Merlin Weekly Macro: US inflation moves stubbornly sideways

On January 5ᵗʰ, our first Merlin Weekly Macro column of 2024 highlighted the significant parting of the ways between government bond yields (and by implication investors’ perceptions of what should happen next with interest rates), and the policy narrative of the central banks who set those interest rates. Yields were tumbling (and prices rocketing) as investors pushed the central banks, and the US Federal Reserve (Fed) in particular, to begin reducing interest rates soon and at a fast pace. But the Fed was sticking to its usual cautious line about the need first to defeat inflation. We warned that the differential “could not be seen as a permanent state of affairs. It seems obvious that polarised opinions separating markets from policy are unsustainable: both cannot be enduringly correct”.

Play ball? No thanks

And so it has proved. For the interest rate doves among investors, those transfixed by the need to relax monetary policy, the wretched US inflation data simply refuses to play ball. However much investors are willing the rate to return to 2% and to stay there, headline CPI remains stuck sideways in the narrow band bordered by 3% and 4% in which it has been trapped without a break since last May. There was an expectation that March 2024 CPI might rise slightly from 3.2% to 3.4%. In the event at 3.5%, still in that band, it confounded the consensus and went higher than expected. Markets reacted accordingly as the chance of an early rate cut took another backward step.

Volatility remains the order of the day: on October 19ᵗʰ in the aftermath of the Hamas attacks on Israel when markets were at peak jitteriness, the yield on the US 10-Year Treasury (the government-issued bonds) was 5.0%. By December 27ᵗʰ when bond managers closed their books on 2023 having been determined to recoup some of the considerable paper losses incurred since early 2022 and the beginning of the policy tightening cycle, the yield stood at 3.77% (remember, in fixed income prices move in the opposite direction to yields); today, at 4.54% more than half the gains made (or more accurately losses recovered) in late 2023 have been given back in 2024. And to think that amid such significant volatility, regulators including the Bank of England, the consultants and others involved in the management of long-term pension liabilities still have an endearing conception that government bonds are havens of stability, calm and security!

Larry Summers puts a cat among the pigeons

While the market consensus is that the likelihood of US interest rate cuts in the second half of the year remains almost unshakable, it is noticeable that some among the Fed’s members are now questioning the wisdom of cutting at all this year. As we queried a couple of weeks ago when debating the apparent insensitivity of the US economy to changes in policy, cited as contributing factors to this change in opinion are that if the US economy is struggling to get inflation back to 2% after the most aggressive rate-tightening programme in history, and the economy is growing far stronger than the Fed thought only a couple of months ago, surely it is counterproductive to be relaxing policy in the foreseeable future? Interestingly, former US Treasury Secretary Larry Summers seems to agree. He said this week that the logical next step is not a reduction in US interest rates but the opposite: “You have to take seriously the possibility that the next rate move will be upwards rather than downwards.”

Meanwhile in Europe, where inflation at 2.4% is gradually tending towards the European Central Bank’s (ECB) own 2% target, while couched in conservative language, it is easy to get the sense that the ECB is still itching to reduce its own interest rate even before the Federal Reserve. If weakness in the euro brings some relief to German and Italian exporters and helps drag their economies from the doldrums, so much the better as far as the ECB is concerned.

Markets appreciating exogenous factors

But lurking in the background is the effect of the increasing geopolitical risk. The deteriorating political and military situation in the Middle East is a growing concern. US and Israeli intelligence sources are predicting the strong likelihood of Iran making a direct attack on Israel in reprisal for the recent fatal IDF drone attack on senior Qud Force officers operating from the Iranian embassy in Damascus. If Iran were to attack Israel or its people directly rather than through one of its proxies, that would presage a dangerous new phase in the escalating hostilities.

Against this backdrop, the uncertainties facing Ukraine, and a resilient global economy growing at around 2.5%, the oil price has risen 10% in the past month; gold is breaking new highs; a number of other commodity prices have been rising sharply (the CRB Commodity index which includes oil is 14% up year-on-year and 15% year-to-date; the London Metal Exchange Index, while broadly similar to a year ago in value, has jumped 15% since early February). Commodity prices are naturally volatile and cyclical but the heightened geopolitical tensions are currently perceived as a potential economic and inflationary headwind, unsettling the timing of those anticipated US interest rate reductions (or, in Larry Summers’ mind, adding to the possibility that rates rise rather than fall).

Stay flexible and open-minded

As we have said often before, these are unusual times. Geopolitics are unstable to which the unpredictable spectre of Donald Trump adds tension; much of what is happening in the world of today’s economics would not be found in any conventional academic textbook; markets are challenging. Even those among us who have been in the markets almost since Moby Dick was a minnow do not (and more importantly should not) presume to have all the answers. But appropriate to the investor’s appetite for risk, a diversified portfolio of good quality assets and an exposure to a diversity of investment styles, such as those offered by the Merlin Portfolios, helps navigate the way through choppy waters. It gives breathing space to assess the risks in a dynamic and unpredictable environment and to take the appropriate action. And to repeat a familiar Merlin dictum, “when the facts change, we reserve the right to change our mind”.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.