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Thought of the day

US consumers’ longer-term inflation expectations rose in February, reflecting the higher cost of daily essentials, according to the latest New York Fed inflation expectations survey. US households are now bracing for inflation in the next three years to be 2.7%, up from 2.4% in January, while the five-year outlook has gone up to a six-month high of 2.9%, from 2.5%. The inflation expectation for the next year remains unchanged at 3%.

The survey comes ahead of today’s consumer price index (CPI) release for February, with markets expecting another strong monthly increase. According to Bloomberg, the consensus forecast is for headline CPI to increase 0.4% on a monthly basis, while core CPI-which excludes food and energy prices-is expected to rise 0.3%.

However, while the February CPI looks set to remain too high for comfort, we think a softening labor market, slower economic growth, and moderating shelter inflation should help overall inflation trend lower in the coming months. We continue to recommend investors manage liquidity, lock in attractive bond yields, and complement their core equity holdings with small-cap stocks in anticipation of rate cuts ahead.

Investors should re-evaluate their cash holdings. Our base case remains that the Fed is likely to gather enough confidence that inflation is coming down sustainably to the 2% target to embark on an easing cycle in June. This means that cash should progressively deliver lower returns, creating a risk for investors who do not lock in returns today. We believe investors should limit their overall cash balances and diversify their liquidity strategy beyond cash and money market funds. A combination of fixed-term deposits, bond ladders, and select structured investment strategies can help investors optimize yields while balancing counterparty, interest rate, credit, and liquidity risks.

Attractive yields on quality bonds can be locked in. With cash rates likely to fall this year, investors should progressively lock in attractive yields on quality bonds. This should provide a more durable source of portfolio income over time, as well as provide the added benefits of diversification and potential capital gains. We particularly like the 5-year duration point, as we think this middle part of the yield curve offers the best combination of high yields, stability, and sensitivity to falling interest rate expectations. Investors should also consider exposure to actively managed fixed income strategies to improve diversification.

Small-caps can add value to equity portfolios. Following a prolonged period of underperformance, we believe small-caps are attractively valued. This part of the market also stands to gain more from rate cuts this year, as smaller companies are more reliant on floating-rate debt than their larger peers. With earnings growth set to outpace that of the broader US index this year, we think small-cap stocks look well placed to outperform.

So, while the releases of economic data may create volatility in markets, we continue to believe the overall macro backdrop of receding inflation and the likelihood of lower rates mean that investors should ensure they are sufficiently invested and diversified.