Inflation slowdown will not change the Fed’s mind – UBS

Slowing beyond expectations, the U.S. consumer price index gave markets hope a day before the Fed’s decision on interest rates – which are now at 2007 levels.

According to the U.S. Bureau of Statistics, the overall index registered the smallest increase since March 2021 of +4% compared to 4.1% expected by the market and 4.9% in April. On a monthly basis, the inflation rate increased 0.1% compared to a consensus of +0.2% and an April figure of +0.4%.

However, the core component – which excludes energy and food – fell less, accelerating at an annual rate of 5.3%, in line with expectations, and compared to 5.5% in April.

These data have consolidated market bets for a halt to interest rate hikes that have been going on for 15 consecutive months. However, expectations for a further increase in July have not decreased, just like the Bank of Canada did at its last meeting by raising rates by 25 basis points after keeping them unchanged in the previous one.

In their Daily Europe note, Mark Haefele, Chief Investment Officer of UBS Global Wealth Management, wrote that May’s data is not “sufficient to allow the Fed to call a final end to tightening,” and nor will it “justify the recent optimism among equity investors.”

He said that the base measure remains elevated, making it more difficult for the Fed to end its rate hike cycle or contemplate cuts before growth or employment data materially weaken.

Looking at the markets, Haefele points out that equity valuations suggest that investors are “overly confident in an economic soft landing,” with U.S. stocks currently trading at about 18.4 times analysts’ earnings forecasts for the next 12 months, a 14% premium over the past 15-year average.

“Price-to-earnings ratios above 18 times are typically associated with periods of healthy economic growth and rising corporate profits. Instead, we expect a period of subtrend economic growth and falling earnings, as the lagged impact of prior rate hikes feed through,” Haefele explained.

Therefore, for UBS, it is unlikely that inflation data will change the Fed’s course. According to them, bankers are likely to pause in June, while signaling the likelihood of further tightening.

Against this backdrop, the Swiss bank maintains a less favorable stance on global and U.S. equities, and suggests investors to “seek quality income in high grade (government) and investment grade debt.”