The Federal Reserve’s rate cut on 18 September was widely anticipated – the most contentious question had been whether it would be 25 or 50 basis points, with the Fed opting for the latter. While the move should lower borrowing costs for businesses and consumers, stimulating the economy, we believe it will also be positive for three sub-asset classes for which we have already assigned positive tactical outlooks – US smaller companies, emerging markets (EMs) and Developed Asia ex-Japan.
A rate cut generally reduces the debt burdens for smaller companies more than their larger peers. A cut also weakens the US dollar, which is welcomed by many EM and Asian countries and companies.
US smaller companies
We raised our ranking for US small caps from a neutral three to a positive four in the first quarter of 2024. Eclipsed somewhat in 2023 by the largest of their US counterparts, the Magnificent 7, small caps have underperformed over the last two years in the rising interest rate environment to the point they offer attractive valuations at discounts versus historical levels. Against the backdrop of a strong US economy, they offer positive fundamentals.
More good news on that front is likely ahead too, with further rate cuts expected this year, which should provide further support. Based on Fed fund futures data,1 the market has priced in a total Fed rate cut of 103bps, or just over a full percentage point, by the end of 2024 – substantially more than the single quarter-point cut signalled by the Fed earlier this year.2
Furthermore, smaller companies may present higher risk, but the quid pro quo is flexibility and nimbleness. Most notably, smaller companies tend to me more sensitive to the fate of the domestic economy and so, if the 50bps cut is a harbinger for greater problems in the US economy, smaller companies may struggle. However, they also tend to be quicker out of the blocks in a recovery and we are firm believers in a small cap premium longer term.
Emerging markets and Asia ex-Japan
This week’s rate cut will also have implications beyond the US. EM and Asian ex-Japan countries tend to borrow extensively in US dollars, so a weaker greenback makes it easier for them and their companies to service their debts.
We have been positive on EMs and Developed Asia ex-Japan for some time. They offer strong fundamentals, including fast-growing economies and supportive demographics.
Over the last two to three years, events in China, coupled with its relative economic malaise, have weighed on emerging markets (EMs) and Asia. However, we see several reasons why EMs may now be more attractive to global investors. Apart from benefiting from the relative appreciation of their own currencies, China has deployed pro-growth stimulus (although this has been underwhelming so far) and while US-China relations remain complicated, the reorganisation of strategic supply chains could create new opportunities for EM nations other than China.
Our view remains that EM equities are highly geared into sentiment shifts – both positive and negative – and are sensitive to domestic and international politics.
As with EMs, we regard Asia as benefiting from the reflation trade and loose monetary policies. It is also looking cheap compared to several other equity markets. These economies generally fared well through Covid, but a lot clearly rests on China and how it supports its economy going forward. Risks remain from the perspective of global sentiment as well as regional political tensions as well as a broader global slowdown which would likely impact export reliant economies.
Keeping to our approach
The US federal funds rate is one of the most important factors influencing global financial markets. It determines borrowing costs, consumer spending and economic growth in the world’s richest country. Indeed, its influence is felt far beyond the US’s shores thanks in no small part to the US dollar’s status as the world’s reserve currency.
Before this week’s announcement, the question exercising the minds of market participants was less whether the Fed would cut but by how much. With inflation down to 2.5% in August3 – around the 2% target level, although still above it – the concern about pushing the economy into a downturn strengthened the argument for rate cuts. The Fed has expressed lingering concerns about persistent inflation, but its remit also includes maintaining maximum employment. In his statement accompanying the rate decision, Fed Chairman Jay Powell said: “The US economy is in a good place and our decision today is designed to keep it there.”4
Whether the Fed cut had been 25 or 50bps, we did not anticipate changing our current approach to investing following the announcement. If the Fed had signalled concern that the economy was cooling too much then this would be new information to incorporate into our tactical asset allocation process. But from our default big picture perspective, there are plenty of data that suggest business and the economy are in good health in the US. Inflation has fallen materially without a substantial impact in terms of the overall economy and with full employment. There might be a short period of negative growth, (i.e. a technical recession) but it probably won’t result in meaningful and substantial destruction of value in the US economy.
1Soure: Bloomberg, 3 September 2024
2Soure: FT.com, 12 June 2024
3Source: US Bureau of Labor Statistics, 11 September 2024
4Soure: FT.com, 18 September 2024
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