15 Oct 2024
Introduction
The US Federal Reserve meeting of mid-September saw the widely anticipated first cut in interest rates, with the Fed deciding on an initial 50bp decrease in rates, something which did not initiate market panic partly no doubt due to the informative press conference of Chair Powell on September 18th. The Fed reiterated their belief that the economy remained in a strong place, but that there was increased confidence that inflation was on course to return to the 2% goal and that longer-term inflationary expectations remained well anchored. Chair Powell emphasised that the Fed was focused on its dual mandate and with inflation returning to target, maintaining and maximising full employment over the medium term was an equally important priority.
The labour market has remained solid, and Powell stated that, despite job openings deteriorating, the economy was a long way from a point where this would translate into higher levels of unemployment and that corporations remained confident on the economic outlook for 2025. The Fed no longer believe that the labour market is a source of elevated inflationary pressures and, with a dual mandate, have moved on to the front foot to ensure unemployment does not increase markedly from current levels.
The SEP published post the September meeting showed more Fed governors projecting multiple rate cuts, although individual views of committee members vary. Powell did state that he did not foresee a return to ultra-low interest rates or negative bond yields and that the neutral rate of interest is probably significantly higher than it was back in that period. Markets, however, have been reassured by the fact that the current restrictive levels of monetary policy allow the Fed to act if economic conditions deteriorate with expediency. Overall, the US economy appears to be in a good place and on course for a soft landing which would cement Powell’s legacy as Fed Chair.
One interesting point towards the end of the press conference was that Powell stated that independent central banks, because they avoid making monetary policy in a way that favours people who are in office as opposed to people who are not in office, achieved lower inflation over time and that he hoped this independence would continue for the future.
US Election & Trump economics
The US election remains too close to confidently call and unless there is a major slip up by either candidate, this election looks likely to go down to the wire. Trump’s policies have been labelled ‘MAGAnomics’ with promises to deliver low taxes, low regulation, low energy costs, low interest rates, and low inflation. This clearly appeals to a lot of blue-collar workers. As well as traditional Republican policies of tax cuts, the main thrust of this new economic agenda includes aggressive tariffs on imports from around the world, especially from China, together with a draconian crackdown on immigration. Trump has also pushed for greater political influence over monetary policy and the dollar.
At the core of ‘MAGAnomics’ are ideas that would turn many aspects of the economic model adopted in industrialised economies over the last century on their head. Trump is looking to return to an era where substantial chunks of government revenue come from trade tariffs rather than taxes: a model used by the British state 200 years ago. Most economic commentators describe this as 19th Century policy with Trump proposing levies on imports, supercharged to levels last seen during the 1930s following the passing of the landmark protectionist Smoot-Hawley Tariff Act. Trump has now moved from wanting to impose a 10% tariff on all imported goods to one of 20% and 60% on Chinese imports. He also said that countries that plan to reduce their dependence on the Dollar would be hit with 100% tariffs as punishment and NATO members not contributing significantly would also suffer high tariff barriers.
The Trump campaign has to date avoided the realisation outside of economic circles that it would be blue collar workers who would suffer the most under these policies. The Peterson Institute for International Economics think-tank in Washington calculates these proposals will trigger a rise of up to $2,600 a year in what the average household spends on goods. Tariffs would disproportionately hit low-income households. Trump’s advisors claim that these tariffs will raise funds for tax cuts, but independent economists refute this, with some estimates suggesting that policies would increase the deficit by $5.8tn over the next decade.
Trump has been openly critical of Fed Chair Jay Powell, which is rather ironic as he was a Trump appointee. Powell’s second term as Fed Chair is due to end in May 2026, with a significant risk that Trump, if elected, will name a successor who is more amenable to influence by the President and his close advisors. This last occurred when Nixon appointed Arthur Burns to the Fed, whose ensuing loose monetary policy resulted in a significant increase in US inflation, only tamed by Paul Volcker and the significant recession necessary to get inflation out of the system.
Even when inflation rose during the post pandemic period and initial stages of the Ukraine war, long-term inflation expectations remained relatively anchored by the judgement markets made that a politically independent central bank would impose restrictive policy if inflation became excessive. Any doubt to the resolve of the US central bank to be allowed to conduct policy independently would, over the longer term, mean higher wages and prices, higher bond yields, and a negative impact on equity market valuations.
