Gareth Gettinby

AT the beginning of 2024, markets were expecting all major central banks to deliver a similar number of rate cuts. This expectation was understandable, given inflation finally appeared to be weakening. Fast-forward to the present and the outlook has significantly changed.

Markets have substantially readjusted their expectations for central bank policy. There is now a clear divergence between the US Federal Reserve (the Fed), the European Central Bank (ECB) and the Bank of England (BoE). As early as January this year, the market was pricing in six rate cuts by the Fed.

However, continued strength in growth data, solid labour momentum and three months of higher-than-expected US inflation has seen markets rapidly price out these cuts, with US yields rising sharply as a consequence.

The question we are left with is whether inflation relief in the US is simply delayed or will prices re-accelerate? And what of other regions?

Rate cuts are more likely in Europe than in the US, given the different inflation dynamics and subdued growth. In the US, inflation has been demand driven, which has helped inflation remain sticky. In contrast, energy is a large component of inflation in Europe and the sharp fall in energy prices should allow for a return to the ECB’s inflation target over the next few months. The UK has a comparable disinflationary outlook to the ECB, with inflation expected to fall close to the BoE’s 2% target in April.

It seems increasingly likely, therefore, that the ECB will be the first major central bank to cut interest rates starting in June, followed by the BoE. Currently the markets are pricing in a 0.25% rate cut in the UK by September or sooner, depending on the data. The scale of cuts required, however, may well go beyond what is currently priced in. For both regions, the debate will turn to how many cuts they can implement while the Fed does nothing?

The main cause of the divergence in policy is the differing macro environment. US “exceptionalism” continues and it is difficult to see the region’s economic growth derailing.

In the last few months there have been signs of both global growth and global trade bottoming out. This should not be extrapolated too far as the US has been upgraded, Europe and the UK are flat, and as such the growth differential remains wide.

Where does all this leave markets? If Fed cuts are pushed further out this will result in a period of volatility. For equities to move meaningfully higher we need to see inflation fall, allowing central banks to adopt an easing bias. We also need to see weakening geopolitical risks as well as robust earnings and resilient economic growth. The bar is set high.

Given the bias is for US rates to be higher for longer, favouring high-quality, income-oriented companies with strong balance sheets and attractive dividend yields seems warranted. Equally, it makes sense to avoid the most levered parts of the market that have a large proportion of debt on a floating rate.

UK gilts are attractive, as the market is – incorrectly – pricing in cuts much closer to the US, while the economy is more aligned to the rest of Europe. Corporate bonds should continue to be supported by the attractive yields on offer, but credit spreads are low, and it is difficult to see spreads narrowing further. In currencies, continued strong US growth, persistent inflation and policy divergence will continue to support the US dollar.

The global economic environment remains complex and navigating the “last mile” of inflation was always going to be difficult. With ongoing geopolitical conflicts and 2024 being a major election year, further surprises cannot be ruled out. Ultimately, though, current rate policies are restrictive, and inflation will eventually fall to central banks targets.

In the meantime, the divergence between the US and other major economies will continue, and while the Fed will remain on hold longer than other major central banks, its cuts are only delayed and not forgotten.

Gareth Gettinby is investment manager at Aegon Asset Management