There has been a dramatic change in interest rate expectations. A month ago, financial futures implied that the US Federal funds rate would end next year at just 0.22%, barely higher than it stands today. Now, that expectation has jumped to 0.5%. Sterling rate expectations have moved even further, up by 0.85%, following increasingly clear signals from the Bank of England that a base rate rise is imminent.
All this reflects the persistence and strength of inflation. Central bankers in London and Washington can no longer claim that inflation is purely transitory: the rate of inflation has risen further than they expected and, more importantly, threatens to become entrenched.
Inflation up and wages accelerating
Inflation expectations have risen and wages are accelerating. Compositional effects make measuring wages especially difficult at present – in the US lots of low paid workers are getting jobs, which reduces the average wage in the economy even as people already in work are getting a pay rise.
In the US, many economists, including those on the interest rate setting committee in the Federal Reserve, look to the Atlanta Fed wage tracker. This is unaffected by compositional effects. The latest number has just come out and it shows wage inflation has jumped to 4.2% versus a year ago. That rate is just not consistent with their 2% inflation target. Last week’s CPI data in the US showed that inflation for rents and other parts of the important shelter component remained strong. This all suggests that inflation is set to sustain a move well above the 2% target.
The Fed has strong reasons to raise rates
It is part of Fed history that they caused the inflation of the 1970s by misinterpreting a rise of inflation as temporary. They do not want to repeat that mistake. Moreover, with the US economy having recovered completely from last year’s pandemic-induced recession, there is no need to maintain rates at emergency low levels.
Further appreciation of sterling is likely
The Bank of England is in a similar position. Indeed, they are set to raise rates earlier and further than the Federal Reserve. Sterling has so far been remarkably unaffected by the prospect of rate rises in the UK. I think we can look ahead to some further appreciation of sterling, especially as the signs from negotiations with Europe are that we will avoid a trade war. Indeed, the UK negotiators seem to have wrung important concessions from the EU with respect to the Northern Ireland protocol.
US investment boom is bullish for equities
What does all this mean for equities? To answer that, we must look to the earnings being reported by US companies. Are they saying that rising input prices and rising wages are squeezing margins? Or are they using strong demand to push up prices and grow earnings strongly? There will of course be a mixture of both, but there is a feature of the US economy that few have noticed that is bullish for equities in the medium term: there is an investment boom underway in the US. That typically leads to stronger growth and better earnings. Investment is picking up in the UK, Europe and elsewhere in the developed world too.
A complicated backdrop but equities set to rally
All in all, the background is complicated. Rising interest rates are undoubtedly a headwind for risk assets. Some companies will see their margins squeezed. But the global economy continues to expand and that means risk assets should outperform. We’ve had the correction that we discussed back in August – September was a weak month for markets. From here on in, we expect the rally in equities to continue.
Past performance is not a guide to future performance. The value of investments and any income derived from them can go down as well as up and investors may not get back the original amount invested.
The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.
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