Last week saw a central shift. After some doubts at the outset of 2024, investors took a leap of faith and committed to falling interest rates in the medium term. We do not expect the policy moves to have any further major impact with rate cuts all but guaranteed. Rather, the question now concerns the timing of the potential correction in stock markets everyone is eagerly waiting to happen.
Central banks: Where do they stand?
The overall message from 15 central bank meetings last week has been supportive. Rate cuts remain on the agenda for major central banks despite some uncertainty about the inflation outlook.
The US Federal Reserve (Fed) kept the target range at 5.25%–5.5% as expected and raised its inflation and growth forecasts but maintained its view that three rate cuts this year are appropriate.
The Swiss National Bank (SNB) surprised markets by cutting its key interest rate by 25% ahead of the Fed or the European Central Bank. The SNB’s decision is a strong signal that economic fundamentals in general, and the inflation outlook in particular, play a central role in monetary policy decisions.
The SNB expects inflation to remain well below its price stability target throughout the forecast horizon until 2026, suggesting further rate cuts. The Bank of England (BoE) left its key interest rate unchanged, but the voting pattern of its committee revealed a shift, with no member believing that further rate hikes are necessary. The Bank of Japan (BoJ) raised interest rates and ended its yield-curve-control policy, representing a tighter monetary policy stance. Finally, five mostly Latin American central banks, including those of Brazil and Mexico, cut interest rates.
Equities: What happens after the first rate cut?
Now that rate cuts have started, how have equities performed during previous rate-cutting cycles in the absence of a recession? Looking at data since the early 1980s, the performance of the S&P 500 over the subsequent 12 months after the first rate cut averaged 14.2%, a higher number compared to the average 12-month return. As such, rate-cutting cycles that are not triggered or followed by a recession tend to be accompanied by strong equity returns.
That said, we acknowledge that each cycle is different. This time around, a lot of the positive performance has been frontloaded, and we are still of the view that developed market equities are ripe for a correction, which would be a healthy development. In the case of a correction, we would use the setback to increase equity exposure. While we still favour an overweight in quality growth stocks, we recommend allocating fresh capital to cyclical stocks in anticipation of the start of the new economic cycle in H2 2024 and beyond. While Equities are set to grow in currency markets, they will likely see the most adjustment.
Currencies: Reaction to central bank meetings
The JPY weakened in reaction to the policy shift, but a strengthening once Western central banks cut rates later this year is still possible. The Swiss franc weakened after the SNB cut, but relative price stability should prevent a significant weakening. A weakening of the GBP, after the shift in the BoE’s voting pattern spurred hopes of earlier rate cuts, but this appears premature.
In Europe, the Swiss franc weakened after the SNB rate cut surprised markets. However, we believe that further franc weakening from here is limited. Given Switzerland’s relative price stability, the fair value of the franc remains in a gradual uptrend. The upside is also limited, as the interest rate disadvantage of the franc should remain broadly unchanged this year with the SNB and the ECB cutting rates more or less in tandem.
Finally, the pound sterling weakened after the BoE’s voting pattern showed that the last remaining hawks, who were still in favour of another rate hike last month, have now also moved to a hold. This was seen by markets as a shift that allows for an earlier BoE policy easing. We continue to expect the first cut in August and believe that the pound can remain robust once the policy divergence to the ECB becomes clearer this year.
What does this mean for investors?
In the absence of a recession, rate-cutting cycles tend to be followed by strong equity returns. In the event of a correction in equity markets, we would use the setback to add to cyclical stocks. Last week’s highly anticipated Federal Open Market Committee meeting has further fuelled the rally in global equity markets.
