Investment Outlook: Gearing up for US interest rate cuts

A monthly round-up of global markets and trends

Written by Daniel Casali

Published on 02 Sep 20245 minute read

The US Federal Reserve (Fed) is likely to follow other major central banks and cut interest rates in response to lower inflation. Assuming the US avoids a recession, lower rates should be a positive for equity investors, particularly as companies continue to generate solid earnings.

The risk for markets is that the Fed holds off from lowering rates. However, faster productivity growth and a cooling labour market should tip the balance in favour of a September rate cut. The upcoming US election should not be a constraint on Fed decision making.

Central banks embark on a new easing cycle

In January’s Investment Outlook, we argued that with slowing inflation there was room for central banks to cut interest rates in 2024, which could boost stocks. It took a while, but finally, the European Central Bank, Bank of England and Bank of Canada have all started cutting rates. Investors are watching to see if the Fed follows suit.

Certainly, market volatility during the early part of August showed the danger to investors of keeping interest rates restrictive for too long. Indeed, when the employment and manufacturing surveys disappointed, investors became concerned about a possible US recession, leading to an equity market sell-off.

This was exacerbated when the Bank of Japan (BoJ) raised interest rates at the end of July, leading to the yen’s sharp appreciation against other major currencies. Some hedge funds and speculators, who had used the yen as a cheap funding currency to buy other higher yielding assets (including stocks), suddenly found themselves exposed to foreign exchange losses and were forced to abruptly close positions. This contributed to the Japanese Nikkei 225 index falling 12.4% on 5 August - the second worst daily decline since the October 1987 crash¹. It rebounded 10.2% the next day after Shinichi Uchida, the BoJ Deputy Governor, stressed that the central bank would not raise interest rates in a volatile market environment.

On balance, it appears that most major central banks are likely to cut interest rates, while the BoJ is expected to gradually hike rates. If anything, the market sell-off changed the narrative to favour a faster pace of rate cuts (excluding the BoJ). The futures market expects the Fed to cut interest rates by more than two percentage points over the next year.

Essentially, lower interest rates reduce the risk of rising private-sector debt defaults and increase the likelihood that the business cycle can be extended. Broadly, this creates a relatively favourable macro backdrop for certain asset classes, like equities, to perform.

The futures market expects the Fed to cut interest rates by more than two percentage points over the next year.

Equity performance when the Fed cuts interest rates

The state of the US economy has typically been an important determinant of future stock market performance. If the Fed is too late to loosen policy and the US economy enters a recession, company cashflows will be hit and equity prices could drop materially. For instance, as the pandemic hit economies in 2020 the global stock market index fell 34% in US dollar total return terms, before recovering as fiscal and monetary policy was loosened².

Alternatively, if the economy continues to grow and interest rates are cut then this could provide more motivation for investors to buy into this two-year old bull market rally. We found that on the last three occasions when the Fed cut interests rates outside of a recession (October 1987, July 1995 and September 1998), global equities rose 23% on average over the following 12 months in US dollar total return terms³.

That’s partly because outside of a US recession, rising company earnings support equity prices. On that point, the US and European earnings seasons for the second quarter have been slightly better than expected, with both regions recording a higher share of companies beating earnings per share (EPS) forecasts compared to the 10-year average. Furthermore, every sector in the US looks to be surprising on the upside. Looking forward, analysts expect EPS for stocks in the MSCI All Country benchmark index to expand 10% this year and 14% in 2025⁴.

To cut or not to cut, that is the risk for markets

Despite some concerns about it running out of steam, the US economy is still growing at around 2% in the third quarter, according to the Federal Reserve Bank of Atlanta’s real-time GDP estimate⁵. After the 2021-22 inflation surge, the Fed will be wary not to cut interest rates too soon in case the economy overheats.

If the Fed fails to loosen rates, it could disappoint investors who have built-up expectations, which could in turn hurt equity returns. However, we believe that the Fed will start cutting interest rates this year and there are three reasons for this:

First, fears that the economy will overheat are probably overstated. Outside of an unexpected event, like a disruption of oil supply from the Middle East, there seems little material inflationary pressure in the data to worry the Fed. Moreover, US labour productivity continues to rebound, increasing by 2.7% from a year ago, the fastest pace since 2010, excluding the pandemic-distorted data in 2020-21⁶. Faster productivity growth increases the ability of the economy to expand without generating inflation.

Second, the labour market may not be as resilient as initially thought. From time to time, the Bureau of Labour Statistics adjusts the employment data with estimates from the Quarterly Census of Employment and Wages (QCEW) to improve its accuracy. The 2024 benchmark revision of the US employment data showed a substantial downward revision, with average monthly non-farm payrolls between March 2023 and March 2024 at roughly 170,000-180,000, compared to the previously reported 242,000⁷.

Moreover, job openings have declined from a peak of 12.2 million in March 2022 to 8.2 million in June this year⁸. The Fed will want to avoid this cooling labour market turning into more of a problem. This was made apparent at the Jackson Hole Economic Symposium, an annual conference attended by international central bank leaders in Kansas City. At the conference, Fed Chair Jerome Powell stressed that the Federal Open Market Committee (FOMC) is alert to labour market conditions. He also made clear the “time has come for policy to adjust”, effectively solidifying a September interest rate cut.

Third, the upcoming US election should not be a constraint on Fed decision making. The central bank has changed interest rates in 11 of the last 13 presidential election years⁹.

In short

The Fed is set to cut interest rates in response to slowing inflation, while the economy still grows. Typically, this is positive for stocks and solid company earnings should lower risks for equity investors even further.

Past performance is not a guide to future performance.