Ask Kelvin video: Why US equities did well in 1H23? (4:20)
CIO's Kelvin Tay on why the S&P500 performed well in the first half of 2023, and what's next.

Thought of the day

US consumer price inflation slowed markedly in June, rekindling hopes that the Federal Reserve could soon be able to call an end to its fastest rate-hiking cycle since the 1980s. Annual headline inflation for the month was 3%, down from 4% the prior month and the smallest increase since March 2021.

Core inflation, which excludes volatile food and energy prices, rose 4.8%, decelerating from the 5.3% in May and coming in below the consensus forecast of economists. There were even promising signs that services sector inflation, which has been a major concern for policymakers, is cooling. Services excluding housing and energy decelerated to a 4% annual advance, also the smallest increase since late 2021. The Fed's Beige book provided further grounds for optimism over inflation, with signs that consumers have started to balk at rising prices.

The data sent the S&P 500 0.7% higher, as investors upped the chances of an economic soft landing. The yield on the 2-year US Treasury, which is highly sensitive to Fed policy, fell from 4.87% to 4.73%—and further to 4.65% on Thursday.

Despite the good news on inflation, our view is that the Fed will be reluctant to declare victory just yet. But the data do support our base case that an end to hikes is now in sight, which will add to pressure on the US dollar.

Core inflation, though declining, is still well above the Fed’s target. The core component of the inflation basket has been declining steadily from the 6.6% peak reached in October. There are reasonable hopes it will moderate further in the months ahead, especially as the measure of housing costs slows and catches up with independent data showing a moderation in rental prices. However, the Fed will likely require more evidence that June’s promising trend is continuing. As Richmond Fed President Thomas Barkin cautioned soon after Wednesday's inflation report: “Inflation is too high. Our target’s 2%... If you back off too soon, inflation comes back strong, which then requires the Fed to do even more.”

The labor market remains too strong for comfort. The latest data releases suggest demand for workers is easing, supporting hopes for an imminent end to Fed tightening. The payroll data for June pointed to the smallest monthly gain in employment since December 2020. It was also the first reading not to top the consensus forecast, following 14 consecutive months of above-expectations readings. However, the jobless rate fell back to 3.6%, from 3.7%, still close to April’s 3.4%, which matched a 69-year low. Meanwhile, nominal wage growth is too rapid to be compatible with the Fed’s 2% inflation target.

The data, however, suggest the rate-hike cycle is near an end, so the US interest rate premium could shrink further. Fed policymakers' most recent “dot plot” of rate expectations implied policy tightening by a further 50 basis points. However, fed funds futures markets point to a more modest 30bps, likely scaling back the tightening trajectory after the inflation data. Meanwhile, we see additional tightening from the European Central Bank. In Japan, an improving economic backdrop suggests the central bank could tighten its very loose monetary policy during the second half. And in Switzerland, we expect the Swiss National Bank to remain hawkish to keep price pressures contained and the franc stable in real terms, meaning we still see value in the CHF as a safe-haven currency versus the US dollar.

So, while encouraging inflation data is positive for stocks, we still view the risk-reward balance as more positive for fixed income, with government bonds rallying following the release. The data reinforced our view that recent dollar weakness will persist. We therefore recommend investors with the Japanese yen, euro, British pound, or Swiss franc as their home currency to strengthen their home bias. We also expect gold, which benefits from a weaker dollar, to reach new all-time highs.