Where higher US inflation leaves rates, markets

Despite slowing somewhat, US inflation stayed high in September. Yesterday’s CPI print showed an annualized rate of 3.7% and a core CPI (CPI minus food and energy) at 4.1%. While both numbers represent a deceleration, they remain higher than predicted and point to the persistence of currently-elevated interest rates and the potential for future hikes.

“Yields are climbing as [investors] weigh whether we’re going to see rates push higher or if we’re going to see rates elevated for a long time. Those are the two scenarios the market’s contemplating, and it’s swinging quite wildly between the two,” says Kevin Burkett, portfolio manager at Burkett Asset Management. “The announcement is an ongoing rethink for folks who felt that the inflation battle had been fought and won.”

Burkett believes that investors have taken a rosy view towards inflation and inflation-impacted assets this year, prompting earlier recoveries in sectors like tech. This CPI print, he argues, validates the view that advisors need to reconsider asset allocations. For the past decade and overweight to equities would generally mean outperformance. Now, however, he thinks returns will be harder to come by and a close examination of the bond market will be key to achieving total returns. He believes that yields are attractive enough for investors to consider their allocations while we await decisions from the federal reserve.

Could inflation mean another hike?

“You can’t discount the prospect of another hike this year,” says Simon Harvey, head of FX analysis with Monex Canada. “Even though Fed members have started to speak more cautiously about the prospect, this inflation data suggests we can’t completely take that risk off the table.”

Harvey highlighted that markets have priced in the chance of one more hike this year at around 45%. He believes that if a hike occurs, it will be at the December FOMC meeting, not over Halloween.

Market and Fed dynamics around a key datapoint like CPI are always sensitive. Harvey highlights that if the Fed gives guidance about tightening, the market will tighten financial conditions and — in doing so — undermine the Fed’s guidance. The same can occur if the Fed gives a dovish sign.

Nevertheless as markets digest this inflation news, Harvey agrees with Burkett in saying that ‘higher for longer’ interest rates are now the bare minimum. He predicts, too, that if we see a rate cut it won’t come until the back half of 2024 — barring any kind of major downturn in the economy or the financial system.

Assets in a new market paradigm

While bonds are an ostensibly lower-risk investment, now showing attractive yields, Burkett insists that advisors need to be familiarizing themselves with bonds, especially differences in duration. He believes that fixed income comes with greater complexity than pure equity investments.

Burkett argues for an opportunity in longer duration bonds given the current rate environment. While we are currently in an inverted yield curve, with shorter-term bonds paying higher rates, he sees the potential for long-term returns in these longer-duration bonds. When the economy eventually does cool and noise shifts to a hike, these bonds may offer significant upside. However, he believes caution is key, a too-quick shift into long-duration bonds could expose clients to undue rate sensitivity.

While some advisors moved towards alternatives during periods of low yields and low interest rates, Burkett argues that the best sources of risk-adjusted return are now on public markets.

“Alternative to what?,” Burkett asks. “You can get a 5-6% yield on a bond portfolio today, so what do you need an alternative to? What are your client’s investment objectives that you’re trying to hit that can’t be achieved with public stocks and bonds?”

While rates may come down somewhat in the longer-term, Burkett agrees that we may be waiting some time to fully understand what ‘normal’ rates look like in future. He argues that as we continue to face volatility from datapoints like this CPI print, the bond market remains attractive.

“I think good portfolio managers are realistic about their ability to guess interest rates in the long-term, but it’s tricky. You can have a well-informed view, but that’s only part of it, there are all these other externalities that come with mounting risks,” Burkett says. “I think bonds are attractive in almost any environment, save for a year like 2022 when we get surprises on interest rates. I don’t see that risk persisting moving forward. I think bonds are a great place to be invested for folks who are concerned about the state of the world.”