Friday Investors Club podcast: What’s next for inflation in the US & China (16:22)

CIO’s Teck Leng, Kathy Li, Zixuan Liu, and Wayne Gordon talk about what inflation in the US and China means for the Fed and the Chinese economy.

Thought of the day

US inflation data indicated a further cooling of price pressures in July, adding to optimism that the Federal Reserve may be able to call time on rate rises for this cycle. The core consumer price index (CPI), which excludes volatile food and energy prices, rose by an annual 4.7%, below the 4.8% economists had expected and down from a peak of 6.6% in October. On a monthly basis, the pace of underlying inflation was unchanged at 0.2%, the smallest back-to-back gain in more than two years.

Economists drew additional comfort from the fact that 90% of the rise in overall consumer prices was due to housing costs, which are set to decline further as moderating rents feed through into the inflation calculation. The monthly increase in price rises is now consistent with bringing inflation down to the Fed's 2% annual target. Equity markets initially responded to the rising possibility of an economic soft landing, in which inflation cools without excessive rate hikes tipping the economy into recession. The release follows signs of moderating demand for workers from the July employment data. Both support our view that the Fed’s 25-basis-point hike in July will prove its last of the cycle.

But risks remain. San Francisco Fed President Mary Daly said the data was not yet sufficient for the central bank to say “victory is ours.” There is still one more CPI report and monthly inflation release to come before the next rate-setting meeting on 19–20 September. Against this backdrop, we advise investors to:

Look for equity laggards: While our base case is for no more hikes, risks of a further tightening remain. A sustained boost to stocks could have to wait until moves toward rate cuts, which still look some way off. As a result, we still see limited upside for broad equity indexes. Instead, we see opportunities in parts of the market that have lagged. The MSCI Emerging Markets index has trailed the MSCI All Country World index by eight percentage points this year, returning just 5.4%, as of 10 August. In addition, growth stocks have returned 23.6% this year in the global index, leaving value behind at 6.2%. We expect these laggards to play catch-up in the months ahead.

Buy quality bonds. The appeal of short-term deposits has increased as central bank rates have climbed. But we see the attraction as likely to be fleeting. With policy rates now approaching a peak, reinvestment risk will likely rise for investors holding excess cash or fixed deposits. Rather, we favor locking in attractive yields. The more defensive, higher-quality segments of fixed income look most appealing to us, given the all-in yields on offer and the potential for capital appreciation as investors shift their focus from inflation risks to growth risks. We expect high grade (government), investment grade, and sustainable debt to deliver good returns over the balance of the year, and we prefer five- to 10-year maturities.

Seek diverse and durable income. Adding to sources of income that will last beyond the rate-hiking cycle is not just about fixed income. Quality dividend-paying stocks can be a good source of income and enhance potential equity returns at a time when the risk-reward outlook for broad indexes appears muted over a tactical horizon. The MSCI World High Dividend Yield index and its sustainable equivalent are currently offering a yield of around 3.75%, coming close to the 4% yield on the 10-year US Treasury. Quality dividend equities tend to be found in the more defensive parts of the market, and history suggests dividend payments should prove relatively stable even in the event of an economic downturn.

So, while the continued downward trend in inflation should support equity market sentiment, a rosy economic outlook has already been priced into stocks. The MSCI US index is trading on 20 times 12-month forward earnings, a 24% premium to the 15-year average that leaves little room for near-term upside, in our view. Investors should look instead to the parts of the market that have lagged, while seeking to lock in the attractive yields of quality bonds.