CIO First Take podcast: May CPI data & FOMC meeting (13:40)
CIO's Jason Draho and Brian Rose weigh in on US inflation, the FOMC, and the market reaction.

Thought of the day

What happened?
Equities and bonds rallied in tandem on Wednesday after a reassuring US inflation release added to hopes that Federal Reserve rate cuts are on the way. The data showed the core consumer price index (CPI)—which excludes volatile food and energy prices—rose by a monthly 0.16% in May, the smallest increase since August 2021. The annual core rate was the slowest in three years at 3.4%, from 3.6% in the prior month. Meanwhile, headline CPI edged up just 0.01% for the month, helped by falling gasoline prices.

As expected, the Federal Reserve left rates unchanged at its policy meeting. The FOMC statement noted that “in recent months, there has been modest further progress toward the Committee’s 2% inflation objective.” But the Fed was cautious over the pace of any rate cuts at the conclusion of its policy meeting. The median forecast of Fed officials based on the “dot plot” is now for just one rate cut by the end of this year—down from three rate cuts in March, when the last projections were published. The Fed also revised up its forecast for inflation at the end of 2024 to 2.6% from 2.4% previously.

Markets appeared more swayed by the inflation data and moved to price in around 44 basis points of easing for 2024 compared to 39 basis points on Tuesday. In turn, US government bonds rallied, with the yield on the 2-year Treasury falling by 8 basis points to 4.76%, while the 10-year bond yield declined by 8 basis points to 4.32%. However, bond yields gave back some of their initial declines on the back of the CPI data after the Fed’s more hawkish dot plot.

The news also added further momentum to the S&P 500, which closed up 0.9%, marking an all-time high, and taking year-to-date gains to 13.7%. The Russell 2000 index, which tracks US small-cap stocks, climbed 1.6%—though it has been trailing the broader index in 2024 with a gain of 1.5% year-to-date.

Sentiment remained positive on Thursday, with S&P 500 futures up 0.2%.

What does this mean?
The release adds to our confidence that the trend toward slower US inflation, which went into reverse in the first three months of the year, is back on track. In our view, this should carry greater weight than the Fed’s dot plot, which by its own admission is a data-dependent forecast. It is also worth noting the median projection for rate cuts in 2025 is now for four rate cuts, up from three previously, and a further four cuts are forecast for 2026.

Fed Chair Jerome Powell said that the main reason for the change in the dot plot had been the move up in the Fed’s inflation forecast. But he also admitted to a “slight element of conservatism” in the Fed’s inflation forecasting, and that while the committee had been aware of the May CPI data, most participants had not altered their dot plots after the release.

In our view, the details of the inflation data were even more favorable than the headlines. In particular, Chair Powell has stressed the importance of seeing a cooling of core services excluding shelter, which fell by 0.04%, the first negative reading since September 2021. This category includes the prices of services such as leisure, hospitality, insurance, and daycare—which tend to have a high wage component. A slowing of this metric could indicate that slowing wage growth is helping to relieve inflationary pressure in these categories.

Owners’ equivalent rent, which has been one of the main drivers of inflation, actually accelerated slightly. But confidence levels are high that this will slow, given high-frequency data showing that rental prices have moderated. Since rental contracts are typically signed for one or two years, this can take time to feed into the official data. But a decline in this important component of inflation should only be a matter of time.

The print should ease concerns over the threat of economic overheating, after data on Friday showed the US generated 272,000 jobs in May—far more than the 185,000 predicted by economists. The inflation release also fits with recent data pointing to gradually cooling activity, including from the job openings and labor turnover survey (JOLTS), the ISM manufacturing index, housing data, and credit card balances.

How do we invest?
The outcome of the Fed meeting and the latest inflation data are consistent with our view that the US is headed for a soft economic landing, which will permit the Fed to cut rates by 50 basis points this year—most likely starting at the September policy meeting. This reinforces our confidence in several core investment strategies we have been recommending to investors:

Buy quality bonds: Government bonds have faced headwinds this year, as investors have become more cautious about the speed and timing of Fed rate cuts. In our view, markets had become too pessimistic. While rate cuts in the US are lagging behind Europe, Treasuries will move swiftly to price in more easing once the cycle is under way, in our view, and we expect the yield on the 10-year US Treasury to end the year at 3.85%. As a result, we advise investors to lock in current attractive yields. We also like investment grade corporate credit, though tight spreads call for a selective approach.

Manage liquidity: The European Central Bank, Bank of Canada, Swedish Riksbank, and Swiss National Bank have already cut rates and the Fed now looks likely to follow by September. This means current returns on cash will not be available for much longer, and investors holding cash or money market funds, or those with expiring fixed-term deposits, should consider managing their liquidity through bond ladders, structured investment strategies with capital preservation features, or balanced equity-bond portfolios.

Seize opportunities in a broadening rally: The FANG+ index, which tracks the top-10 most traded US tech companies, was up 1.75% on Wednesday, outperforming the broader S&P 500. We remain positive on the outlook for the tech sector, where we see global earnings rising 20% year-over-year in 2024, with AI a key driver. But we also see numerous stock opportunities arising from a broadening rally, including in Chinese stocks, smaller US companies, European best-in-class companies, and long-term disruption beneficiaries. Small-cap stocks stand to benefit disproportionately from rate cuts, given their greater reliance on floating-rate debt compared to their larger peers. Having lagged the broader equity market rally, small-caps trade on a historically large discount to large-caps.

Diversify with alternatives: In an environment of economic moderation and potential market volatility, we believe investors should consider an allocation to alternative investments within portfolios. Including an allocation to hedge funds can mitigate portfolio volatility at times when equity and bond markets may move together. Private markets can provide an alternative source of return to further diversify portfolios. Investors should be aware of the inherent risks of this asset class, such as illiquidity and the complexity of certain strategies.