An investor who has all the answers, didn’t understand the question (J. Templeton).
Germany’s Industrial Production March MoM out today at 8am (estimate -1% vs +2.1% in February) and Italy’s March MoM Retail Sales at 10am (est. +0.2% vs +0.1% in February).
Orders to Germany’s March MoM industry were lower than expected yesterday (-0.4% versus +0.4% expected), but improved – although remaining negative – compared to -0.8% in February. The data indicate that the improvement of the German economy and probably that of the entire Euro area appears to be continuing more slowly than expected. Moreover, the high cost of financing makes a growing number of investments less and less profitable. March MoM retail sales in Europe grew compared to expectations (+0.8% versus +0.6% expected and -0.3% in February).
Following the 1Q24 inflation surprises the Fed has reversed its view from last December and now appears to have accepted that interest rates will indeed remain higher for longer. Perhaps even longer than the Fed itself expected. After all, Powell has always said that monetary policy would be guided by data.
We live in a world shaped by structural and supply-side forces, creating more uncertainty for the Fed and markets than a few years ago. That’s why we keep an eye on new data, not so much the Fed’s signals, to evaluate the monetary policy path. Markets now reflect a view of high rates for a longer period than last December. And here we must say that the Fed has led the markets to accept a completely different vision compared to six months ago, while remaining around the highs of the period.
At its December meeting, the Fed’s communications and economic forecasts signaled that inflation would fall towards 2% by the end of this year, which meant the central bank would be able to cut rates in 2024 However, any forecast of inflation steadily falling towards 2% assumes that goods prices will continue to fall and that services inflation will moderate substantially from current high levels. We believe these results are highly uncertain. However, both goods and services inflation was higher than expected: a reality check for both the Fed and the markets.
For our part, we expected goods deflation to briefly push inflation towards 2%, before service price growth pushed it back above target in 2025. Our view on the dynamics of inflation is probably still valid. But the surge in commodity prices suggests that even a short-term decline will be difficult to achieve. The Fed, in accepting that rates must remain higher for longer given the stickiness of inflation, also rejected increases.
However, increased macroeconomic volatility makes it more difficult for both markets and FOMC members to predict what will happen in the future. That’s why we rely on new data, rather than Fed policy signals, to shape our view of the likely path of monetary policy.
Higher interest rates usually hurt stock valuations. Instead, strong first-quarter earnings supported stocks, even as high rates and lofty expectations raise the bar for what can keep markets optimistic. According to LSEG data, about 77% of companies in the index beat the consensus. Technology stocks and those benefiting from artificial intelligence maintained their robust growth, while other sectors also saw a recovery.
Given the volatile data and economic policy uncertainty, we believe long-term US Treasury yields can swing in either direction – for now – and remain neutral over a six-to-12-month tactical horizon. Over the longer term, it is possible that long-term yields could rise as investors demand higher term premiums, or compensation for the risk of holding bonds. With the US Treasury increasing leverage, we expect an increase in debt leading to the return of the term premium.
Prolonged high US interest rates cannot help but have implications globally as well, such as in Japan, where the yen slipped to 34-year lows against the dollar. Suspected attempts by Japanese authorities to buy dollars could slow its fall, but the divergence between the monetary policy of the Bank of Japan and that of the Fed is the source of the yen’s weakness.
As for Europe, the ECB may be able to cut rates as early as June, even if the Fed maintains restrictive policy for longer. European inflation is cooling further towards 2% and economic activity is weak from 2022, despite a surprise increase in first-quarter GDP.
At a market level, modest growth and a weak earnings environment suggest an underweight in European stocks. Unlike US stocks, where we would remain overweight due to earnings support and long-term neutral bonds given continued yield volatility.
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