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Written by: Kevin McCreadie, CFA®, MBA | AGF
What is your impression of the investor reaction to the U.S. Federal Reserve (Fed)’s first rate cut in more than four years?
Global financial markets reacted much like you would expect at the beginning of a new rate-cutting cycle. Equity market indexes – led by the S&P 500 Index in the United States – climbed immediately higher on the Fed’s announcement in mid-September to cut rates by 50 basis points and they have continued to move higher over the past month, often hitting new all-time highs in the process. While part of this latest leg in the rally can also be attributed to the latest U.S. earnings season getting off to another hot start, what’s been most noteworthy about recent gains to me is the sea change in market breadth that we’ve witnessed over the past quarter or so.
Remember, at this time last year, almost all the S&P 500’s year-to-date positive returns were generated by just seven stocks as investors shunned companies whose bottom lines were more susceptible to higher interest rates. But in the third quarter of this year, that seemed to change with 79% of S&P 500 constituents netting positive gains and 55% outperforming the S&P 500 itself, which returned 4.6% in the three months ending September 30. This is a very good development for equity investors and one that could be instrumental in possibly pushing global equity markets higher in the weeks ahead should it continue.
What do you expect from the U.S. Federal Reserve and other central banks going forward?
It’s fair to expect more cuts as the Fed moves toward a more “neutral” level of interest rates, which, being a theoretical concept, could be anywhere between 3.75% on the high end to 2.25% on the low end, depending on who you ask. So, the question isn’t whether they will cut again. The current Fed rate of 4.75-5% is clearly too high. Instead, the question is how measured the Fed will be in trying to achieve its eventual Goldilocks target.
And herein lies the potential risk. For instance, it’s plausible that an aggressive Fed that cuts rates significantly in a short period of time could result in monetary policy being too loose –especially if the U.S. economy continues to prove more resilient than some anticipate – thus reigniting the embers of inflation. Yet, if the Fed moves too slowly or doesn’t cut deep enough, it’s very possible that the economy weakens from here and, worst case, could tumble into a recession.
Given that dynamic, I believe it will take more than a few months for the Fed to lower rates below 4% and I don’t expect them to fall much more than that – at least not anytime soon. After all, monetary policy usually works with a lag, so caution may be advised. Granted, that may not sit well with some investors who believe the Fed can be much more aggressive without fear of overheating the economy again.
This difference in views could result in greater market volatility going forward, yet the only reason to cut rates zealously is if the economy shows real signs of faltering, which, following last month’s better-than-expected employment figures and last week’s U.S. retail sales data, doesn’t appear to be the case right now. Moreover, if the economy does start to wane significantly, we believe that may not be good for U.S. equity markets – at least initially – even if it prompts a more aggressive response from the Fed. That’s because a dramatic slowdown in economic growth could bode poorly for demand – and therefore corporate profits – in the early going. In fact, bond markets may have it better in a scenario of weakening economic growth and aggressive rate cuts because U.S. treasury yields would likely fall from current levels. This seems particularly true of short-term maturities, but also perhaps longer-dated maturities that may be pricing in a more moderate rate-cutting cycle as well.
Short of that, investors may benefit from being cautious about the Fed taking a pause at some point on the way to neutral. While not the base case, this could trip up global equity and bond markets temporarily, but currency markets too. The U.S. dollar could spike most of all, especially if the Fed takes a break from lowering rates and other central banks like Canada do not.
How could the upcoming U.S. presidential election and escalating geopolitical tensions change this dynamic?
Post the election, there are several policy issues that could change the backdrop for investors – including things like higher tariffs if Donald Trump wins or more stringent regulation if Kamala Harris wins – but the biggest concern is a contested result that isn’t resolved in short order because that would likely erode confidence in the world’s largest economy and lead to greater market uncertainty. Moreover, that uncertainty may force the Fed to respond by lowering rates more than it would otherwise.
The escalating conflict in the Middle East, meanwhile, is deeply troubling from a humanitarian perspective and could have economic consequences as well. The most obvious impact of a full-blown war in the region would be a spike in oil prices, but the repercussions could go beyond that depending on how it plays out.
All in then, investors have a lot to mull heading into the final two months of the year.
Related: Why a Tight U.S. Presidential Race May Not Be Good for Investors
The views expressed in this blog are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.
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