Interest rate cuts are good for companies and the consumers, and consequentially for the economies. So it is with great pleasure that we see the FED joining the club and initiating its own rate-cutting campaign, about one year after they last increased them. And we have argued that especially in Europe, rates have been kept too high for too long. But in the US, economic growth remains ok, albeit with weakening signs and consumers keep spending money they do not have. The S&P500 registered a new high, which increased the possibility of a further rally. Bond yields rose a little but remain close to the lows of the year. An ideal situation, so far, but far from sustainable.
Were equity markets to rally a further 10% in the short term, would that be a reason to celebrate more ? The simple answer is a solid "YES" , as our clients' portfolios will further rise ! And the market has already adopted its favorite scenario for the rally to continue: "Goldilocks", or in other words just enough growth to keep the economy going, inflation trending down and rate cuts have arrived. Then again, if we rally another 10% (in the short-term) with "just enough growth", equities will become extremely expensive and prone for a big correction, which will bring them back to where we are today or lower, in just a few months. So not much of a progress, one would say.
Why could a further rally in equities endanger this beautiful "Goldilocks" scenario ? We cannot ignore the fact that all these events combined together (lower rates, lower bond yields, a further big rally in equities) render the financial conditions very loose. With corporate spreads so tight, risk-free rates at two-year lows and the S&P500 at record high, not to mention the growing money supply again, all this corresponds to the FED having already cut much much more than the actual 50bp it just did. Growth will re-accelerate under these financial condtions, which is not bad of course. But how will the FED react if already high inflation components (rents, house prices, wages etc) start to pick up again, thanks to this euphoria. To avoid any misunderstadings, we certainly do not "wish" for economies to fall into a recession, which is a guarantee for lower inflation. But the current ideal situation cannot continue as it is, with bonds and equities rallying. Something has to give.
The FED chose to "surprise" the markets with a 50bp rate cut. As mentioned in our latest weekly review, the probability of a bigger-than-expected cut was increasing during the very last days before the meeting, as the market had caught the message from some last-minute FED speak. The vote was not unanimous however, with one dissenter. And as also expected, Chair Powell said the decision was a "recalibration toward a more neutral rate", which was the only market-friendly explanation of a 50bp cut, which is usually an "emergency cut". But he also cautioned against thinking 50 bp rate cuts were the new pace and noted the intent to maintain restrictive policy, in order to ensure inflation's return to 2.0%. Equities initially did not like this, but the next day they exploded higher with enthusiasm.
The issue that arises is whether the credibility of the FED has now been dented. It was not just a few weeks ago that the FED was guiding for an "insurance cut" , which usually takes the form of 25bp and quite a few FED officials were pubicly questioning whether they would cut at all ! And now, all but one, voted for a 50bp rate cut, with the latest data on employment and retail sales actually being better than feared. The FED is now guiding for another 50bp cuts in total for 2024, but is anyone listening ? We yield to the "conspiracy theory" temptation to believe that the FED (as the ECB) would like to walk away from providing any forward quidance and be able to act spontaneously, at each meeting. If that is the case, we are probably moving into an era of violent moves in bond and equity markets, in both directions, until the data show a clearer path of where interest rates are going.
US equities stole the spotlight, last week due to the FED meeting. The S&P500 and the Dow Jones registered a fresh record high with 1.5% moves, while Nasdaq approached its own high with similar gains. European equities were rather flat to negative on the index level, as new profit warnings from automakers (Mercedes) and the dependence of consumer companies on China are haunting the region, for now. Having said that, Hang Seng jumped 5% last week, as local chinese markets also rose by 1.5%, with no real reason than money chasing opportunities.
Bonds lost some ground, but remained close to the recent lows, not subscribing yet to this Goldilocks scenario. The US 10-2 yield differential is becoming steeper, which is a normal event after the inversion and as the FED has started cutting rates. This has potential implications for how equity sectors perform in the next 6-9 months, based on historical data, which of course are just statistical averages. According to these, Utilities, Autos, Food Producers, Household Products are among the best performers, while Semiconductors, Software and Pharma have negative returns.
Chart of the Week : Is this time different ?
The above chart by Apollo Global shows how the FED's rate has moved after the first rate cut. The blue line is the average path of rate cuts in the first 12 months when there was a recession. The light yellow line is the average rate path, when there was not recession and it shows a much shallower path , which eventually stops as there is no need for further rate cuts. Interestingly, the middle line (red) is the current pricing of the FED's rate for the next 12 months, which shows that it looks more like a recession-linked path than an "insurance" cut. Of course these things change dynamically and a few weeks from now we might be looking at something else. The point however is that bonds are pricing an economic scenario where the US GDP slows to zero or even mildly negative. Unless this time is different and a steeper rate-cutting path (as shown in the chart) will not necessarily correspond to a recession. Time will show.
Disclaimer
• The content of this document has been produced from publicly available information as well as from internal research and rigorous efforts have been made to verify the accuracy and reasonableness of the hypotheses used. Although unlikely, omissions or errors might however happen.
• The data included in this document are based on past performances and do not constitute an indicator or a guarantee of future performances. Performances are not constant over time and can be positive or negative.
• This document is intended for informational purposes only and should not be construed as an offer or solicitation for the purchase or sale of any financial instrument and it should not be considered as investment advice. The market valuations, views, and calculations contained herein are estimates only and are subject to change without notice. Any investment decision needs to be discussed with your advisor and cannot be based only on this document.
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• Sources: Chart of the Week : Apollo Management, photo:
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