Review of the week: Here comes the Fed

As the US central bank prepares to make its first interest rate reduction since 2008, many investors see the move as the end of an era. Our chief investment officer, Julian Chillingworth, thinks the impending death of the economic cycle may be greatly exaggerated.

The US Federal Reserve (Fed) is widely expected to cut its benchmark interest rate band from 2.25-2.50% to 2.00-2.25% when it meets on Tuesday and Wednesday.

This cut couldn’t have been telegraphed any clearer than if the Fed committee had left an unlocked briefcase on a park bench with a couple of doves inside it. As we noted last week, by trying to be ultra-transparent Mr Powell managed to get some investors so giddy that they figured the Fed would hack a full 0.5% from rates rather than the typical 0.25%. He has done his best to rectify this misapprehension since, but some incorrigible optimists (or economic pessimists?) still hold out hope.

We’re not among them. We believe a 50-basis-point cut is completely inconsistent with the Fed’s monetary policy framework. Instead, we reckon the Fed could end up with a ‘one-and-done’ rate cut. Dubbed an ‘insurance’ cut, this softening of Fed policy is more of a pre-emptive move that aims to encourage investors and businesses during a turbulent political period that has wobbled markets somewhat. For all the wild-eyed worry and strident calls for dramatic cuts to interest rates, economic growth and inflation aren’t actually all that bad. Both have decelerated and there have been some relatively blue data releases, but we’re nowhere near panic stations. To us, it seems a bit much to argue that the Fed should reverse more a fifth of the cumulative rate increases it has managed to eke out over the past three and a half years in one fell swoop.

We’re in the minority, however. Markets still forecast three rate cuts in the next six months, a very aggressive path that may end up in disappointment. If the Fed doesn’t meet the market’s expectations, there’s a chance that the market could drop sharply in the coming six months. But it’s not a given. We looked at the equity risk premium of the US market –the extra return you expect above the ‘safe asset’ of government bonds for taking on the risks of the stock market – and found it was pretty high. In English, it means the prices investors have been paying for their American stocks have included quite a large cushion of returns to make up for the risk.

So if markets are dragged down by fewer rate cuts than many would like, there could also be an upward pressure at the same time. Because if the Fed is to stop cutting it would likely be persuaded by better economic growth. Better economic growth would ease the risks of businesses undershooting their profit targets and increase the chances of them over-delivering instead. That would reduce that equity risk premium and push prices higher. Which would prevail, the risk premium effect or the effect of interest rate policy? Who knows, but the tension between the two may prevent a sustained drop in equity markets.

Index

1 week

3 months

6 months

1 year

FTSE All-Share

0.7%

2.2%

12.5%

2.0%

FTSE 100

0.6%

2.6%

13.7%

2.9%

FTSE 250

1.3%

0.8%

8.3%

-1.5%

FTSE SmallCap

0.3%

-0.6%

6.1%

-2.3%

S&P 500

2.6%

7.9%

21.6%

14.8%

Euro Stoxx

1.5%

6.2%

16.8%

3.1%

Topix

0.6%

4.3%

9.1%

-1.1%

Shanghai SE

1.6%

-2.4%

18.3%

7.0%

FTSE Emerging

0.2%

3.9%

12.1%

7.5%

Source: FE Analytics, data sterling total return to 26 July

America vs the world

US corporate earnings are on track to post their second quarter of year-on-year declines, FactSet data shows. A stronger dollar and weaker trade has held back multinational American companies. These effects are a sort of double-whammy: trade disruptions reduce the amount of business these companies do and then these reduced profits are worth less once they are brought home because of the high dollar. With about 40% of the S&P 500 having reported, the index is on track for a 2.6% fall in profits compared with a year earlier.

FactSet’s numbers are stark indeed. It split the S&P 500 into two groups: those that made more than half of their sales outside the US and those that made more than half of their sales inside the country. The domestically focused businesses averaged earnings growth of 3.2%; the international cohort’s profits fell 13.6%. Industrial companies and information technology firms are doing the most to drag down index-wide earnings; energy and materials were heavily international as well but less affected. Healthcare, financials and real estate were the top-performing sectors in the second quarter.

The US appears to be ticking along reasonably well, it’s just the rest of the world that’s in flux at the moment – ironically because of American trade and foreign policy. US and Chinese delegates are meeting this week to try to settle at least some of their differences. The negotiations will focus on intellectual property protections, punitive tariffs on American soybeans and the onerous US regulation of Chinese telco Huawei. It’s fair to say expectations are at a low ebb, which means any good news that pops out could be taken well by investors.

