Why it's too early for investors to declare victory over inflation

Stock markets have ignored central bank warnings but it could be an opportunity to buy on the dip

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Stock markets have had a bumpy start to the year, especially in Europe and the UK, bringing 2023’s end-of-year rally to a crashing halt.

Investors who hoped their portfolios would pick up in 2024 where they left off may be feeling sorry for themselves, but they need to check their privilege.

After the economic and political volatility of recent years, 2024 was never going to be a parade and a pullback was always on the cards. It might even be a buying opportunity.

Shares soared in November and December as hopes grew that inflation was finally on the run and monetary easing would duly follow.

Markets were cheerfully pencilling in six interest rate cuts by the US Federal Reserve in 2024, starting as early as March.

They glibly ignored co-ordinated warnings by the Fed, European Central Bank and the Bank of England that it was too early to declare victory over inflation.

Then January’s data landed, and it looked like the central banks had called it right.

Instead of falling, US consumer price inflation climbed to 3.4 per cent in December, from 3.1 per cent in November.

In the eurozone, it jumped to 2.9 per cent from 2.4 per cent, and to 4 per cent from 3.9 per cent in the UK.

That increase of 10 basis points was enough to wipe almost 2 per cent off London’s FTSE 100 index, its biggest one-day drop in five months.

Inflation isn't behaving as markets thought it would and could take longer than expected to return to the central bank target of 2 per cent, says Joshua Mahony, chief market analyst at online trading platform IG.

“The size of the recent increases caught many off guard.”

Investors desperately need the jolt of optimism that falling inflation would bring. They should get it, too. If they're patient.

James Smith, developed market economist at ING, warns against reading too much into just one month’s data.

“The wider inflation story is looking brighter, despite this latest setback,” he says.

ING forecasts that US inflation will fall to 2.5 per cent in the second quarter, then slip below the Fed's target to 1.9 per cent in the third.

UK inflation will fall at a faster rate, hitting 1.7 per cent as early as April or May, although price growth could prove stickier in Europe.

Jeremy Batstone-Carr, European strategist at Raymond James, shares Mr Smith’s optimism, suggesting that after January’s “small upwards nudge”, inflation should continue to slide in the coming months.

He says this isn’t a forecast but a “mathematical consequence” of last year’s price spikes falling out of annualised calculations.

Yet, while Europe, the UK and emerging markets are having a hard winter, spring appears to have arrived early in the US.

Last Friday, the S&P 500 flew to an all-time high of 4,839.8, wiping out all the losses of the last two years.

Investors appear to have shrugged off fears that the so-called Magnificent Seven mega-caps – Microsoft, Apple, Google-owner Alphabet, Amazon, Nvidia, Facebook-owner Meta and Tesla – are overvalued.

The Nasdaq jumped 1.7 per cent on Friday, but remains 4 per cent off its 2021 peak, which suggests there could be more fun to come.

It wasn’t the smoothest start to 2024 for Big Tech, says Matthew Weller, global head of research at City Index and Forex.

“But they’ve quickly got back on track due to strong US economic data,” he adds.

He notes that the Magnificent Seven are collectively trading at an “eye-watering” price-to-earnings ratio of 50 times earnings.

Yet, they look good as earnings season approaches.

“The only thing that could drag down the Nasdaq 100 now may be poor results,” Mr Weller says.

January’s inflation data may have disappointed, but it also showed that the US is in pretty good shape, still growing, still creating jobs, still consuming. Its economy can withstand higher interest rates.

Europe, the UK and emerging markets less so. They desperately need that first rate cut to have any chance of playing catch up with the buoyant US stock market.

Today's biggest worries are mostly geopolitical, as fears grow that the Middle East conflict could escalate, while the US-China stand-off isn’t helping.

Samy Chaar, chief economist at Lombard Odier, says markets still expect the Israel-Hamas conflict to remain “largely localised”.

“Red Sea attacks are affecting trade, but should have a manageable inflationary impact,” he says.

Red Sea attacks are affecting trade, but should have a manageable inflationary impact
Samy Chaar, chief economist, Banque Lombard Odier

“We expect oil prices to drift up towards the low-end of $80 to $90 a barrel range, with short-lived price spikes possible in an extreme scenario.”

He notes that “the past 25 years of Middle East turmoil have had limited impact on global growth and financial markets”, and even suggests that further volatility “could offer opportunities for tactically adding risk to portfolios”.

William Dinning, chief investment officer at fund manager Waverton, says a recession is still a threat, with markets currently pricing in “the best soft landing scenario of all time”.

However, markets could struggle if that doesn't happen.

Ed Davies, co-founder of digital platform TPP, says January’s disappointing inflation data doesn't fundamentally change the macro picture.

“Global growth is slowing, inflation should continue to moderate, and central banks will likely need to cut rates to stave off recession,” he adds.

When that happens, markets could rally and in the interim, investors need to perform their usual trick of tuning out the short-term noise and focusing on the long term, according to Mr Davies.

This year was never going to be smooth sailing and risks remain. Investors will, no doubt, spend the next few months glued to inflation data, but they shouldn’t look at it too closely.

That first rate cut will come and others will follow. Investors should hold tight and buy the dips rather than fear them.

The big question is whether to invest in the booming US stock market – or go bargain-seeking elsewhere.

Updated: March 13, 2024, 8:44 AM