TIM HEXT: Investors should position now for lower rates later this year

Consumer inflation accelerated faster expected in the US this week, while wholesale price rises were more moderate. Pendal’s head of government bonds TIM HEXT explains what it means for investors

• US inflation looks sticky at around 3%
• Bonds are nearing the buy zone
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

THIS week’s hotter-than-expected US inflation numbers would be disappointing — but not alarming — for the US Federal Reserve. 

Late last year the Fed glimpsed core annualised quarterly inflation nearing its 2% target. That’s now given way to a pulse above 4%.

In other words, 0.2% monthly results have been replaced by 0.4% results.

Jumps in rent, car insurance and health

What’s driving this jump in US consumer inflation?

Firstly, rents have remained stubbornly high, ignoring lead indicators that suggest some relief.

Rents and “owners-equivalent rents” (an estimation of what homeowners would pay if they were renting their own home) are both growing at 0.4% a month, rather than the 0.2% suggested by the Zillow rent index.

The direction of these numbers is important, since they represent almost a third of US CPI.

We still expect moderation ahead.

Secondly, a number of services have shown unexpected price spikes.

Car insurance and hospital services jumped sharply in March. The former looks strange, but the latter reflects a surge in medical wages over the past year. Either way service prices are drifting up not down.

Finally, oil prices have shown a slow-but-steady rise since the start of the year, now up 20%.

Although this is excluded directly from core inflation, second-round impacts do matter.

Wholesale prices look better

This week we also saw data from the US producer price index, a measure of inflation at the wholesale level.

The PPI numbers showed a more positive story, reflecting ongoing moderation of price pressures in goods markets.

This is partly a commodity price story (oil aside) and also a falling margin story.

But after almost flat-lining late last year, the data is now showing a steady 0.2% pulse, again showing that disinflation is no longer the main story.

On ANZAC Day we will see new data from the Fed’s preferred inflation reading — the broader core Personal Consumption Expenditures Price Index (excluding food and energy).

(This will arrive two days after Australia’s first-quarter CPI numbers.)

We expect a number around 0.3%, the same as last month.

This means 1% for Q1, or 4% annualised — a meaningful pick up from last year.

This all suggests US inflation will be sticky around 3% for a while.

The Fed needs to see 0.2% outcomes on average before starting any meaningful easing.

US Inflation medium-term outlook

Where does all this leave the medium-term picture? 

We are not drifting back into high-inflation territory. For that we would need to see new supply shocks.

Supply chains are normal, wage growth is moderating and margins are still falling.

Even the US fiscal pulse, which remains very strong, is showing some small moderation. So patience is required — and the US Fed has plenty of that.

Economic commentators can choose from a variety of recent Fed speaker quotes to fit their own outlook.

But the one I like best is from New York Federal Reserve governor John Williams.

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There was no need to adjust rates in the “very near term” Williams said on Thursday.

“I expect inflation to continue its gradual return to 2%, although there will likely be bumps along the way, as we’ve seen in some recent inflation readings.”

This would allow rate cuts later this year.

Bonds nearing the buy zone

A move higher in yields is seeing opportunities to look at duration once again.

In Australia, the US sell-off has seen our 10-year government bonds near the cash rate and semi governments once again above 5%.

While the US won’t be easing near term, the European Central Bank still looks disposed towards a June rate cut.

Inflation will be sticky above targets for some time. Our core view is inflation over the next five years will average 2.5% in the US and 3% in Australia.

However, this is not consistent with 5.5% and 4.35% cash rates medium term.

In our view, investors should position now for lower rates later this year.

About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

About Pendal

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

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