Tuesday will be a treasure trove of data for anyone interested in the health of the US economy. US household income and spending figures come out, along with the core PCE inflation number. The PCE isn’t the headline CPI that most people watch, but is the one that the US Fed prefers when making its policy decisions. There will also be the Conference Board Consumer Confidence Index, which is forecast to improve on the previous month, and a raft of housing data.

UK housing numbers come out on Wednesday and then the Bank of England meets to discuss its monetary policy on Thursday. Both are expected to be muted. That is not how you would describe the new Prime Minister of the UK. Boris Johnson has found his voice following an uncharacteristically quiet period as Conservative Party members made their votes. After trouncing rival Jeremy Hunt, Mr Johnson has wasted no time in selecting what can only be described as a war Cabinet. Focused on one issue only (Brexit, of course), Mr Johnson’s team is completely behind a “do or die” Brexit. It makes sense, as Mr Johnson likely must solve the Brexit impasse one way or another – and quickly. Failure to do so will see him turfed out so any focus on longer-term policies seems wasted effort. Sterling certainly got Mr Johnson’s message: the pound has slumped to its lowest point against the dollar sine early 2017. It was trading at $1.23 this morning.

Will Mr Johnson be able to secure more concessions from the EU in a few months? Will Parliament allow him to unilaterally drive the nation out of the trade bloc? Will the last-ditch attempt at a hard Brexit slew into the muddy ditches of convention, process and bureaucracy? What are the chances of a general election before the year is out? We’ve updated our decision-tree to take account of recent events, so check it out if you have a few spare minutes.

It’s definitely helped us get our thinking straight in a complicated and turbulent situation!

 

Bonds

UK 10-Year yield @ 0.69%

US 10-Year yield @ 2.07%

Germany 10-Year yield @ -0.38%

Italy 10-Year yield @ 1.56%

Spain 10-Year yield @ 0.37%

 

Economic data and companies reporting for week commencing 29 July

 

Monday 29 July

UK: Consumer Credit, Mortgage Approvals, Money Supply (M4),

US: Dallas Fed Manufacturing Activity

Final results:

Interim results: Hammerson, Hiscox, Keller Group

Trading update: Cranswick

 

Tuesday 30 July

UK: Consumer Confidence, BRC Shop Price Index, Lloyds Business Barometer

US: Personal Income, Personal Spending, PCE Core Inflation, Pending Home Sales, Conference Board Consumer Confidence Index

EU: Business Confidence, Investor Confidence, Consumer Confidence, Business Climate, Indicator; FRA: GDP (Q2); GER: CPI, Consumer Confidence

Final results: Games Workshop

Interim results: Aggreko, Centrica, Elementis, Greggs, Jupiter Fund Management, Provident Financial, Spectris

Trading update: Reckitt Benckiser

 

Wednesday 31 July

UK: Nationwide House Price Index

US: MBA Mortgage Approvals, ADP Employment Change, Chicago Purchasing Manager Index, Fed Rate Decision

EU: GDP (Q2), CPI; GER: Retail Sales, Unemployment Rate, ITA: GDP (Q2)

Interim results: 4Imprint, BAE Systems, Countrywide, Dignity, Direct Line, Indivior, Intu Properties, Just Eat, Lloyds Banking Group, Man Group, Rentokil Initial, Restore, Serco, Smith & Nephew, Smurfit Kappa, St James’s Place, StatPro, Taylor Wimpey

Trading update: 3i Group, Mitchells & Butlers, Next

 

Thursday 1 August

UK: PMI Manufacturing, BoE Rate Decision

US: Wards Total Vehicle Sales, Challenger Job Cuts, PMI Manufacturing, ISM Manufacturing, Construction Spending

EU: PMI Manufacturing FRA: PMI Manufacturing; GER: PMI Manufacturing; ITA: PMI Manufacturing

Final results: Renishaw

Interim results: Barclays, British American Tobacco, Coats, ConvaTec, London Stock Exchange Group, Merlin Entertainments, Mondi, Rio Tinto, Royal Dutch Shell, RSA Insurance, Schroders, Standard Chartered, UK Commercial Property Trust

 

Friday 2 August

UK: Construction PMI

US: Nonfarm Payrolls, Unemployment Rate, Average Hourly Earnings, Trade Balance, Factory Orders, University of Michigan Expectations Survey

EU: PPI, Retail Sales

Final results:

Interim results: BT, Essentra, International Airlines, Royal Bank of Scotland

Total votes: 63

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