Weekly Investment Update (09/20/2024)

A non-recessionary easing of monetary policy has been a foundational component of our market outlook since the beginning of the year. Using data back to 1980, rate cut cycles that occur in the absence of an economic contraction historically have been accompanied by solid equity market performance, with the S&P 500 averaging a 10% return six months after the first non-recessionary cut. After forecasting fewer than two rate cuts for 2024 as recently as June, the median FOMC member now sees another 50 basis points (bps) of cuts before year end, 100 bps next year, and a terminal rate of 2.9% in 2026. Although we believe there is evidence that economic growth is slowing, data reported this week refutes the notion that the Fed is materially behind the curve. This helps underscore our current overweight to equities relative to fixed income.

Meanwhile, activity data has come in stronger than expected this week. On Monday, the Empire State Manufacturing index far outpaced expectations, reaching its highest level in over two years. Later in the week, retail sales, industrial production, and housing data (both building permits and housing starts) also came in better than forecasted. Perhaps most importantly, initial unemployment claims remain stable, coming in below consensus this week at 219,000 versus estimates of 230,000.

Federal Reserve Kicks off Easing Cycle with a 50-Basis-Point Cut

What is happening: The Federal Reserve cut interest rates by 50 basis points this week, lowering the target rate to 4.75%-5.00% and concluding the second longest Fed pause in history at 14 months. While it is less common for the Fed to commence a cutting cycle with a 50-basis-point cut, Powell indicated it is a sign of confidence in the ongoing decline in inflation and a move focused on managing risks pertaining to the labor market. The decision saw broad support from Fed committee members, with only one dissenting vote. Still, the Fed cautioned that 50 basis points should not be the expectation for subsequent cuts.

Within the Summary of Economic Projections, unemployment projections were revised up for the year, while growth and inflation projections were revised down. The Fed also reduced its year-end 2025 fed funds rate projection to 3.4% from 4.1%, predicting a more aggressive cutting cycle than previously outlined. The rate cut coupled with the Fed’s updated forecast led the market implied fed funds rate for the end of next year to drop an additional 10 basis points to 2.85%.

Why it matters: A 50-basis-point move was a sign of the Fed’s commitment to support the labor market as the risks between inflation and employment have come into balance. The bond market remains more dovish than the Fed, pricing in an additional 75 basis points of expected rate cuts before year-end, relative to the Fed’s projection of 50 basis points. As we have seen this year, however, the Fed often deviates from its forecasted policy trajectory as economic conditions evolve.

We believe the Fed will continue to have a dovish reaction function with the aim of preventing a downturn in the labor market. Interest rates are still restrictive, and a sizable number of cuts will be required to return interest rates to the Fed’s estimate of neutral. Easier monetary policy, along with a growing economy, will likely be a supportive environment for risk assets, in our view. As a result, our asset allocation maintains an overweight to equities in portfolios.

Six of 10 Major Central Banks Lowered Their Policy Rates Before the Federal Reserve

What is happening: Since March, central banks in England, Canada, Switzerland, Sweden, New Zealand, and the European Union began reducing their policy rates before the Federal Reserve. Each completed at least one reduction in advance of the Fed’s initial 50-basis-point cut this week. Japan is the outlier among developed countries as the Bank of Japan raised rates twice this year to curb the yen’s depreciation; additional hikes are expected.

The fact that many central banks began easing before the U.S. underscores the weaker economic conditions in these economies relative to the U.S. For example, second quarter GDP for the European Union rose 0.2%, and the U.K. GDP was up 0.6%, each lagging considerably behind the U.S.’s 3% growth rate.

Why it matters: Interest rate differentials, or the difference in interest rates between countries or regions, will often drive investor demand to the higher yielding currency. Consequently, this dynamic strengthens the currency of the higher yielding country relative to the counterparty’s currency. The earlier interest rate cuts by international central banks were supportive of the U.S. dollar. However, since end of June, the U.S. dollar index has weakened nearly 5% against a basket of non-dollar currencies as anticipation mounted for the Fed to cut its policy rate.

A weaker dollar improves U.S. exports’ competitiveness and inflates the value of foreign earnings for multinational firms when repatriated, thereby boosting profit margins. Conversely, a stronger dollar lowers the cost of imported goods, countering inflation, and decreases the value of revenues earned by multinational companies, subduing profit margins. The bond market’s pricing of ~10 federal funds rate cuts through 2025 means investors are already anticipating a significant drop in U.S. rates. However, longer term yields are less impacted by Fed policy, so we believe the relative pace of economic growth across geographies may have a larger impact than policy cuts on interest differentials and, therefore, the dollar going forward. Related to this would be any shift in the Fed’s balance sheet policy, which we expect is likely off the table until after the election. Given our view of relatively stable U.S. growth meanwhile, the dollar should be somewhat supported even as the Fed begins to ease policy.