Higher-for-longer inflation and interest rates — and what it means for equities and currencies

US interest rates appear set to remain higher for longer. And equity markets are, finally, coming around to accepting — and pricing in — this scenario (which we had long believed in and written about in past articles). Investors started the new year on what we thought were wildly optimistic expectations — that is, for the first rate cut to happen in March and for a total of up to 1.5% reduction by end-2024. This bullish outlook sent stock prices sharply higher. Risk appetite returned as investors abandoned recessionary expectations and jumped on the “soft landing” bandwagon. The S&P 500 index made 22 new record highs in the first three months of the year, gaining 10.2% in 1Q2024 alone.

As we explained several weeks back, the problem is that the pieces of this puzzle — the combination of rapid disinflation (and sharply lower interest rates), soft landing (moderating economic growth and resilient job market) and double-digit earnings growth (margins expansion) — simply can’t fit together. These factors are inherently incompatible — they cannot all happen at the same time.

For instance, if the economy and consumer spending remain strong, companies will flex their pricing power and expand margins and profits. But this will lead to resurgent inflation, or at the very least, sticky inflation, not rapid disinflation. And sticky Consumer Price Index (CPI) — not falling back to the US Federal Reserve’s 2% target rate — in a resilient economy with near-record-low unemployment rate means there is little reason for the Fed to aggressively cut interest rates. Alternatively, if the Fed does start cutting interest rates sharply, it would likely be because the economy and job prospects are deteriorating too quickly, which would be bad news for sales, margins and profits.

As it turns out, the US economy is far more resilient — growing faster than expected — despite enduring almost two years of sharply higher interest rates. One of the reasons is that many households and businesses emerged from the pandemic with stronger balance sheets, thanks to massive government spending and the proliferation of cheap, fixedrate borrowings since the global financial crisis that buffered against immediate rises in borrowing costs.

And disinflation is stalling, pouring cold water on the market’s perfect scenario (see Chart 1). CPI figures have topped market expectations for three straight months. In the latest March report, prices came in 3.5% higher y-o-y (up from 3.2% in February) and 0.4% higher m-o-m. Inflation, on a three-month annualised basis, is running far ahead of the 2% target.

The labour market is robust, with the economy continuing to add jobs at a faster than forecast pace. Case in point, the US economy added 303,000 jobs in March, beating even the most optimistic forecast by a mile. The March job additions exceeded expectations for the fifth straight month. Clearly, there is still plenty of demand for new hire. Unemployment fell marginally to just 3.8%.

Importantly, real wage remains positive — incomes continue to catch up to the price surge during the pandemic — underpinning consumer spending and, in turn, the economy. On a positive note, it is not accelerating despite the strong job additions, thus avoiding the dreaded wage-price spiral (see Chart 1).

The intense labour shortage during the pandemic has receded with a recovering participation rate. The other major factor is likely the massive spike in immigration post-pandemic (see Chart 2).

The influx of labour supply helped keep a lid on wages in a tight labour market and is positive for economic growth (more workers equal greater production capacity and output). However, immigration is, without question, a growing political issue, especially heading into the critical last leg of the presidential election. Will politics prevail? Immigration falls and wages rise, causing a wage-price spiral thereby making inflation even harder to tame even as the economy slows?

!e secular inflation and interest rate decline is reversing

We have written a lot about the secular decline in inflation and era of ultra-low interest rates in past articles. One of the biggest factors was that China has been exporting goods deflation — underpinned initially by cheap labour cost and economies of scale and, later, through the building of efficient supply chain ecosystems and innovation — to the rest of the world for more than four decades. And the US has benefited immensely, driving consumption growth and raising American standards of living while keeping inflation and the cost of borrowings low, which in turn, drove investments and innovation.

But the politics of today — China is now perceived as a threat to the US’ economic and military dominance — has changed this narrative. Case in point, US Treasury Secretary Janet Yellen has just accused China of flooding the world with cheap goods due to its “industrial overcapacity”. (For more, read our article last week, “Allies today, enemies tomorrow: Relative prosperity of a nation drives geopolitics and trade”.)

Aside from growing tension between the world’s two largest economies, there are increasing military conflicts as well as the costs of climate events and green energy transition to contend with. Oil prices, for example, are

now above US$90 per barrel — well above the average price of less than US$70 per barrel in the past decade — as intensifying conflicts in the Middle East threaten to disrupt supply. And while positive real wage growth is supportive of consumption, it is also contributing to the stickiness of inflation, notably, services inflation, where wages is a big factor.

