Rate cuts to the rescue?

First central banks were blamed for causing inflation by keeping rates too low for too long during the post-COVID-19 recovery. Then they were accused of driving the economy into recession by leaving rates too high for too long in their fight against inflation. However, now the consensus has shifted, and the US Federal Reserve (Fed) seems to have achieved a ‘soft landing’, or a cooling down without a recession. Interest rates are coming down again, and stock markets are enjoying another double-digit year.

Yet lest we forget, higher interest rates did take their toll. While the US and Eurozone continued to grow, the United Kingdom, Germany and Japan all suffered mild recessions in 2023. As for the US, the limited historical record shows that by the time the Fed started cutting rates, a US recession was often only a few months away. How likely is it that this time will be different?

Even if we ignore the extreme high-rate periods of the 1970s and early 1980s, the historical picture is not encouraging. Non-recessionary cutting cycles were very minor, with much smaller cuts than we expect from this current cycle (2-2.5%). We also note that during recessionary episodes, the Fed was usually cutting rates into an already weakening economy. Is this the case in 2024-25?

Recessionistas today highlight that inflation has eaten into real wages and savings, confidence is low and credit delinquencies are rising. More ominously, the US unemployment rate has risen by almost 1% in the past year – something which has never happened without a recession.

Jobs vs interest rates

However, there are legitimate reasons to doubt the historical comparison. Professor Claudia Sahm, creator of the employment based Sahm rule which flashed red for a US recession in August, talked down its predictive power considering the impact of immigrant workers in the model. Now the rate of unemployment has dropped for two months in a row, and wage growth has started to increase again, suggesting that the economy is actually strengthening rather than weakening.

Now two months of improving jobs data does not mean that the US economy is out of the woods, but it does paint a more positive picture than we saw two months ago. Conversely, it also means that interest rates may not come down as fast as expected. Fortunately, because the reason for higher rates is stronger economic data, markets took this adjustment in their stride, and pricing is now more in line with the Fed’s projections.

As they currently stand, market expectations for interest rates feel roughly right to us. With the weakest business surveys and inflation already below the 2% target, the Eurozone is the readiest region for lower rates. The UK still has service and wage inflation close to 5%, which will make the Bank of England slower to cut.

The difference in future interest rates is reflected in exchange rates, where the pound is probably fair valued now at over 1.30 to the dollar, whereas the euro is still a little cheap under 1.20. The Japanese yen is cheaper again, due to the Bank of Japan’s sluggish pace. The risk here is that US wages and inflation stay stronger, supporting US rates and the dollar.

Bazooka time in China?

After years of ‘sleeping dragon’ metaphors and disappointment on the policy front, China grabbed the markets’ attention in late September with its most serious set of initiatives in many years. The central bank and regulators announced lower interest rates, mortgage rates and bank reserve ratios, along with support for the stock market and property sector. As a result, the local market jumped by over 30% in a few days. No doubt short sellers were caught out and had to get out of their bets.

The first question is whether this is it – the Chinese equivalent of the ‘bazooka’ stimulus package that US policymakers fired in 2008-9 to turn around their financial and property sectors. The answer appears to be no, not yet. The following fiscal announcement was much smaller than expected and the market pulled back on the news. However, there are signs that the government is taking this seriously at the highest level, and so we expect a more sizable fiscal package soon.

The next question is what this means for the rest of the world. The stimulus news lifted China-related assets globally, including big exporting markets like Australia and Germany and capital expenditure related commodities like iron ore. If China is really to turn the corner though, the solution will have to be more about boosting consumers than building more industrial capacity, so the beneficiaries may not be the same as before. Either way, China is so big that its recovery will be felt around the world.

Stock market – the 1990s again?

Over the past three years, the stock market has surged or stalled based on the outlook for interest rates. Now that a soft landing and lower rates have become the consensus view, it’s reasonable to question whether the current buoyant market is consistent with previous rate-cutting cycles. Again, the historical record is mixed at best.

As with the economic outcomes, the market outcomes vary widely and are driven by more than just interest rates. While we expect more cuts than the mid-1990s examples, these periods are relevant today because we are again in an expensive bull market, dominated by tech stocks. However, we caution that the Shiller CAPE1, a well-known long-term valuation metric, uses a 10-year earnings window, which may not fully capture the phenomenal recent earnings of the tech sector.

