Eastspring Investments
Sep 2024 | 5 min read
Summary
The US Fed’s decision to front load its rate cut reduces the risk of a hard landing in the future. The rate cut is likely to influence Asian central banks to follow suit, potentially increasing the appeal of Asian bonds. Meanwhile the USD is also likely to lose its relative carry appeal, providing tailwinds to Asian currency strength. However, markets are expected to remain volatile on the continued unwinding of Yen carry, global slowdown, and geopolitical risks.
The US Federal Reserve (Fed) initiated its rate easing cycle with an outsized 50 basis points (bps) cut. This rate cut, the first in more than four years, leaves the Federal Funds Rate at a range of 4.75% to 5%. Heading into the Fed’s decision, market expectations for the cut ranged between 25 to 50 bps. The Fed’s decision reflects their growing confidence that inflation has moved sustainably towards their 2% target range and that achieving its employment and inflation goals are roughly in balance.
Inflation is no longer a key concern for the Fed given that the annual Consumer Price Index fell to 2.5% in August, down from 2.9% in July. The Fed has revised its year-end unemployment rate to 4.4%, noting that while it is an increase in the projection, it is still not elevated. In this regard, August’s unemployment rate of 4.2% remains below this rate, although it has risen from 3.7% at the start of the year.
The focus has now shifted to the Federal Funds target range for the end of 2024 and 2025. The economic projections provided by Fed officials at the meeting suggest that the central bank will cut rates by another 50 bps by the end of this year.
Implications for investors
According to our Multi Asset Portfolio Solutions team the pace of rate cuts going forward will depend on how quickly the US labour market weakens, among other factors. The Fed has room to cut rates to help prevent a significant contraction in the US economy. The interplay between the highly anticipated Fed rate cuts and the performances across asset classes therefore largely depends on the broader economic conditions (i.e., a “hard” landing scenario versus a “soft” landing scenario).
That said, US Treasuries typically perform well in an easing cycle. If the likelihood of a recession scenario increases, US Treasuries have the potential to gain meaningfully via capital appreciation.
Meanwhile the response of the equity markets to the onset of rate cuts has historically been modest, but the subsequent longer-term performance varied depending on the outcome of economic growth scenarios (e.g., no landing, soft landing, hard landing). A noteworthy point is that equities are entering this rate cut cycle at already lofty valuations and thus susceptible to the downside in line with late market dynamics.
We expect markets to stay volatile as it remains vulnerable to the continued unwinding of the Yen carry trade, the global slowdown, changes in US market sentiment and heightened geopolitical risks (e.g., US elections, Middle East tensions).
Against this backdrop and over the 12-month horizon, the team is expected to be defensive in their multi asset portfolios, in line with late cycle dynamics, with a greater preference for duration over risk assets.
A boost for Asian fixed income
Our Asian Fixed Income team notes that following this “hawkish” 50bp rate cut, the summary of economic projections is implying another 50bp of cuts in 2024, 100bp of cuts in 2025, and another 50bp in 2026 to bring the terminal rate to 2.75-3%. This is slightly higher than what had been priced in the futures markets prior to the meeting.
The Fed’s healthy assessment of the US economy, together with Chairman Powell’s assessment that it was unlikely to return to the earlier regime of ultra-low interest rates, is likely to keep US Treasury yields supported in the near term even as the Fed embarks on its rate cutting cycle.
The Fed’s easing cycle is also likely to provide Asian central banks with a catalyst to cut rates. Inflation has been more moderate in the region, giving Asian central banks more leeway to cut. This was evident in Bank Indonesia’s surprise policy rate cut of 25bps yesterday, just ahead of the Fed’s policy meeting.
As the Fed continues to cut rates, the interest rate differentials between Asia and US will likely widen, increasing the relative appeal of Asian bonds. Meanwhile the USD is also likely to lose its relative carry appeal, providing tailwinds to Asian currency strength.
The team remains bullish over the medium term as slower global growth will support bond markets and intends to scale into long bond position on selloffs. Longer duration bonds stand to benefit from capital gains as central banks cut rates and the still high yields from Asian bonds present investors with attractive income streams.
However, market narratives can change quickly, and volatility is expected to remain elevated as we head into the US presidential elections. As such, the team maintains a tactical nimble positioning with a bias towards quality bonds.
Weaker USD to support Asian and EM assets
Meanwhile, our Regional Asia and Global Emerging Markets (EM) Equity teams believe that as the Fed starts its rate cutting cycle, the US dollar will likely weaken, and this is usually favourable for Asian and Emerging Market assets.
Since late 2020, we have seen corporates, and governments worldwide, renew their focus on capital expenditure and infrastructure spending. It will take time to catch up with a decade of underinvestment, but the impact can already be seen as earnings in emerging markets, for the first time in a decade, are growing faster than developed markets - and this is set to continue.
Compared to US equities, Asian and Emerging Market equities are attractively valued and offers diversification against the US market.
A potential change in leadership in Japan
Our Japan Equity team believes that the narrowing rate differential between the Yen and USD could lead to stablilisation or further strengthening of the Yen. This environment could also shift market leadership away from large-cap, yen-sensitive names to a broader cohort of companies, including domestic-focused and mid/small-cap stocks.
However, there is no change in their bottom-up investment views as their approach, which focuses on sustainable earnings trend of companies, has already accounted for the potential normalisation of monetary policy by the Bank of Japan in their valuation of investee companies.
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