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INTEREST rates are set to rise again after this week’s US CPI figures, though the data shows some heat is coming out of inflation.
The January headline rate of inflation in the US was 6.4 per cent higher than a year earlier. Core inflation was up 5.6 per cent.
It was “pretty much as expected”, says Pendal’s head of multi-asset Michael Blayney. “Inflation is too high but it’s coming down.”
How should investors react?
“There are always risks,” says Blayney. “It’s a natural feature of the economic/market cycle. Inflation, interest rates, earnings and the potential for a recession are all in focus.
“For investors, that means sticking to their plan.
“Markets are fair value at the moment and it’s a good time to be a bit like Switzerland – neutral. It’s time to be patient and wait for an opportunity.”
While the absolute CPI numbers matter, markets tend to react relative to expectations, notes Blayney.
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Market reaction to this week’s CPI print was relatively muted.
“For the market, it’s not what the number is,” says Blayney. “It’s what the number is relative to what the market expected.”
“The US inflation figures reinforce the high probability of a 25-basis point hike to 5 per cent in March.
“But it doesn’t change the overall picture of high-but-moderating inflation.
Futures markets are implying the Fed Funds rate will peak around 5.25 per cent mid-year.”
One difference this cycle is that the Fed will be determined to see inflation falling before cutting interest rates – having learnt from past experiences, Blayney says.
He notes that market volatility after an inflation print or Fed rates decision has lessened in recent months.
“Those factors remain very important, but markets have shifted their attention somewhat to recessionary risks and corporate earnings.”
In terms of recessionary risks, Blayney says leading indicators have been weakening over the past year, though there has been a small bounce recently.
“They’re still bad, but less bad – and that usually makes markets reasonably happy.”
And while corporate earnings have been downgraded, things aren’t as poor as first feared.
Blayney adds a caveat: “Historically spikes in inflation and the related Fed hiking cycles have flowed through to earnings with a lag.”
Another factor is Pendal’s in-house market stress indicator, which has been falling for a number of months as markets start to see a turning point for inflation.
Finally, China reopening, and Europe emerging from winter much better than expected in economic terms, has mitigated global recession risks.
Blayney says it’s a good time for investors to be Switzerland – neutral.
“Markets are around fair value. Economic data is contradictory and market momentum is patchy so it’s a good time to be close to neutral.
“But there are still some reasonable relative value opportunities.
“For example in equities, small caps all around the world are cheap relative to large caps. In the US for example, small and mid-caps as a percentage of market cap are near 20-year lows.
“That doesn’t necessarily mean they outperform in the short term if there is a recession, but it does mean they have a great set-up for the next decade.”
Bond holdings should be around investors’ strategic long-term level.
“They will still be helpful in the case of a recession, and are now generating much better yields,” Blayney says.
“It’s hard to make a compelling case for credit at the moment given spreads have shrunk. Right now you simply aren’t paid well to take on credit risk.”
As always, it’s about having a diversified portfolio, Blayney says.
“You need to own some assets that will do well if growth is better than expected, like equities, and some assets that will do better in a recession, like bonds.
“And you should hold some assets with cash flows that are indexed to, or resilient to, higher inflation.
If market pricing is wrong and there’s persistent inflation, investors are going to want this because historically inflation has tended to be bad for earnings and bad for bonds.”
Michael Blayney leads Pendal’s multi-asset team. Michael has more than 20 years of investment management and consulting experience. He was previously Head of Investment Strategy at First State Super and head of Diversified Strategies at Perpetual.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
The team — which also includes Allan Polley — manages our multi-asset portfolios with a focus on strategic asset allocation, active management and tactical asset allocation.
Find out more about Pendal’s multi asset funds:
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