Equity markets could initially react positively to Trump winning re-election due to promises of lower corporate taxes and de-regulation but his policies, if enacted, are less likely to be market friendly over the longer-term due to the negative implications for firstly inflation through tariff policy and lower global economic growth with retaliatory measures potentially harming US multinationals who have benefitted so strongly from an open global economy.
China and policy to course correct
For much of the year, the Chinese and Hong Kong stock markets have languished along with the economy, where lack of confidence and weak domestic demand has made trading conditions difficult for many domestically orientated businesses. Demand in China has not collapsed, but many industries have suffered from over supply and intense levels of competition. Individuals in China had focused much of their savings on property and with still high levels of housing inventory, prices have continued to fall, resulting in a negative wealth effect.
Looking at developed economies, when housing downturns occur, it is hard for consumer confidence to rebound significantly, and for much of 2024, the lack of policy response by the authorities in China has been a surprise to most commentators. The CCP have always relied on improving levels of prosperity to compensate citizens for the lack of political freedoms compared to the West and the policies being pursued by the authorities risked setting the country on a collision path.
This has been China’s boldest stock market rescue package since the 2015 market meltdown and has led some investors to believe that Beijing is now determined to stabilise the market and boost investor confidence recognising at last that policy needed to course correct.
After the unexpected Politburo meeting, President Xi issued a rallying call urging officials across the nation to prioritise reviving the economy. There was a vow to help tide over enterprises facing hardships and a reassurance to officials that they could act boldly, boosting the economy without worrying about the consequences of making mistakes. Holding a Politburo meeting to discuss economic affairs in September is a rare move for the authorities, as normally these only occur in April, July and October. The meeting also called for the stabilisation of China’s property sector to prevent it from further declines and to ensure necessary fiscal expenditures. The background to these announcements has been the deterioration in the economy, which made the 5% growth target for this year look increasingly hard to achieve.
Actions by the authorities suggest that they now recognise the risks of a prolonged deflationary spiral, with widespread pessimism after many companies have reduced hiring or laid off employees and even slashed wages, which when combined with the downturn in property prices, has led to a deflationary mindset among consumers.
The measures announced have driven an extremely sharp stock market rally, as hedge funds looked to unwind short China positions and domestic investors re-entered the market. In the last few days of September, FOMO was the dominant market sentiment. Even after the sharp rally, China remains one of the cheapest markets on valuations (trading at around12x) and within it some companies have continued to deliver earnings growth, especially in the internet related sectors. The government now needs to follow up with fiscal measures that provide support to consumption. Stabilisation of the property sector is now a Party objective, and this is necessary before consumption can see a sustained recovery as the negative wealth effect is only encouraging higher levels of saving. Cash deposits in the system are believed to be equal to the entire market cap of China equities.
India’s economic story
The Indian market has continued to perform strongly with some industrial names seeing a significant run up in valuations. The economic story of sustained growth in manufacturing continues, with India a long-term beneficiary of multinationals ‘China Plus One’ strategies. Demographics are a positive and India, far from having labour shortages, still struggles to provide enough formal jobs for the large number of new entrants to its workforce. A vast labour supply of over half a billion provides the country with both opportunities and challenges. After its electoral setback, the Modi administration will need to focus on providing a better employment outlook for its young people, which further de-regulation of the economy would encourage. India continues to be well placed to see strong growth for at least a decade and the relatively high market valuation reflects in part this opportunity. After market gains, careful stock picking has the potential to add significant value, by avoiding the most overvalued names. Another positive for Indian equities is the strong domestic investor base with individuals and mutual funds favouring the stock market as their vehicle for long-term savings.
Mexico’s potential
In Mexico, the election of new president Sheinbaum and potential judicial reform which some fear will result in an erosion of democratic freedoms, has resulted in currency weakness, which has been the main negative for investors, not the actual stock market. Mexico’s budget deficit has risen to the largest since the 1980’s and the economy is slowing, when the incoming president has promised further social programmes to help the poor. Inflation has fallen which, together with the US moving to cut rates, allows scope for lower interest rates. Mexico, through its membership of NAFTA and its successor USMCA, has great potential but needs a government that allows private enterprise to grow.
Summary
There are three important differences today versus the 2010-2020 decade.
