Oliver Blackbourn, a Fund Manager on the UK-based Multi-Asset Team, discusses the strong likelihood of the FOMC delivering a rate cut at their July meeting - and beyond.
Ahead of the July Federal Open Market Committee (FOMC) meeting, we are expecting an interest rate cut; the market is seemingly certain of one. Anything else would be viewed as a disappointment at the moment. Chairman Powell raised expectations of pre-emptive action with his comment that “an ounce of prevention is worth more than a pound of cure”; this represents a step change; only one member of the FOMC actually voted for a cut when given the opportunity in June. Markets are currently pricing almost a 100% probability of one cut of 25 basis points, having until Friday 5 July given a reasonable chance to a 50 basis points move.
There also remains a reasonable chance of follow-up action through the rest of the year and investors are giving a probability of over 85% for two or more reductions by year-end. We can see the case for a couple of supportive cuts this year given that the Federal Reserve (Fed) does not have a lot of room to move from here should the economy deteriorate rapidly. Any move lower can be justified by unresolved trade tensions, expectations for slower economic growth over the summer and the fact that inflation remains stubbornly low. On this last point, at the time of writing, core PCE (Personal Consumption Expenditures) was still only at 1.6% year-on-year, with a CPI update due. Given the discussions about adjusting the way that the Fed targets inflation, it seems that cuts could easily be justified by a number of the committee members.
We are approaching the end of the third ‘mini-cycle’ since 2009, led by the corporate sector. Previous slowdowns were driven by the eurozone debt crisis and the oil price slump. The headwinds in this ‘mini-cycle’ have come from the uncertainty relating to the US-led global trade tensions. The US economy looks likely to see a slowdown in the coming months, from the high 2%/low 3% levels seen in recent quarters following the tax cuts. Rising trade tensions last year led to increasing inventory, which boosted growth. These episodes tend to be followed by an unwind that creates a subsequent drag.
US total aggregate pay growth
The key to whether the US economy falls into recession is the American consumer. There was some weakness in the first quarter, but this was nothing new, with a trend of weak starts to the year appearing recently. The jobs report last Friday confirmed that the labour market remains in reasonable health and total aggregate income growth is still solid, which should support consumption. The consumer is also benefiting from recent declines in mortgage rates and, despite a dip, small business confidence – the core of corporate America – remains strong.
US equities have performed strongly in the first six months, with the S&P 500 returning 20% as it bounced from a poor end to 2018. This means that US equities no longer look cheap on a price-to-earnings ratio of 17 times. It is hard to see further strong performance from here, as expectations of monetary easing appear to have been a significant driver of the moves year-to-date; current pricing leaves room for disappointment. However, there has been a US$55 billion outflow from US equity funds in the first six months of 2019 and investor sentiment is still recovering from the lows seen earlier in the year, leaving scope for investors to increase allocations. We could still see the US stock market deliver positive returns over the second half, but market volatility may be greater.