Hopes for lower rates next year look wishful as high inflation will likely persist

Stocks finished the month of July in a joyous mood on hopes that the US Federal Reserve’s latest big interest rate hike will be one of the last few tightening moves that will pave the way for easier monetary policy next year. However, as we have argued, we have grave doubts about such a scenario as we see inflationary forces to remain stubbornly high despite weaker economic activity and we see stagflation as the most likely outcome going into next year.

We also view Fed’s inflation target of 2% as highly unlikely to be achieved without its policy stance moving aggressively towards a more restrictive mode. Also given the central bank’s dual mandate, although there are signs that weaker economy is leading to some hiring freezes and layoffs, we think this will unlikely to be enough for it to become concerned about unemployment enough to start easing rates for the foreseeable future.

Indeed, with structural labour shortages persisting in the US (and Japan), we see wage pressures to remain on the upside while employment levels likely to remain fairly elevated. Structural shortage in US housing market is also another factor in keeping rents and cost of living high.

To be sure, there are some components within the inflation gauge that look to be easing thanks to weakening sales of durable goods after two years of strong replacement demand. This is also helping lower logistics costs while household spending budgets are diverted towards holidays and leisure following last few years of pandemic-related restrictions. Falling used car prices is another factor that could help ease inflation as car production output improves and incentives start to rise again.

However, from a broader perspective, global economic policy makers are facing rising costs from deglobalisation, climate change, growing labour disputes and the war in eastern Europe which looks highly likely to drag on into the next winter and should re-exert upward pressure on food and energy prices. We think none of these factors have gone away to expect inflation rates to ease and stagflation to be avoided. 

Moreover, with speaker of the US House of Representatives, Nancy Pelosi likely to visit Taiwan in her coming Asian trip, hopes of thawing of relationship between China and the US look to be equally wishful. Indeed, with technology export restrictions to China broadening further as we have long been expecting, we see more negative surprises ahead from this important segment of the market which makes up the bulk of growth names. 

Finally, we think the recent rebound in stock markets in July and indeed the jump in value of the Japanese currency will likely prove short-lived as we expect US long term rates to head back up while corporate earnings to weaken further in H2 of this year. Meanwhile, rising inflationary pressures above expectations, especially in Japan, should once again hurt the value of the yen, at least until BOJ abandons its QE.