Hot Inflation Signals this Week Could Ignite Market Volatility

Published on 25 March 2024

Edward Smith, co-chief investment officer at Rathbones

Edward Smith, co-chief investment officer (co-CIO) at Rathbones, discusses some of the concerns surrounding stubborn inflation signals in core services and the potential for market volatility if core Producer Consumption Expenditure (PCE) numbers come in hotter than expected.

Smith unpacks the high volume of bond issuance we’ve seen in the first quarter; whether the demand will continue to match the supply and what parts of high yield space could warrant some “nervousness” and attention from traders and investors.

The co-CIO also talks through why European assets have been outperforming in the last month and how he expects this to play out this year. Finally, he delves into the investment profile of India; where valuations stand, where there might opportunities and risks and what to expect from JP Morgan’s inclusion of India in its bond index in June.

North America: Weekly Review and Outlook on Markets

  • Last week, equities volumes were down week on week yet we saw a spike in activity mid-week. Bid-ask spreads widened but were still tight for historical ranges.
  • Last week, US investment-grade volumes remained elevated and liquidity appeared to remain favourable.
  • This week’s data: Short Interest release on March 26, US GDP on March 28, PCE inflation signals, and Fed Chair Jerome Powell’s speech on March 29.
  • This week in primary equities: There are 9 IPOs expected to price this week for $179.7 million, for example, Boundless Bio.

Europe: Weekly Review and Outlook on Markets

  • Last week, equities volumes fell relative to mid-March highs but bid-asks spreads have widened since the start of February.
  • Last week, euro investment-grade volumes remained elevated for historical levels, with consistent improvement in liquidity (bid-asks) since the start of the year.
  • This week’s data: Spain’s Inflation rate is out on March 27, the UK’s GDP numbers are released on March 28, and France’s Inflation rate is available on March 29.
  • This week in primary equities: There are IPOs expected to price this week on European exchanges.

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Interview Transcript

Presenter Jo Gallagher Edward, we have potentially quiet week coming up. What are you expecting in terms of market activity and what should trading desks pay attention to?

Edward Smith Sell-side bank surveys are telling us US macro data is a really key focus for investors and for traders at the moment. And at the end of the week we have obviously got the PCE inflation data and I think all eyes are going to be on that, particularly as investors are digesting last week’s central bank action.

Now Powell kept up his really optimistic language and said last week that progress on inflation has continued. But we kind of all know that’s hot air right. Because Core Services ex-shelter, which Powell and his colleagues have said is really the only thing to watch at the moment, that’s running over 6% on the three month annualized numbers.

It’s been doing that for two months in a row, and just last summer that was back down to 2%. So that’s really quite the reversal. And so I don’t think the Fed has got another meeting where investors will let them get away with this narrative. While key parts of the inflation basket are heading in the wrong direction.

So this Friday’s PCE numbers I think, are going to be closely watched, next month’s, even more so. But if we could see a bit of volatility at the end of the week.

Presenter Jo Gallagher We’ve had a big quarter in terms of bond issuance. Do you see that appetite for issuance continuing, and how would you be advising desk in terms of their short-term and long-term strategies?

Edward Smith So issuance usually kicks off the year really quickly right. Usually get a dull December and then lots of issuance comes out for Easter break and Easter breaks early this year. Now demand has definitely been far exceeding supply.

We’ve seen some issues ten times oversubscribed. And yeah, that’s quite something. And so the initial price talk spreads are really frequently way off where the bonds end up coming in at and new issue premiums are just getting sucked out of the market.

Now with central bankers implicitly or explicitly signaling rate cuts, treasurers who don’t need to raise capital immediately may wait now. So we may actually see that demand-supply balance even more towards demand.

There are some sectors to be careful of at the moment where supply may not be absorbed quite so well. Utilities, particularly water and power generation. They’ve got really high CapEx demands and their regulated business models can’t really pass on costs. So higher rates are difficult for them even if they come down a bit from here.

European high yields we know in 2025 and 2026 about 50% of the market’s going to refinance, so you could start to see some nervousness there. CLOs and CMBS, particularly the states commercial mortgage-backed securities, they are potential problem areas. There’s a lot of risk there around office-backed issues and supply may be difficult to absorb, but in general, we don’t see demand being a problem.

Presenter Jo Gallagher We’ve heard so much about U.S. exceptionalism, but more recently we’re starting to see some positive signs out of European and UK assets. Why is that? And how do you see that playing out for the rest of the year?

Edward Smith So yeah, Europe has been leading the way, particularly in equity markets over the last month. And I think some of that is global macro. Some of that is Chinese stabilization. But finally the worst is behind us and China and Europe’s a bit more geared into that part of the world.

Some of it is European domestic macro. And some of it I think, is just positioning, broadening out from really overcrowded trades in US high-growth companies looking for growth elsewhere.

Earnings underlying European equities, they’re more cyclical than the US and the UK. So when more optimism about the global economy creeps in, when you see leading economic indicators tick up then Europe tends to outperform. And then domestically we’ve seen European indicators tick up. We’ve had the Sentix survey, the PMI surveys are all inflecting higher over the last few months.

The PMI survey business expectations have been rising for six months in a row now. Some parts of the European market in equities are overextended. They’ve run on further than what you would expect, given the extent to which those leading indicators have run higher. So there may be a pullback and there is some risk. But continue to look at the macro.

We’ve got the European Sentiment Indicators survey out this week. So that’s something to watch.

Presenter Jo Gallagher We also have JP Morgan’s inclusion of India in its bond index in June. What are your expectations for that event and how would you be advising investors in terms of their approach to Indian assets?

Edward Smith So the economic prospects for India are really exciting. We’ve done a big deep dive on this at Rathbones just recently. It’s not about demographics, which is all sort of India really used to have going for it. That tailwind is fading, in fact.

Female labour force participation, which is already among the lowest in any significant economy, is actually declining. So it’s all about investment spending and productivity, and its trends here are getting really encouraging. Foreign direct investment is increasing, not least because the rest of the world is turning away from China and looking for a destination, for EM capital.

The government has also achieved a lot of land reform, property reforms that allows the government to ramp up public infrastructure spending that crowds in investment. And there’s been great strides in financial inclusion, bringing domestic savings into the formal economy and the investment landscape that can be recycled by the banks.

Despite that macro optimism, equity markets, I think are priced to perfection, valuations are really tough to justify, even though we’ve got a pretty optimistic and long-term economic growth forecast. So you’ve got to be careful there. There may be some active gems, but I think blanket exposure is a bit difficult.

The bond market perhaps more interesting. You haven’t seen spreads compress there quite so much. So it’s possible that the JP Morgan inclusion may be an event that catalyzes some outperformance there.

Presenter Jo Gallagher Thank you, Edward, for your insight and thank you for watching the Speech Trader TV this week.