Whichever valuation measure we use though, we can’t escape the reality that the US market is very expensive. But we would counter that the index valuation is dominated by the largest tech stocks. If we look at the average US stock, or the average global stock, we find much more reasonable value. This was not the case in the late 1990s when the irrational exuberance in technology and telecoms bled across almost all sectors and countries.

Finally, before we sound too negative on the tech sector, we note a few points. First is that even in the tech index, the valuation of the average stock is quite different from the biggest ‘mega caps’. Second is that these few mega stocks have mostly delivered in earnings terms. Lastly, even though they are investing hundreds of billions of dollars in artificial intelligence, they are so profitable that they can fund this from cash flow, not from debt or equity issuance as happened in the 1990s.

War and commodities – the 1970s again?

Two autumns ago, with war raging in Ukraine and inflation reaching double digits, we were looking at the prospect of a cold winter recession. As it turned out, Europe found alternative energy sources and it was the prospect of higher interest rates that kept the global stock market down. At the time of writing, the conflict in the Middle East appears to be escalating and fears of an energy price shock have re-emerged.

While we don’t want to downplay the seriousness of what is happening in the region, we don’t believe that this will have much impact on the world economy, and therefore on risk assets. Iran’s oil production, of roughly 3.5m barrels per day, is less than the combined spare capacity of Saudi Arabia and the United Arab Emirates. Unlike the Arab embargo of 1973-74, when prices quadrupled, it is difficult to see enough supply being taken out to cause more than near-term volatility.

However, there is one part of the commodities complex that is reliving its 1970s glory years. Despite inflation receding and real rates holding up (as rates stay higher than inflation), gold continues to break new price records. The continued political uncertainty, unending government deficits, and a growing aversion in the East and the ‘global South’ to the US-dominated financial system are all helping to sustain demand for the oldest alternative currency out there.

The wildcard – the US election

On top of all the usual worries about economic growth and equity valuations, 2024 also brought the added uncertainty of an unusually large number of elections across the world. The biggest of them all, the US presidential election, is in early November, and polling indicates that there is very little between the two candidates at this stage. Given the high political stakes, is this a reason to hold off on investing?

Analysts have dissected the policy promises of both candidates, vague as they are. They’ve concluded that, while there will be winners and losers either way, their aggregate impact may not be that different, assuming they are ever implemented. Under either president, fiscal policy will remain loose, and deficits will remain uncomfortably high, adding pressure to inflation, interest rates, and bond yields. Higher corporate taxes under President Harris would slow profit growth, while Trump tariffs and tax cuts would add more inflation, deficits, and eventually interest rates.

At the margin, stock markets might prefer a Trump win, but what they really want is more stability and less uncertainty. This would come from a split outcome, with the president not in control of Congress and therefore unable to push through much change. As far as market impact goes, we can expect some volatility around the election, and potentially the aftermath, but beyond this the impact on investment returns is most likely to be, in the words of Trump himself, a “nothing burger”.

Investment conclusions

As always, we must acknowledge the uncertainties and remind ourselves of the multiple potential outcomes, both good and bad. In Q4 now we have a US economy that appears to be strengthening rather than weakening, interest rates are coming down, and China is looking to stimulate too, all of which are positives for the global outlook. Of course, we will be focused on US jobs and inflation, and Chinese policy, to see that this strength is for real.

Our main concern is that markets are already expensive. We know that this is concentrated in certain sectors, and our solution is not to bet against the overall market, but to lean away from areas that are too stretched or vulnerable to correction. This approach can take time to work, and after a runaway first half of the year, we are encouraged that markets did start to rotate away from tech in the third quarter. We will continue to watch this space and adapt accordingly.

Summary of portfolio changes in the third quarter 2024

1. US Dollar. Following the appreciation of the euro vs the dollar, we took profits and closed out our dollar hedges, i.e. we bought back dollars.
2. European Equities. In June (before the tech sell-off) we reduced our exposure to the US tech sector by rotating from global equities towards the European market (including the UK).
3. Chinese Equities. After a year of underperformance due to the lack of stimulus from the Chinese government, we reduced the overweight position.

¹ The Shiller CAPE is the cyclically-adjusted price/earnings ratio, developed by Nobel prize winner Robert Shiller. It compares the price of the stock market with the past 10 years of inflation-adjusted earnings.