View From The Top: Blink

View from the very top: US interest rates are set to fall for the first time since March 2020 later this month. The Fed has not blinked throughout its recent hiking cycle and has succeeded in bringing inflation back under control. Key for investors is whether they will understand why the Fed is now cutting rates – namely from a position of strength rather than for fear that the economy is rapidly weakening. Economic slowdowns are inevitably hard to gauge in real-time, but we see greater current evidence for post-pandemic normalisation than imminent recession. This has never been a conventional business cycle and nor will it become one. Investors should still guard against complacency. Another volatility shock or a widening of credit spreads could easily shift sentiment and risk appetite. However, for us, the direction of travel matters most. A trend towards looser monetary policy globally while the economy is still expanding should be positive for investors. Use inevitable intra-cycle drawdowns as an opportunity to allocate capital and continue to diversify.  

Asset Allocation:

• Equities: We have been encouraged by the broadening of the equity market rally, notwithstanding the brief intra-month correction witnessed in August. The equally weighted MSCI World Index reached a new all-time high on 30 August. This move has been supported by a sixth consecutive quarter of year-on-year earnings growth for the Index, per Bloomberg. Rising volumes of share buybacks by US corporates also speak to market confidence. Nonetheless, the MSCI World Index (unweighted) trades at a c15% premium to its ten-year historic median and owning large-cap tech remains the most crowded trade among investors currently, per Bloomberg and Bank of America Merrill Lynch respectively. We favour diversification into less crowded areas such as small caps as well as truly active managers, both of which should benefit from lower rates too.
• Fixed Income/Credit: The prospect of lower interest rates sent 10-year Treasury yields to a new low for 2024 over the past month. Credit has rallied across the spectrum, with the Bloomberg US Investment Grade Index at an 18-month trough. The comparable High Yield Index is at its lowest since mid-2022. There is a logic in seeking to secure higher-quality debt before interest rates drop. Fewer than 40% of US corporates with IG ratings now offer yields above 5%, per Bloomberg. We also see a logic in increasing duration at this stage of the economic cycle.
• Currencies: The US Dollar Index has enjoyed a broad rally since 2010. We may now be at the end of this super-cycle, especially with the Federal Reserve poised to cut rates imminently and from a higher starting point than other comparable Central Banks. The Euro and Pound have made recent year-to-date highs relative to the Dollar and could appreciate further, while the Yen-Dollar carry trade continues to unwind. A weaker Dollar is clearly positive for EM currencies.
• Gold: The precious metal has gained over 20% year-to-date and we believe further appreciation is possible. Gold and the Dollar are inversely correlated. The asset class continues to represent a hedge against geopolitical risks. Furthermore, falling real rates decrease the opportunity cost of owning gold.
• Alternative Assets: Owning assets with collateral-based cashflows brings additional diversification to portfolios. These assets can also act as a useful inflation hedge. We advocate being highly selective across this broad and diverse area, favouring differentiated and uncorrelated strategies.

Blink, and you may have missed it. Summer is almost over. Imagine you had taken all of August off and not thought about markets at all. No huge surprise to find that equities are higher and bond yields lower relative to a month ago. However, what you would not have seen was the huge spike in volatility, drop in share prices and rise in Treasury yields that occurred mid-month. Sure, volumes always dip at this time of the year, but there is something more important to take away. The Federal Reserve, arguably the most important force driving markets, did not blink. It has remained consistent in its messaging. When the data show it is time to cut rates, the Fed will – and not before. We concur. Forget the noise and focus on the bigger picture.

Let’s be clear at the outset. Intra-year stock market corrections are commonplace, even in years when the market rises. More importantly, the US economy is not poised for recession any time soon, based on the evidence we see. August’s recession scare turned out to be just that, just a moment of brief panic. Predictions of a downturn have fallen flat for the last two years. The reason is simple: this has never been a typical cycle. Consider not only the exogenous shock of the COVID-19 pandemic but the extraordinary response that followed. Subsequent monetary tightening inevitably needed to follow severe supply side disruption. We are still living with the after-effects now.

Monetary tightening has not inflicted much damage on aggregate demand to-date. Further, there appear to be few signs of economic and financial stress currently. Look at the data. US GDP rose at an annualised rate of 3.0% in the second quarter and the Atlanta Fed GDPNow tracker is pointing to at least at 2.0% rate for the third quarter. Small businesses are at their most optimistic since early 2022, new home sales are at their highest in over four years and retail sales growth accelerated in the last month for which data is available (all per Bloomberg). Anecdotally, your author witnessed streets busy with shoppers and restaurants absolutely packed when in the US during August. Sure, the jobless rate may have risen to a level not witnessed since 2021, but a 4.3% unemployment print may simply reflect more people entering the workforce for the first time rather than a growing level of joblessness.

