Preparing for inflation

Forward guidance may be out of fashion these days, but there were no surprises from the world’s central bankers last week. With the notable exception of the Bank of England, the guardians of monetary stability are moving in lockstep to get on top of persistent inflation. And investors are preparing in turn for the higher interest rates that implies.

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Follow the Fed

With slightly higher interest rates than its global peers, the Bank of England had the luxury of waiting and seeing for one more meeting last week. Rates stayed unchanged at 3.75% despite the market’s growing view that at least four rate hikes are on the cards over the next 12 months.

Elsewhere, central banks are taking their lead from the Fed, which raised rates last week for the first time in three years. It was a significant statement from the new head of the central bank, which reassured markets that Kevin Warsh is his own man. Facing down pressure from the White House to cut rates in the face of higher than target inflation pleased bond investors. Yields at the inflation- and policy-sensitive long end of the curve actually fell on the news.

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The dot plots, which signal rate-setters intentions, point to one more rate hike this year and no cuts in 2027. Importantly, inflation is not expected to return to the 2% target until 2029. That will be eight years of above target price rises. This is no longer a post-pandemic inflation spike. It looks more like a new inflationary regime. With a higher cost of capital to match.

What happens next will depend in large part on whether the AI spending boom continues. The money being thrown at data centres, semiconductors and power grids is significant enough to move the economic dial. Continued spending and rate hikes look both necessary and manageable. An end to the spending boom, on the other hand, and higher rates will quickly bite in the rest of the economy.

The other important rate hike last week was in Japan. Again, it was expected. But there’s little consensus on what happens next. Messaging from the central bank was ambiguous, but with rates well behind the rest of the world at 1.25%, and a free spending prime minister in charge, further hikes look likely. A persistently weak yen adds to the case for tighter policy.

Quiet week ahead

After all the consequential central bank action last week, the next few days look less significant. The focus in most countries is on the strength of the economy via purchasing managers index announcements. In most cases the outlook is for more growth.

Japan’s manufacturing and services PMIs look like being safely in expansion territory, above the 50 watershed. Companies are winning export orders and business sentiment is improving. Again, that points to more rate hikes ahead.

Likewise in Europe, despite a 40% rise in the oil price since July, the eurozone economy is holding up better than expected. PMIs are expected to be above the 50 mark, and the highest level in four years.

The UK’s growth rate is also reasonable for now, but sentiment ahead of the October Budget is subdued. Rising energy and borrowing costs are clouding the outlook for new Chancellor John Healey. Worryingly, his fiscal headroom - the margin by which he is able to meet the rule of balancing the current budget - has narrowed sharply over the summer. It all points to yet more tax rises next month and the speculation about where they will fall has begun in earnest.

Markets hold their breath

This is all being reflected in stock markets that are close to their recent highs but running out of momentum. The AI trade has stalled, bond yields are rising, and that is putting pressure on equity prices. Despite that, credit spreads remain tight, suggesting investors are not too concerned about he corporate outlook, and earnings are growing strongly.

The market has broadened, which has disguised the slowing of the technology boom, but enthusiasm is clearly waning. Just 29% of companies are above their 50-day moving average and about half above the 200-day average.

Investors looking for a catalyst for the next market up-leg are struggling to find one. And there is plenty on the horizon to worry about. But equally anyone looking for parallels to previous market peaks like the dot.com bubble see important differences this time around. Strong earnings growth has kept valuations at about 20 times earnings. There’s no evidence here of a bubble.

The prevailing view among investors is that it’s right to keep dancing while the music plays. But everyone’s keeping an eye on the remaining chairs to avoid a nasty bump if things take a turn for the worse. Cautious positioning and diversification look sensible.

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