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We’ve said before that this new macro and market regime is marked by persistent, structural inflation pressures. We think U.S. inflation can fall further toward 2% this year due to falling goods prices. See the orange line in the chart below. Yet we see it on a rollercoaster back up in 2025 as the drag from goods deflation fades and elevated wage growth in a tight labor market keeps services inflation higher than pre-pandemic.
Inflation is likely to settle above the Fed’s 2% target in 2025. The spike in services inflation for January (yellow line in the chart above) now looks like a one-off, but we think it keeps inflation on an elevated track that is inconsistent with overall inflation at 2%. And after months of falling goods prices driving inflation lower, they suddenly rose in February. We see more goods deflation to come in the near term. Yet these one-offs may be offering a glimpse of the trickier inflation environment ahead later this year.
Markets are, for now, comfortable that inflation will cool enough to allow the Fed to make three quarter-point rate cuts this year and keep cutting. We think upbeat sentiment can persist as inflation keeps falling. That’s why we stay overweight U.S. stocks and lean into the artificial intelligence theme as tech drives corporate earnings growth.
The earnings recovery in other sectors is supporting risk appetite. Yet inflation could come in stronger than markets expect again and challenge risk-taking. That outcome would limit how far and how fast the Fed can cut rates from restrictive levels. We see Fed policy rates staying higher than before the pandemic as inflation likely settles closer to 3%. We believe that calls for staying nimble in portfolios.
Meanwhile, the Bank of Japan (BOJ) is focused on keeping inflation sustainably at 2% after decades of ultra-low inflation. Its challenge: gauging how to normalize monetary policy without undermining its hard-won revival of expectations for sustained inflation, in our view.
Rising import prices have helped Japan’s inflation rise above 2%. Yet keeping inflation there will require such expectations to feed through domestic prices and wages. The good news: Annual union wage negotiations resulted in pay gains topping 5%, the largest since the early 1990s. That should boost the BOJ’s conviction of overcoming a decades-long undershoot of its inflation target.
Markets are pricing that the BOJ could end negative interest rates as soon as this week. If markets see the policy shift as normalizing policy, we think that would support risk appetite. Yet if this policy change is viewed as the BOJ getting nervous about inflation, that could spell bad news for sentiment.
Without buffering for swings in the yen, we’re overweight Japanese stocks. Their outlook seems positive given mild inflation, strong earnings growth, and ongoing corporate reforms. Our overweight there will likely remain for longer than our U.S. stock overweight over a six- to 12-month tactical horizon. We’ve been underweight Japanese government bonds since July 2022. We expect yields to rise as the BOJ winds down loose policy, including yield curve control, even if likely in a measured manner.
U.S. inflation has been volatile recently, but we expect it to fall further this year before resurging in 2025. We see the BOJ ending negative interest rates – but eye risks to market sentiment. We’re overweight U.S. and Japan stocks.
U.S. stocks retreated from near all-time highs to end last week largely unchanged, surrendering gains after the U.S. CPI and other inflation gauges surprised to the upside. U.S. 10-year yields jumped more than 20 basis points to near 4.30% after February CPI was hotter than expected, prompting markets to price out Fed rate cuts. Japanese 10-year yields reached this year’s high near 0.8% as markets eye an end to negative rates this week. U.S. crude oil prices gained 4% on supply concerns.
The Fed policy decision is the main event this week. Although markets don’t expect the first rate cut until midyear, we think they’ll focus on how the Fed is responding to recent higher-than-expected inflation data. Markets may also assess whether Fed projections indicate a more persistent inflation outlook. Meanwhile, the BOJ could end its negative interest rate policy as soon as this week, with markets pricing a small hike. We also await the Bank of England policy decision.
Jean Boivin is Managing Director, Head of the BlackRock Investment Institute at BlackRock Inc.
Wei Li is Global Chief Investment Strategist, Blackrock Investment Institute at BlackRock Inc.
Nicholas Fawcett Macro Research – BlackRock Investment Institute, and Tara Iyer Chief U.S. Macro Strategist – BlackRock Investment Institute, contributed to this article.
Disclaimer
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.
© 2024 BlackRock Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. This article first appeared March 18, 2024, on the BlackRock website. Used with permission.
Image: iStock.com/Ca-ssis
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