View From The Top: What next?

View from the very top: don’t fight the Fed. The most telegraphed interest rate cut in recent history has provided further ammunition for the rally in risk assets. For us, the direction of travel is what matters most. The US Central Bank (and its global peers) are cutting rates from a position of strength, while economic growth remains surprisingly strong. Should conditions deteriorate, they also have ample ammunition. The bigger consideration is how much of this good news is already discounted by investors and whether the Fed may disappoint were it to cut rates at a pace more slowly than forecast. Should macro now prove to be less of a driver of returns going forward than it has in the past, then something will need to replace it. There will be a growing onus on equities to meet and exceed consensus earnings expectations. In any assessment, it pays to guard against complacency. However, the logic of deploying cash in a lower rate environment should be clear. Allocate with diversification.

Asset Allocation:

• Equities: The rally in equity markets continued during September, with the MSCI World Index now up 17.5% year-to-date. We believe that there are good reasons why further gains can be achieved. With the equally weighted global index trading at a 15% discount on forward earnings relative to its market capitalisation weighted peer (18.3x vs 21.6x), many businesses clearly offer compelling value. A lower rate environment should help drive regime change and diversification away from the large cap tech businesses that have already delivered strong gains. With fewer than 30% of active managers outperforming so far in 2024 (in the US, per Bloomberg), there is strong scope for catch-up. Earnings, of course, will need to deliver. We favour balance across equities and continue to see attractions in Japan and emerging markets.
• Fixed Income/Credit: The yield on US 10-year Treasury debt has dropped markedly from its 2024 peak (from 4.7% to 3.8%). While further yield compression may be possible, fixed income markets have already discounted an aggressive easing cycle. With credit spreads also very narrow (the gap between B and CCC rated credit is its narrowest in two years, per Bloomberg), investors may need to take on more risk to sustain high returns. Record corporate credit issuance speaks to a desire to lock-in yield at current levels. Our strategy has been to gradually increase duration while remaining pragmatic.
• Currencies: The US Dollar Index fell almost 5% during the third quarter. Further weakness may be inevitable, especially should the Federal Reserve continue its rate cutting strategy, and from a higher starting point than its peers. A weaker Dollar benefits emerging market currencies especially, while the Yen carry trade should continue to unwind.
• Gold: Lower rates clearly lower the opportunity cost of owning commodities including gold, which do not pay a yield. The precious metal is indeed enjoying a golden moment, recording a gain of over 27% so far in 2024. Further gains look likely given the macro backdrop. Central Banks (especially in the Middle East) remain buyers of the commodity too.
• Alternative Assets: Owning assets with collateral-based cashflows brings diversification to portfolios. Many benefit from an illiquidity premium too. We advocate being highly selective across this broad and diverse area, favouring differentiated and uncorrelated strategies.

The wait was long, but also worth it. The most telegraphed interest rate cut in recent history (or “recalibration of policy stance”, as Jerome Powell euphemistically described it) occurred on 18 September. The Fed went large, with a 50 basis point reduction. Investors broadly rejoiced. The chances of a much-vaunted soft landing now look proportionately higher. So far, so good. For us, the more intriguing question is what happens next. In summary: enough for the current bull market to be sustained a bit longer.

Let’s get three things clear at the outset. Here is a trio of lessons we have learned during our time as investors. These continue to inform our world view and asset allocation approach. First, it is the direction of travel that matters most. In the ‘real’ world, people care about absolute change – hence the frustration felt by many over inflation and higher prices. For the investment community, the rate of change is the key variable. A path towards lower interest rates trumps the magnitude of the cuts, even if there is no instant gratification for consumers. Next, don’t fight the Fed, or other Central Banks. Words can count as much as actions. Commentary followed by policy suggests that monetary authorities will do what it takes. The ‘Fed put’ (or effective safety net of intervention under certain circumstances) remains alive and kicking.

A final consideration would be don’t trust forecasters, or experts. All predictions of imminent recession over the last few years have been proven wrong. The same charge could be levelled at estimates for inflation. The folly of crowds can be dangerous. Although almost forgotten by now, there was a period in the middle of the last quarter when it appeared that concerns over stubbornly high inflation had been replaced almost overnight with growing worries over rapid economic decline. At the same time, almost no-one has been willing to give Jerome Powell the benefit of the doubt. Notwithstanding the above observation about the Fed, it will have to count as a remarkable achievement on the part of the US Central Bank if an orderly slowdown and soft landing is achieved.

