As global inflation rates slowly fall during 2023, we discuss the accuracy of analyst forecasts and if a ‘pivot’ from the Federal Reserve is on the horizon. The combination of elevated core inflation and the uncertain outlook for traditional assets has created a challenging environment for portfolio managers to successfully navigate, who may need to consider other more creative ways to generate a real return in their portfolios.
Why inflation forecasts matter
Market analysts regularly make forecasts on changes to the economic outlook of countries. As inflation levels rose sharply in 2022, not helped by geopolitical pressures, more attention has been paid to the predicted trajectories of inflation rates globally.
Changes to the rate of interest and money supply (commonly known as monetary policy) are a key lever in the armoury of economic policy makers. They can be used to help stimulate growth in a slowing economy through greater access to credit, encouraging consumption. Alternatively, they can help control expenditure when markets are overheating to try and ensure a stable and sustainable rate of growth.
However, the impact of changing interest rates is more widespread than on just consumer finance. Rising borrowing costs also restrict investment by private companies, who may indirectly be affected by a reduction in the disposable income of their customers, creating downwards pressure on their stock prices. This is one of the reasons there is historically an inverse relationship between stock market performance and the base rate of interest.
Whilst decisions on changes to monetary policy are never straightforward, one of the many factors they incorporate is the current rate of inflation. Sustained higher levels of inflation therefore create pressure on global policymakers to increase interest rates. This means that market participants may become bearish about the future performance of stock markets. As a result, we pay close attention to analysts’ inflation forecasts.
If analysts were wrong on the way up, why would they be right on the way down?
Looking back to the forecasts of the FOMC as inflation rose, as per Figure 1[1], the consensus was clear. Analysts were slow to accept that inflation would rise to the levels that it did, then consistently predicted that it would quickly fall and return to the long-run levels of 2%. This is the rate of inflation that is commonly considered to achieve maximum sustainable employment and price stability and is the target of the Federal Reserve. The same observation can also be made in analyst predictions across all major global economies – and the highly correlated nature of the forecasts may lead some to question whether there is some evidence of a herding bias.
A trump card played that cannot last forever
Energy prices were a significant contributor to the elevated level of inflation, especially as crude oil approached $120 per barrel in May 2022. The Strategic Petroleum Reserve (SPR) is a large underground storage facility along the coastline of the Gulf of Mexico held by the US government that can be utilised to address any supply issues, usually for emergency purposes. More than 180 million barrels were extracted from this source in the period May 2022 to May 2023[2], helping to reduce crude oil prices to around $70 per barrel, notably easing inflationary pressures. Whilst effective in the short-run, this is a finite resource that clearly cannot be expected to come to the rescue indefinitely.
A lack of breadth in the current market recovery
Though significant progress has been made in curbing the rate of inflation, in order to do so, the Federal Reserve has made historic changes to monetary policy whilst the government has also played their ‘trump card’ in tapping into SPR stocks. The former has strengthened the US dollar considerably, and initially, weighed heavily on equity markets. US markets have rallied strongly in 2023, however, deeper analysis shows all is not as rosy as it may seem on the surface. The bounce in the S&P 500 is driven almost entirely by only 8 stocks – the FAANGs[3] plus Microsoft, Nvidia and Tesla. Furthermore, their strong performance year-to-date is in no part due to improved profitability or other fundamental metrics. Instead, they are behaving like technology stocks, buoyed by the hope from market participants that the Federal Reserve will soon begin to cut interest rates.
Conflicting signals suggest it is too early for the Federal Reserve to ‘pivot’ on interest rates
However, the typical signals used to determine whether a pivot in interest rates is on the horizon are at odds with one another. The job market continues to prosper, with 1.6[4] open jobs for each unemployed worker and hires greater than quits across all major sectors. The US housing market is also surprisingly resilient, with supply and demand imbalances pushing up prices and cash purchases representing a sizeable share of transactions, limiting the impact of recent rate hikes.
On the other hand, excess savings in the US that were built up by households during the extended period of money printing to counter the economic impact of the coronavirus outbreak have now been fully depleted. Furthermore, if we listen to the messaging from the Federal Reserve, US interest rates are not yet considered restrictive. Only when the entire yield curve is above the Core PCE rate of inflation[5] will they consider that the job is “done” on rate hikes. As we can see from Figure 2[6] below, there is still some way to go yet.
Worryingly, if the Federal Reserve is to make good on their promise of returning to 2% inflation, how much further will interest rates have to go and at what cost? The alternative is to accept a new normal of higher long-run rates of inflation in the US. This is politically difficult to communicate and would considerably undermine their credibility on any future economic pledges.
The combination of elevated core inflation and the uncertain outlook for traditional assets has created a challenging environment for portfolio managers to successfully navigate. Some are therefore looking to more alternative strategies to offer both diversification to traditional assets and provide a real rate of return in this highly inflationary market.
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[1] Source: US Federal Open Market Committee and Federal Reserve Bank of St Louis.
[2] Source: US Energy Information Administration.
[3] Facebook, Apple, Amazon, Netflix and Google (Alphabet).
[4] Source: US Bureau of Labour Statistics, as of 1st August 2023.
[5] The Federal Reserve’s preferred inflation measure that excludes the prices of food and energy.
[6] Source: US Federal Open Market Committee and Federal Reserve Bank of St Louis.