Highlights:
· A 50 bps interest rate cut by the Federal Reserve during the quarter was interpreted as a sign that the battle against inflation has been won and the job market is currently the predominant economic risk.
· The Bank of England and European Central Bank took a more cautious approach to respective rate cuts during the quarter due to unique challenges each is facing.
· The Bank of Japan raised rates due to concerns about the historically weak yen and China unleashed an unexpected barrage of mammoth stimulus packages.
· A long-term, constant commitment to diversified equity exposure will continue to give you the highest probability of success in the markets.
Commentary:
“We don’t have a lot of examples of cutting in a healthy economy, in one that’s not showing serious signs of distress.”
-Jon Faust, Former Senior Special Adviser to Fed Chair Jerome Powell
There is a saying that economic expansions do not die of old age; the Federal Reserve (Fed) murders them. Fed Chair Jerome Powell is trying his best to disprove this maxim in his effort to engineer a soft landing that brings inflation down without a big rise in unemployment. Powell has spent the past two years willing to risk a recession in order to beat inflation. By cutting rates by half of a percentage point during the quarter, rather than by 25 basis points, the Fed signaled that the battle against inflation, which is at its lowest level in three years, has been won and the job market is now the predominant economic risk. This was the first rate cut in nearly four years and how it will ripple its way through the economy is an open question. Famous economist Milton Friedman once likened changes in Fed policy to “a water tap that you turn on now and that then only starts to run six, nine, 12, 16 months from now.”
One thing that we do know is that this rate cutting cycle will be unique. Usually by the time the Fed starts cutting rates, the economy is already in trouble. That is not the case this time around where the labor market still looks decent, with an unemployment rate of 4.1% that is relatively low by historical standards, the economy continues to add jobs and post solid growth, inflation is slowing and approaching the Fed’s 2% target, and equity markets continue to see strong returns.
Most economists believe it is actually a better economy than it was in 1995, which was arguably the one time the Fed achieved a soft landing. Most people today are not living in fear of losing their jobs because companies are not as quick to lay off workers after re-hiring proved to be daunting following layoffs during the pandemic. That is one reason the labor market has held up better than economists expected after the Federal Reserve started hiking interest rates in 2022. Thus, there is a risk that lower interest rates could boost spending more quickly, which could reinflate the economy.
It should also be said that while in most circumstances, a cooling labor market is a bad thing; it was just a couple years ago that the labor market was arguably too hot. Companies raised pay and still could not find the workers needed to properly run businesses. In addition to leaving customers frustrated with poor services, and workers exhausted and burned out, the hot labor market was a headwind for the Fed in its fight against inflation because businesses were more likely to keep raising prices as labor costs rose.
Fed officials signaled that they are likely to cut the key rate again in coming meetings as worries about inflation ease and concerns about the jobs market grow. However, the most recent jobs report showed U.S. hiring accelerating in September well beyond expectations, and average hourly earnings higher than economist estimates, which makes another half-percentage-point rate cut at the Fed’s next meeting in November unlikely. No one really knows where the Fed will take rates from here or how fast they will get there. We are fairly confident, however, that interest rates will not return any time soon to the rock-bottom levels seen before this most recent inflation crisis.
The Bank of England (BOE) also cut interest rates for the first time in more than four years during the quarter, but appears to be taking a more cautious approach than the Fed in loosening the restraints it imposed on the economy to tame inflation. The U.K. has battled a particularly stubborn inflation problem, due in part to the effects of Brexit and a shortage of workers, which led the BOE to pursue one of the most aggressive policy-tightening campaigns in the developed world. While the BOE said it is likely to follow up over the coming months in anticipation of a decline in inflation to its 2% target late next year, it expressed concern about the still rapid pace at which services prices and wages are rising. BOE Governor Andrew Bailey all but ruled out a move as aggressive as the Fed’s, or a quick succession of smaller cuts, when he said, “We should be able to reduce rates gradually over time. But it’s vital that inflation stays low, so we need to be careful not to cut too fast or by too much.” Bailey followed through on that sentiment by leaving rates unchanged at the BOE’s September meeting.
