cutting cycles.

“Most developed markets, including the US, are at or very close to their peak in this rate cycle, although the UK is a notable exception.”

In this scenario, the peak in the interest rate cycle has historically been good for fixed income investments, elaborates Thirumalai. “As such, adjusting portfolios to an overweight bonds position seems appropriate at this juncture.”

Reza Hendrickse, Portfolio Manager at PPS Investments, echoes this sentiment. “The cycle is close to the end because rates in the US are already above what economists consider 'neutral', which is the rate consistent with an economy at full employment, and that enables price stability,” she explains.

“The Fed is not oblivious to the fact that inflation is moderating, but for the sake of credibility, the central bank needs greater comfort that 2% is within reach, and that another flare-up in inflation is unlikely.”

Investors will need to consider that, even as rates peak, the lag with which contractionary monetary policy works will continue to affect markets, adds Thirumalai.

“This will potentially place pressure on earnings in the next year or two. The uncertainty with risk to the downside, combined with attractive fixed income valuations, means that fixed income assets may play a more valuable role in portfolios than they did in the last few years when equities have provided very strong real returns.”

However, while the rate-hiking cycle is likely nearing an end, Hendrickse cautions that a rate-cutting cycle remains some way off.

“With the labour market still tight and little evidence that tight policy is starting to choke growth, the Fed can afford to take its time before contemplating a cut. It would also prove difficult to maintain tight policy should inflation reach 2%.”

However, Hendrickse says that should the US economy enter a downturn, it would force the Fed’s hand.

“In that scenario, growth assets should come under pressure temporarily, and bonds should do well, which would pave the way to consider adding equity incrementally to portfolios.”

“The ideal outcome is that the central banks can get it right without doing significant damage to the global economy,” concludes Cousins.