The direction of travel for inflation provides the best indicator for post-pandemic normalisation. The most recent report showed that headline inflation had dropped to below 3.0% for the first time since 2021, whole core levels are only a touch higher (3.2% vs 2.9%). When consumers are asked where they see inflation in three years’ time, the answer given to the New York Fed is 2.3%, a 60 basis point drop since the start of the year. It would seem as if consumers have overcome their fear of inflation. Jerome Powell may well be right when he sees inflation is on “a sustainable path back to 2.0%.”

We have long been supporters of the Fed’s mantra of data-dependence. It now looks as if the Fed has done what it takes to quell inflation. It is hence able to start cutting rates, crucially from a position of strength. Importantly, even if the market wants a dovish Fed, Jerome Powell has not blinked. He has stood firm rather than giving the impression of acceding to the market’s every wish. The knowledge (or moral hazard) that Central Banks are there to bail investors out may be tacit, but it has never been explicit under Powell’s tenure.

Investors have been understandably euphoric about Powell’s Jackson Hole statement that “the time has come to cut rates,” two-and-a-half years after the hiking cycle commenced. However, the crucial questions are as follows: how will the Fed present its planned interest rate reductions, and will they be understood by the market? Disappointed markets can be volatile, which in turn, can have an impact on the decision making of Central Banks. The narrative on rates has also moved from ‘when’ to ‘how many.’ Given that interest rate expectations have consistently shifted throughout the year, with predictions consistently incorrect, we see this as a moot point. It is the direction of travel that matters.

Central Banks do, of course, face considerable challenges. Economic slowdowns are hard to gauge in real time. Further, inflationary embers could easily re-ignite price pressures. No-one seems willing to declare outright victory on inflation. There is the danger that were the Fed (or any of its counterparts) to cut too much, then it may risk another inflation surge. Conversely, were they cut too little, then growth could falter more. Do not forget, Central Banks have hardly had a perfect track record when it comes to avoiding making mistakes.  

The bottom-line – and this is what matters when it comes to considering risk appetite – is that the Fed has significant flexibility. A starting point of interest rates at 5.25% gives a lot of room. Contrast this picture with the 2010s, when rates were rarely above zero. Other Central Banks may also feel more emboldened to follow the path of the Fed. A cycle of broadly synchronised rate cuts could easily create a new leg for the bull market.

From an economic perspective, signs of normalising inflation do allow the Fed to increase its focus on the labour market, the other side of its dual mandate. Jerome Powell has been clear that it will “not welcome [a] further cooling in conditions”. Nonetheless, a slowdown, or even a post-pandemic normalisation, is very different to a recession. The latter ‘typically’ only starts when a rising unemployment rate is predominantly caused by surging job losses, not by new supply. Economic or financial crises are typically the necessary pre-condition for a recession since events such as these freeze up business activities, forcing businesses to liquidate assets and lay off workers.

It is important to strike the right balance between greed and fear. Remember, equities have enjoyed an almost unbroken run upwards since October 2022, with the MSCI World Index having generalised annualised returns of more than 25%. A forward earnings multiple of over 21 times can hardly be considered cheap, especially when compared to a 10-year median figure of less than 19 times (per Bloomberg). Against this background, it is wrong to be complacent. Another volatility shock or widening of credit spreads could easily shift sentiment, lead to a re-assessment of risk appetite and potentially tip the economy closer to recession. Geopolitics also remains a significant tail risk to monitor, particularly with a highly febrile and unpredictable current situation in the Middle East.

What to conclude from all the above? Don’t expect a return to normalcy any time soon. This has never been a conventional cycle. A bifurcation between high-income and low-income consumers, between tech (or AI proxies) and the rest of the stock market, and between the economies of the West and that of China create additional complications. We have remained consistent in our view about not fighting the Fed, or other Central Banks. Follow the direction of monetary policy when considering asset allocation decisions, do not panic when markets inevitably correct, use these moments to deploy cash and continue to diversify. As we said in January, buckle up for the remainder of the year, but continue to ride the rollercoaster.

Alex Gunz, Fund Manager, Heptagon Capital