The Fed’s decision to trim rates by a larger amount than most economists and analysts anticipated presents a challenge for the BOE and other central banks that have signaled a more gradual approach. In response to the changed outlook for interest rates, the British pound appreciated against the U.S. dollar. Further increases in its currency could add to downward pressure on inflation by lowering the prices of many imports, but would also make it more difficult for Britain’s exporters to sell to U.S. customers.
The European Central Bank (ECB) similarly cut interest rates by another 0.25 percentage points during the quarter. It also cut its key deposit rate to 3.5% to provide further relief to Eurozone households and businesses. However, it warned that the path ahead would not be smooth, saying that “inflation is expected to rise again in the latter part of this year, partly because previous sharp falls in energy prices will drop out of the annual rates.” The rate-setting council, led by ECB President Christine Lagarde, continues to have to balance concerns about a disappointing growth outlook with the need to ensure that inflation reaches and stays at the bank’s 2% target.
Flipping the script, the Bank of Japan (BOJ) raised its benchmark interest rate during the quarter due to concerns about the historically weak yen. BOJ governor Kazuo Ueda embraced a view spreading among Japanese officials that a rate increase, normally seen as constricting the economy, could instead help growth by pushing up the yen and reassuring consumers who have had to pay more for imported goods.
China’s central bank announced a barrage of measures towards the end of the quarter to support the country’s weakening economy, imploding housing market, and waning stock market. The People’s Bank of China (PBOC) indicated it would cut its benchmark interest rate and lower the amount of cash that banks need to hold in reserve in order to try to free up more resources for lending. It also said it would cut the interest rate payable on existing mortgages and lower down payments for second homes. It furthermore announced it would offer 500 billion yuan (~$70 billion) in loans to funds, brokers and insurers to buy Chinese stocks, and put up another 300 billion yuan (~$42 billion) to finance share buybacks by listed companies.
The PBOC has taken several stimulus measures over the past decade in response to economic challenges, but the most recent measures mark the most aggressive steps it has taken since the pandemic, and signal growing unease after a series of bleak numbers on jobs, spending and inflation. The consensus among economists is that this latest round of stimulus, while welcome, will not be enough to pull China’s economy out of its current low-growth rut marked by falling prices, a real estate downturn, and escalating tensions over trade. China’s economy is unusual because it relies less on consumer spending and more on investment, such as in property, infrastructure and factories, and exports. As property investment has collapsed over the last couple of years, there has not been enough consumption to meet the PBOC’s growth targets. The consensus amongst economists seems to be that robust steps to boost consumption and the real estate market, including directly providing stimulus to households, are needed to spur a durable recovery in the economy and fend off deflationary pressures.
The problem is that China has been resisting this type of stimulus for over a decade now, seeing this as more of a temporary solution. Rather, it has favored supporting production, especially in strategic, high-end industries like electric vehicles, clean energy, and advanced computing. In this regard, China has been pouring money into its factories, which has not yet resulted in a boost to economic growth. It is possible that structural overhauls and a fundamental mindset shift is needed before real change can come to China.
Economic forecasts will continue to be plentiful, but the constant cycle of conflicting data and changing predictions has made it hard to trust that any forecast will stick. Thinking and acting for the long-term remains your highest probability of success in the markets. If you cannot handle the occasional volatility and down years that come with the territory of being an equity investor, you should reduce, or even eliminate, your portfolio’s exposure to equities. At the same time, it is fair, if not preferable, to maintain a cautiously optimistic attitude that economies and markets will continue to expand over time, in fits and starts of course. As J.P. Morgan once said to a pessimistic friend as they were admiring the skyscrapers that were starting to define the Manhattan skyline at the time, “Funny thing about these skyscrapers, not a single one was built by a bear!”
Urban Financial Advisory Corporation – October, 2024
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