Weekly Investment Update (09/15/2023)

This Week’s Views and Positioning

Once again, central banks and inflation were in focus this week. A notable takeaway from the European Central Bank members was their belief that rates are now sufficiently tight to return inflation to their 2% target over time. Given that eurozone core CPI is still at 5.3% (versus 4.3% in the U.S.), the ECB’s implied pause may have implications for the Federal Reserve. As we know, monetary policy does not operate in a vacuum, and we believe a pause from the ECB could serve to further encourage a pause from the Fed, especially considering that U.S. inflation is a full point lower compared to Europe. The implications of an anticipated ECB pause are important because above-consensus economic data in the U.S. has led to some anxiety on the part of equity investors as they weigh the likelihood of a Fed pause. Overall, incremental data suggests a high likelihood that we’ve reached a peak in the fed funds rate (such as the ECB’s current policy stance), which should support U.S. equities in the near term.

Sticky Inflation Is Supportive of a Higher-for-Longer Interest Rate Backdrop

What happened: Inflation for August rose more than consensus expectations. The annual headline inflation rate ticked up from 3.2% in July to 3.7% in August, while the annual core rate, which excludes the volatile food and energy components, fell from 4.7% to 4.3%. Headline inflation was driven by a reacceleration in energy prices with gasoline accounting for over half of the increase. Meanwhile, the shelter component continues to be the largest driver of core inflation. Core services excluding housing, a metric that is in focus for the Federal Reserve given its correlation to the labor market, saw its largest monthly increase since March primarily driven by higher fuel costs driving volatile airline prices higher.

Why it matters: The August inflation report adds to concerns surrounding potential upside risks to economic growth should a reacceleration in economic momentum reignite inflationary pressures and, in turn, place pressure on the Federal Reserve to reinforce a hawkish stance. Still, one data point does not make a trend, and as we have previously cautioned, the disinflation process is likely to be nonlinear. Factors that have been a source of disinflation — such as goods prices, energy, and favorable base effects — are now reversing, thus making it more difficult to see a swift deceleration in the sticky components of services and shelter. As the Fed focuses primarily on core inflation (it does not make decisions based on volatile energy and food prices), sticky service prices are likely to support a higher-for-longer interest rate backdrop. Market pricing for interest rates for the rest of this year remained unchanged following this report's release, but the pricing of interest rate cuts in 2024 decreased some after this report. In support of our overweight to stocks, we continue to believe that additional signs of weakening economic growth will give equity investors confidence that the Fed’s interest rate hiking cycle is complete.

ECB Likely Hikes Final Time This Cycle

What happened: The European Central Bank (ECB) hiked its key deposit interest rate by 25 basis points (bps) to 4.0% this week, noting it was necessary as inflation is likely to remain elevated for the foreseeable future despite continued declines. However, the ECB hinted in the press release that this week’s hike will likely be the last in the cycle, noting, “Based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target.” ECB President Lagarde stated that going forward, the ECB would follow a data-dependent approach to determine the appropriate level and duration of interest rates. Moreover, the ECB released its latest economic forecasts with headline inflation revised upward for 2023 and 2024, while GDP growth was revised lower over the next few years.

Why it matters: The ECB having raised rates by an additional 25bps puts additional pressure on an economy that is already experiencing slowing growth momentum. Elevated inflation, tighter credit, and continued impacts from the energy crisis last year have damped economic momentum as indicated by contractionary PMI readings in both the manufacturing and services sector. As Lagarde noted, interest rate hikes are being transmitted to financial conditions faster than previous cycles, and we may continue to see slowing economic growth persist in the eurozone over the medium term as the lagged impact of rate hikes continues to permeate the economy. Bessemer’s All Equity Model Portfolio is underweight Europe relative to its benchmark given Europe’s equity market composition; relative to other developed markets, European equities have greater exposure to cyclical-oriented companies that could be more impacted by a slowing growth environment. For more information on our thoughts on Europe, please see our recent Investment Insights "Spotlight on Europe: Renaissance or Reckoning?"