Now What?
Gary Dugan, Chadi Farah, Bill O'Neill
The Global CIO Office
- The Fed makes a good start to the rate cutting cycle, trimming rates by 50bps
- The peaking of US policy rates often means trouble ahead; we hope this time is different
- US inflation is certainly in abeyance but not totally beaten
- Asian and emerging equity markets offer good upside as they cut rates
- Japan and India with their medium-term positive fundamentals offer further upside.
- You will still need your gold
To our relief, the Federal Reserve slashed interest rates by half percentage point last week. Given the historical context, the markets must now be a bit apprehensive about what lies next. Here are a few thoughts and suggestions:
Don’t get carried away and take on greater portfolio risk. Historical evidence suggests that the peaking of the Fed funds rate and the initial cuts in interest rates don’t always lead to good returns in the subsequent year. Back in 2007, the Fed made its first rate cut of 50bps on 18 September and two further 25bps rate cuts before the year ended. The stock market rallied 11% between when the first rate cut was announced and mid-October. But by the end of the year the economy was in recession and the equity market was on the slide. To be fair at this stage, a soft-landing looks like a probable outcome. But we can never be sure.
Chart 1: First Rate Cuts Don’t Necessarily Mean Vibrant Equity Market a Few Months Later
Source: Bloomberg
2. Remember that inflation risk has not truly disappeared. Indeed, it was interesting to see an uncharacteristic dissenting vote from Fed governor Michelle Bowman against the 50-bp cut. The Fed governor argued for a more modest cut of 25bps, and it’s essential to be cognizant of why Bowman would have wanted a more measured approach. The Fed does not have inflation exactly where it wants it. Inflation still lingers, particularly in the service sector where super core inflation excluding housing is still above 4% (Chart 2). Let’s suppose too much anticipation of lower rates leads to a sudden burst of consumer spending. In that case, we may be facing up ticks in monthly and disappointments on inflation instead of settling back into the Fed’s target range of around 2% to 2.5%. Such a scenario is not our core belief, but it is important to keep a wary eye out for probable trouble.
Chart 2: Super-Core Service Sector Inflation
Source: Bloomberg
3. The clear market hope, discounted in the rally in equities at the end of the week, is that the US economy is in the midst of a Goldilocks scenario with softer growth and no drama. We will have a pause for the US Presidential election; but if the market can still see line-of-sight of a profit growth in line with consensus GDP growth forecasts (Chart 3) then equities could make further progress.
Chart 3: Remarkable Reversal in the Yen’s Previous Weakness against the Dollar
Source: Bloomberg
4. The rate cuts nevertheless provide good support to emerging markets. We have already seen the Bank of Indonesia immediately following suit and announcing rate cuts. We expect other central banks to follow. Hence, the more immediate investment opportunity for portfolio leverage to lower rates is probably in the Asian markets, where investors can see several interest rate cuts coming through in the months ahead.
5. Lower interest rates are good news for global liquidity, and they’re particularly good news for investment themes with good macro support. Hence, we continue to favour markets such as Japan and India, which have their own internal dynamics that encourage us to believe that there are some very good long-term returns to come from both these markets.
6. Bond markets will feel more confident with a progressive Fed regularly cutting policy rates. We expect credit to outperform government bonds and medium-term government debt to offer better risk-adjusted upside.
7. We expect the ECB to follow the Fed and the BoJ to move in the opposite direction largely at the pace the market is expecting.
8. Gold remains an important risk diversifier and lower US dollar rates help still further to generate good absolute returns. The dollar is likely to remain under some downward pressure as US rates fall. Meanwhile inflation is not completely beaten. The upcoming emerging market forum will highlight how the US’s fiscal and government debt positions are not conducive to believing the dollar is the answer to capital and spending power preservation for investors in the future. We expect the gold price to push on towards $3000.