- The structural environment of one in which there was low inflation and low interest rates appears to have moved to one of higher inflation and higher rates, and therefore the neutral rate of interest will be higher than before - something which Powell seemed to acknowledge at his post Fed press conference. This can be called moving from a 3D to a 6D world with the deflationary influences of debt, demographics and devices (technological change) now seeing counterinfluences from de-globalisation, de-carbonisation (green agenda spending) and defence (geopolitics). The latter three give some impulse to inflation and central banks will need to be vigilant to ensure that inflation remains in check. Geopolitics are now much more dangerous than in the majority of the post-Cold War era.
- In the US, policy is being unusually pre-emptive, with the Fed prepared to cut rates as inflation remains comfortably above the 2% level which could be described as being in front of the curve, rather than behind it - a major difference from most other economic cycles. In this cycle, household balance sheets have remained strong and incomes and employment relatively buoyant. Many consumers have benefitted from the wealth effects of rising stock markets and house prices, especially in the West. Businesses are continuing to spend on capex, especially in the field of AI as many of the large-cap technology names are cash positive.
- Governments are running record deficits, especially in the US, and this is unusual for this stage of the cycle. US spending has been boosted by the IRA and politics and as a result, recession risk is a lot less than it normally would be at this stage of a cycle with the probability of a soft landing much higher now than at the beginning of the year. There now appears to be a much shallower economic cycle. There is also a significant change in stock market players with the influence of algorithmic and other quant-based traders with considerable herding of positioning with people all one way when looking to make portfolio changes, resulting in a rise in short-term volatility, as there can be a lack of liquidity to absorb changes in sentiment in the short-term.
Market sentiment and returns
This is an environment where investors have a need for portfolio resiliency and, if possible, to be positioned to cater for extreme reversals in market sentiment with the geopolitical arena a potential driver of this. The speed of the rally in China demonstrates how far and fast markets can move if sentiment changes at a time investors are all pointing in the same direction. There can be large percentage moves over the short term. Investors need to be prepared to be flexible in their approach and active alpha generation could become more important rather than a reliance on market beta to deliver returns. Indices have become much more concentrated, and therefore investors, if following an index approach, need a view on the large constituents of these, or in other words - do you like the index you are buying? Sentiment is now more important when looking for market entry points and as well as technical analysis, should include survey data and investor flows/positioning.
As ever, investors should focus on valuation, fundamentals and sentiment and the market has moved quickly on the fundamental side to price in a US soft landing which continues to look likely, and there is a belief that inflation news should allow significant rate cuts. Markets have moved exceptionally quickly to adopt this view. There could be a danger that the market is looking for multiple cuts which may not occur, or the Fed may move more slowly, especially if economic growth and employment remain resilient. The US appears to be returning to a period of greater normality in terms of interest rates.
The exogenous element is the US election, and investors will focus on this more strongly as the date approaches. Outside of significant policy changes by either winning candidate, fundamentals remain positive, although US valuations are on the high side. Trump’s proclaimed attitude to immigration, influencing interest rates and tariffs, would be bond unfriendly and likely to result in higher inflation. Harris has promised more regulation and price controls which could be bad for profits, and the bond market has the potential to provide a more difficult backdrop for equities in the run up to the election or early next year.
China would face headwinds to its export driven growth model under Trump tariffs and might be forced to pursue policies more focused on its domestic economy which would be a change of course. Trump’s policy on Taiwan is unclear. Tech stocks have re-rated and more recently consolidated, but the AI story is likely to stay strong over the next few years, even if the future winners outside of the tech hardware space are hard to pick.
For longer-term investors, risk assets such as equities and corporate debt, remain the best home for those wishing to grow long-term wealth above the rate of inflation, providing that there is an acceptance that markets do not move up in a straight line for ever. Markets have come a long way quickly in Q3 after the dovish messaging from the Fed. In many pre-election periods in the US, markets can become bumpy, but longer-term investors should remain invested and be prepared to sit through market volatility if it occurs. Post the US election, investors will be able to assess new policies with more clarity although markets are likely to react to any significant changes very quickly. In the majority of Fed rate cutting cycles when there is not a recession or significant economic downturn, equities have delivered positive returns, and this remains the most likely scenario unless political factors drive significant policy change in the US.
Graham O’Neill, Senior Investment Consultant, RSMR
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