Markets expect at least two rate cuts of 25 basis points (bps) each in the U.S. this year. But the U.S. Federal Reserve (the Fed) has projected just one 25 bps rate cut in 2024 as it waits for more progress on the inflation fight. We see merit in the Fed’s caution.
Financial markets had a strong run in May and both equities and bonds built on those gains in early June. While the U.S. continued to post strong job numbers throughout 2024, the fight against inflation stalled during the first quarter of 2024. But that changed in May, when consumer price inflation (CPI) decelerated to 3.4%, the slowest pace in more than three years. Further, retail spending also moderated in the world’s largest economy. All these pointed to market expectations of a “goldilocks” scenario - stable growth alongside mild inflation for the U.S. economy. As a result, the S&P 500 hit another record high level in May and U.S. Treasuries had their best month in 2024.
As May’s inflation figures fell, markets rapidly priced in two 25 bps interest rate cuts from the Fed and equities rose further. But the Fed took a more cautious stance and forecast just one 25 basis point rate cut in 2024 as it cited the need for more progress to fight inflation.
We think the Fed is right to be cautious. Since the beginning of this interest rate hiking cycle in 2022, inflation has blindsided markets a few times. In early 2024, when markets believed that the Fed would cut interest rates multiple times, stubborn inflation held back the Fed. Even now at 3.4%, CPI is above the Fed’s target. While we see inflation is likely to fall, we also see the need to be vigilant against upside risks to inflation.
We believe we are late in the economic cycle, and that equity markets could get more volatile even if they continue to climb. Further, while the U.S. economy has shown resilience thanks to strong government spending, other major markets including Europe and Canada are weakening as higher interest rates weighed on their economies. In the U.S., equity markets continue to be driven by a handful of technology stocks. Market breadth, or the portion of stocks driving the rally, is currently better than 2023’s breadth, but is still narrow. This worries us.
Given this scenario, we are neutral towards equities across geographies except for our small tactical overweight position in China, where extreme market pessimism has resulted in favourable valuations. We think bonds are more attractive and we are looking for an opportunity to increase our exposure to the asset at more advantageous yields.