The numbers should speak for themselves. The rate of economic growth has remained surprisingly strong. Consider that US GDP for Q2 was revised up, from 2.8% to 3.0%. The latest GDPNow estimate from the Atlanta Fed for Q3 stands at 2.9%, markedly higher than its 2.1% forecast posted mid quarter. Supporting this world view, services output is currently running at its highest in 11 quarters, while US retail sales figures continue to come in ahead of estimates. These dynamics have been achieved at the same time that headline inflation has fallen for five consecutive months and has now dropped below its 20-year average for the first time since before the pandemic. We do not see a 4.2% unemployment rate as a cause for concern, partly since it has been bolstered by new immigrants entering the labour market. Hiring may be softening, but lay-offs still look limited, with latest jobless claims at their lowest since May.

Even with the Fed continuing to reiterate its mantra about the importance of data dependence, we see the 50 basis point September cut in the Fed Funds rate as highly logical. To reduce rates by this magnitude speaks less about fear of falling (or being seen to fall) behind the curve and more about focus. See it as a precautionary move, a mechanism to help ring-fence the economy. Furthermore, it also constitutes a very effective signalling function. Ever since the end of the credit crisis, the Fed has sought to avoid surprises in its communication. September’s move demonstrates that it can act quickly, if needed.

Most importantly, the Fed is cutting from a position of strength. It is not responding to a recession or a financial crisis. Its decision may also legitimise further rate reductions from other Central Banks globally, creating a virtuous circle of looser money and potentially better economic growth. Regardless, the market is still discounting at least 100 basis points more of interest rate cuts in the US in 2024 and another more in 2025. If the forecasters are correct, then the Fed Funds Rate will be below 3% by the end of next year.

This is very different to the view of Jerome Powell and the Open Market Committee. On its projections of 2.0% GDP growth in both 2025 and 2026 (its September forecasts had not changed relative to those made in June), unemployment will only rise slightly from current levels and just six interest rate cuts of 25 basis points each will be required before the end of next year. What we are witnessing is a de facto normalisation in the economy after the extremes of the pandemic and other subsequent supply side shocks.

This is hardly the first time that there has been a disconnect between Central Bank projections and investor expectations. At present, an orderly slowdown looks like a much more likely scenario than a recession. Almost 80% of Fund Manager respondents to the latest Bank of America Merrill Lynch survey see a soft landing as the most likely economic outcome. Further, the Fed (and its global peers too) have a lot of ammunition should conditions deteriorate. For context, the last time CPI inflation was at its current 2.5% level, US interest rates were at 1.75%.

Nonetheless, we believe there are three key implications from all the above. First, there may be disappointment should the Fed cut more slowly than the market hopes. Put another way, is all the good news already priced in? In this scenario, bond yields may go up, and equities trade lower. Next, if the current level of rate cuts is already discounted, then only a severe recession would force the Fed to cut more aggressively. Whatever the optimists may believe, not even Central Banks can abolish the economic cycle. A recession will eventually happen. Calling when, however, is a lot harder. Watch for a potential exhaustion in household savings, markedly worsening labour market trends and a possible deterioration in residential real estate. Consumers are, apparently, more concerned about keeping up with their debt payments than at any time since the start of the pandemic, in April 2020 (per Bloomberg).

Finally, if macro is potentially going to be less of a driver for investment returns going forward, then something will need to replace it. With the path towards lower rates as a relative given, equity investors may start to focus more on earnings growth (and fixed income investors on yield). Consensus data on Bloomberg call for 11% earnings growth for the MSCI World Index and 13% for the S&P 500 Index in 2025, driven largely by margin expansion. The onus will clearly be on businesses to deliver. Disappointment may follow if they don’t.

We also think it pays to guard against complacency. Interest rate changes can have long and variable lag effects on both the way up and down. At the same time, do not forget about the elephant in the room – government budget deficits. These average 4.4% of GDP across the OECD, and 7.0% in the US. A day of reckoning may occur, even if not immediately. The final quarter of 2024 will almost certainly bring its share of surprises too. Geopolitics remains a wild card. For now, however, prospects look compelling. Lower rates reduce the attractiveness of holding cash, increasing the logic for judicious allocation with diversification.

Alex Gunz, Fund Manager, Heptagon Capital