That’s why we believe the CPI will be higher than it has been over the past decade, at least in the short to medium term. We should brace for interest rates to also remain higher — that is, not returning to their previous ultra-low levels — even after the Fed starts cutting. We think rate cuts might still come, perhaps sooner than market currently expects, despite hotter-than-expected inflation, considering the government debt level and servicing burden.

The Fed has thus far maintained its forecast for three cuts of 25 basis points each for 2024, based on its recent dot plot. That said, several officials have been warning of fewer cuts on the heels of stubborn inflation readings. If higher CPI persists, we suspect the Fed might subtly shift its current 2% target (neutral) CPI level slightly higher. Higher levels of CPI and interest rate have consequences, not only for the US but also the rest of the world.

Remember, time in market is more important than timing the market

In the short term, the recalibration of inflation and interest rate expectations has increased market volatility. Right now, pricing for federal funds futures shows investors almost evenly split on the probability of the first cut far out in either the September or November FOMC (Federal Open Market Committee) meeting while the total interest rate cuts for the year have been materially pared back to just 0.25% to 0.50%. In other words, the market has made a huge pivot and is now forecasting fewer rate cuts than the Fed.

The CBOE Volatility Index (VIX) hit its highest level this year on the back of increased uncertainties on interest rate cuts, but nevertheless remains relatively subdued (see Chart 3). This suggests that market sentiment is still largely positive. Indeed, the pullback in equity markets — as the benchmark 10-year Treasury yield, which forms the reference cost for most commercial borrowings, rose to its highest for the year — has been mild so far.

Mathematically, higher interest rates will reduce the valuations for all stocks. And valuations are already on the high side, based on historical ranges and relative to other major markets in the world, to start. That means stock prices will be more sensitive to negative developments (smaller margin for error). There are myriad risks that could send stock prices even lower from hereon.

For one, we do think current US earnings expectations may still be too high, especially if borrowing costs stay elevated for longer and if consumer spending begins to soften. The higher cost of debt must eventually have a dampening effect on the economy. And given the outsized influence of the US dollar in global markets, higher-for-longer US interest rates also affect global economic growth. For example, renewed strength in the greenback has forced some central banks to expend forex reserves to defend their currencies and/ or delay reducing domestic interest rates to shore up their economies. A weaker currency will raise import costs and generate domestic inflation. It will worsen the debt-servicing costs for countries with US-dollar denominated borrowings. Slower global growth will eventually have negative feedback into US corporate profits. As we said, some 40% of sales for the S&P 500 companies are derived from outside the US.

Conflicts in the Middle East and the Russia-Ukraine war could escalate, further disrupting crucial supply chains and commodity markets, and fanning inflation. The high levels of government debts (post-pandemic) is another major risk factor. And yes, there may be a Black Swan event, which by definition is unpredictable, just around the corner. We know it will happen, but we don’t know when or in what form.

In short, there is little point in trying to time the market. And that is why we say, for long-term investors, it is time in market that is key.

What we are fairly certain of is that, short-term volatility aside, the US economy and Corporate America (as a whole) will continue to outperform the rest of the world. At least for the foreseeable future. The US will wield its military strength and/ or soft power through outsized economic and political influence to ensure its continued economic dominance and leadership role in the world, from which it will continue to extract massive benefits. US equity and debt markets account for more than 40% of the total value of the global capital market. The New York Stock Exchange is the first-choice listing destination for the majority of the world’s largest and most promising companies, whether or not they have operations on US soil. It is highly liquid and attracts investors and funds from all over the world. In short, US businesses can grow earnings faster while cost of capital will continue to be kept relatively low, a significant comparative advantage for new investments that, in turn, drive innovation and future growth prospects.

For this reason, we think those predicting the ringgit to strengthen against the US dollar once the Fed cuts interest rate will likely be disappointed. Observe the yen. Right after the Bank of Japan (BoJ) raised interest rates to positive — ending nearly a decade of negative interest rate policy and its first hike since 2007 — the yen fell, contrary to widely held expectations (see Chart 4).

The Malaysian Portfolio fell 1.4% for the week ended April 17, dragged down by Insas Bhd (-3.7%) and Insas-WC (-9.8%). Last week’s losses pared total portfolio returns to 188.2% since inception. Nevertheless, this portfolio continues to outperform the benchmark FBM KLCI, which is down 15.8%, by a long, long way.

The Absolute Returns Portfolio also fell by 3.3% last week, amid the global equity market selloff. All the stocks in our portfolio closed lower for the week. The biggest losers were SHK Properties (-7.1%), Tencent (-4.2%) and Swire Properties (-3.6%). Total returns since inception is now at -3.5%.

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.