After years in the shadows, inflation burst back onto centre stage during the Covid pandemic, hitting levels not seen since the 1980s and it continued to creep up at the start of the year in many economies. 

Interestingly though, we’re seeing financial markets pricing swing from an environment where the battle against inflation has been won which allows central banks to cut interest rates, to that of inflation remaining sticky. For example, 10 year US Treasury yields troughed last quarter beneath 3.9% to then rise to above 4.6% at the time of writing. That being said, unemployment remains very low by historical standards, during lower levels of economic growth, and investor confidence remains relatively robust. So, where are we exactly in the inflation fight?

Craig Hoyda, Investment Manager, takes a closer look at the global economic outlook and how central banks around the world are continuing to combat inflation and the associated implications for growth and easing monetary policy. He also considers sources of uncertainty surrounding US activity, the upcoming US election and how different scenarios may affect investors.

Curbing inflation - will the ‘last mile’ prove the hardest?

Despite optimistic musings at the beginning of the month, both the European Central Bank (ECB) and the Federal Reserve (the Fed) have announced a hold on rate cuts. The Governing Council of the ECB has opted to keep rates on hold for the fourth consecutive meeting while making it clear that a June cut is very likely. We expect the ECB is proceeding cautiously with its easing cycle, fearing an overly aggressive cutting could lead to an inflation rebound. Nonetheless, we still expect four rate cuts this year starting in June.

Meanwhile in the US, Jerome Powell, Chair of the Fed announced a likely delay to rate cuts. The Fed’s confidence that inflation is headed back to target has taken a bit of a knock and as such we their first rate cut is likely to be pushed out beyond June. Keen to avoid the policy mistakes made by their predecessors in the 1970s and 1980s, the Fed is seeking to avoid loosening policy prematurely while inflation remains a threat.

On a more positive note, inflation in the UK is expected to drop markedly in April due to the Ofgem energy price cap falling by 12%. However, underlying inflationary pressures could remain in place as the year goes on.

Other expected rate cuts

Across emerging markets, cooling inflation along with a high starting point for real rates (interest rates that have been adjusted to remove the effects of inflation) means there’s room for rate cuts. We’re already seeing rate cuts well underway in Latin America, although cuts in Mexico are likely to wait until after the Fed has moved.

Meanwhile, Asian central banks who did not have the need to hike as aggressively as their counterparts have shown that growth has held up better in much of the region. Although, we still expect rates to be lowered later this year.

The Bank of Japan (BoJ) will be a notable outlier. Admittedly, the data paint a mixed picture about the sustainability of Japan’s emergence from low inflation. However, a decent Shunto wage round (or annual wage increase) should be enough for the BoJ to continue on its interest rate hiking path.

What’s next for interest rates?

We believe the ECB and the Fed’s decision to hold rates does increase the risk of a ‘no-landing’ scenario for the global economy – that’s where growth remains strong but inflation fails to moderate fast enough. In this scenario, interest rates would need to remain on hold for longer, or the next interest-rate move could even be higher. In the near term the market would price this as reflation, but it could cause a more pronounced downturn in the future.

As expected, the ‘last mile’ in this marathon of a battle against inflation is indeed not as easy as the ‘first mile’. For now though, we still think the European Central Bank and the Bank of England (BoE) can deliver rate cuts this summer.

Looking ahead

Despite the Fed’s recent announcement, the financial strength of households and firms in the US suggests the peak impact of higher interest rates has already passed. However, many of the drivers such as household savings, fiscal support, rising labour participation rates, and a rebound in productivity – should fade in 2024. So, we expect the pace of US growth to decelerate this year. In terms of asset allocation, an environment of non-inflationary growth, even if that is slower growth, should be supportive for both equity and bond markets. However, a backdrop of inflationary growth is not a favourable one for bonds. 

Elsewhere, we expect to see the UK and Eurozone to slowly emerge from recession-like conditions in 2024, helped by positive real wage growth. But it’s likely Germany will continue to struggle from cyclical and structural headwinds to its growth model.

Contrasting fortunes for China and India

In China, policy continues to ease, with recent intervention aimed at boosting weak equity markets. However, real estate activity and property prices continue to show a marked slide. The Chinese government’s desire to hold the line on de-risking the property market has had significant consequences and these headwinds may continue to outweigh stimulus measures.

By contrast, while Indian growth will slow from 2023’s heady rate, it should still be a global growth outperformer thanks to favourable structural tailwinds. Reform momentum after Prime Minister Narendra Modi’s almost-certain re-election this year will be key to further boosting the economy.

US Election uncertainty

The US election is undoubtedly a source of significant uncertainty. Former president Donald Trump’s proposed 10% across-the-board tariff on all foreign goods imported to the U.S, and 60% tariff on China, could hit both global trade and sentiment. This in turn could increase US inflation while having a negative effect on growth.

Although potential fiscal easing could support growth, these measures could then increase pressure on raising interest rates. This will be a difficult balancing act should these tariffs come to fruition.

Inflation may have a trump card yet to play

While the majority of the Covid-induced supply bottlenecks have been overcome, allowing goods-price pressures to ease, the threats to this are numerous and justifies the recent pragmatism shown by US central bankers when they emphasised the need to be data dependent, rather than date dependent, when making decisions.

Whether it be renewed threats to global supply chains, an escalation of geopolitical tensions in the Middle East and the feed through to oil prices, costs associated with climate transition or labour-market dynamics, there are many reasons to believe that inflation may not be completely under control. Central bankers who, only recently, could afford to focus solely on bringing inflation lower, will now be judged on their ability to do so without causing unnecessary economic pain. Rarely has their job been less enviable.

Many investors have expressed their concerns over the heightened levels of uncertainty this year. At times of economic uncertainty there will be winners and losers – there are always investment opportunities for those willing to do their research and hold their nerve. It’s important to remain calm, especially if you’re investing for the long term.

There’s support if you need it

If you’re not sure how market and economic events may affect your investments, or are concerned about the impact, consider speaking to a financial adviser.

If you’re already an abrdn client, get in touch with your financial planner. If you don’t have an adviser, you can find out more about how our financial planning services can help you.

The information in this article should not be regarded as financial advice. Please remember that the value of investments can go down as well as up and may be worth less than was paid in. Information is based on abrdn’s understanding in April 2024.