In this short video, James Klempster analyses the potential drivers of the decision to cut US rates and the asset classes that are likely to benefit the most.
Hello. It's Friday, the 20th of September. I thought we'd pause for a few moments and just reflect on what's been going on in markets this week. In our video last week, the debate was around whether the Fed would do 50 basis points or 25 basis points of cuts, rather than whether there would be a cut at all. It was a done deal that something would happen, and we saw it this week. As the week progressed, the probability of seeing that 50 basis point cut grew, and indeed that is what we saw. And it's been well received by markets. The S&P was up 1.7% yesterday and hit a new all-time high. It's been in the doldrums since July, which was the last peak it had. It's been drifting, a bit listless over the summer. But here we are now with the 39th all-time high over the course of 2024. And clearly when markets are on a run, and when they're doing well, you do get regular all-time highs beating the previous one. So you get large numbers of consecutive all-time highs as these returns compound up.
So the 50 basis point decision – what was going on there? There's three schools of thought, because it's unusual to see such a large move in the first cut. Traditionally, as we saw in the UK, you normally get a 25 basis point cut to start off with, unless the picture isn't a particularly rosy one. For example, the start of the pandemic was the sort of time where historically you would see a 50 basis point cut. And yet this one has been greeted fairly positively by markets.
Three arguments
So what's going on? Well, there's three possible arguments I think you can divine from everything you can read about it. The first one, and it's a bit of a circular one, is that the Federal Reserve cut 50 basis points because that's what the market expected. And the Federal Reserve essentially, tacitly didn't want to spook the markets. Now clearly that flies in the face of orthodoxy, which is classically 'don't fight the Fed', whereas clearly that approach would be more along the lines of 'don't fight the market'. The Federal Reserve is falling in line with the tune played by the market rather than the other way round, which would be historically pretty unusual. But you can see an argument for why the Federal Reserve wouldn't want to rock the boat at the moment. The second is that ultimately the Federal Reserve is looking forward a year or so, as monetary policy tends to take quite a long time to have a meaningful effect, looking forward a year and forecasting with lots of data and tools available that we don't have, and essentially presuming there is a less rosy picture out there a year from now.
So the Federal Reserve is starting to cut more aggressively perhaps than you otherwise would, to try and get ahead of the curve and prevent that hard halt that we talked about again in the video last week. The third option is the sort of narrative that the Federal Reserve wants us to take on board, which is that in essence, inflation is down pretty substantially, which it clearly is. Employment is fine, the economy's fine, so we might as well cut 50 because the inflationary problem is largely behind us. Jay Powell made comments to that effect to say we think the economy's all right, we want to keep it that way, so we might as well cut 50 basis points. The reality is possibly there's a germ of truth in all those three. We will only ever know the reality of course with the benefit of hindsight. In the future we will be very easily able to pick over the bones and decide what the reality is. But as ever, as investors in the here and now, we're faced with uncertainty, not peril necessarily, not deep uncertainty, but of course uncertainty as a common and, in fact, a constant when it comes to investment management.
Three markets that could do well
So what can we do to ride out this uncertainty? Well, we rely on two of our regular friends that we mention in these videos, diversification and valuations. And thinking about some of the markets in a diversified suite that's available to us and that could do well from a cut in US interest rates – we have Asia ex-Japan and emerging market equities and US smaller companies. So going through those three in turn: Asia ex-Japan and emerging markets, a lot of the debt issued by those businesses is in hard currency. Hard currencies are often, in fact more often than not, US dollars as the world's reserve currency, and whether it be financing or servicing that debt on an ongoing basis, if those interest rates come down, it's cheaper to issue new debt. But also of course, if you're having to fund it in dollars, a lower interest rate tends to lead to a weaker currency, which makes it easier for those businesses to afford those dollars as well. On the smaller companies side of things, again on the finance side, they often have a fair amount of debt in their business, often at floating rates. A reduction in prevailing interest rates should make servicing that debt easier. At the same time, as we've talked about before, smaller companies tend to be more sensitive to the domestic economic situation. So a reduction in interest rates should improve the picture for consumers. It's easier for them to service their mortgages, for example, if they're floating rates. And again, that should increase their propensity to consume and that should benefit smaller companies as well. So a couple of examples of asset classes, or a few examples of asset classes that we have scored as four out of five on our metrics, not only because of their valuation, but also we think they are well positioned for the environment we are in now, which is that rate-cutting cycle.
BoE held rates
Elsewhere in the world, the Bank of England kept the base rate in the UK flat. It didn't move following the 25 basis point last time. So we're already in a position where the Fed's done one move, the Bank of England has done one move and the Fed's cutting cycle is already more aggressive than the UK. It doesn't necessarily mean very much. The Bank of England has said it's fine to leave it as it is, and it is setting a tone in its comments that is a bit more hawkish. It is a bit more nervous around the persistency of elements of inflation, whereas the Federal Reserve seems to be a bit more relaxed about that. We had some data from the UK this week about consumer confidence, which is as low as it was in January this year. It slumped down a little bit, following a better period over the earlier half of this year. If you remember at the start of this year, the UK was in a technical recession. And the argument is that the new government is laying the foundations for a tough budget in the autumn, which has weighed on sentiment. And it's a nice example of how rhetoric not only impacts markets and creates noise and volatility in markets, it can also spill over into the real economy. We just need to be mindful that we don't need to talk ourselves into recession, which is a possibility if the mood music, if the nature of the news flow is universally negative. People can respond to that by tightening their belts even if they don't individually need to. It's a reasonable response to a picture being painted for you.
That's it from me. Have a good weekend when you get there and we'll see you next time.
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