US, European stocks rise despite looming risks
The potential for significant deregulation and tax cuts has excited many investors, leading US stocks to “climb the wall of worry” despite immigration and tariff risks.
The Federal Reserve (Fed) cut rates by 50 basis points last week to keep the US economy in good shape and avoid falling behind the curve.
The Fed’s start of easing is critical in terms of adding to the environment of monetary policy accommodation beginning in much of the world.
However, despite accommodative monetary policy, markets are swimming in a sea of uncertainty over the next several months.
First, mea culpa. I was wrong. I was confident that after passing on an opportunity to cut rates in July, the Federal Reserve (Fed) wouldn’t deliver a jumbo interest rate cut in September. But alas, we Americans like to supersize more than even I thought. And so — despite 50 basis point cuts being used in modern times as “crisis cuts” (2001, 2007 and 2020) — the Fed chose to cut 50 basis points last week as a “preemptive” cut, one intended to keep the US economy in good shape and avoid falling behind the curve and into recession.
What’s more, the Fed’s “dot plot” revealed plans for significant easing ahead: The projected year-end median policy rate was revised down to 4.4% for 2024 (from 5.1%), 3.4% for 2025 (from 4.1%), and 2.9% for 2026 (from 3.1%), where it is expected to stay in 2027.1
Here are my key takeaways from Federal Reserve Chair Jay Powell’s press conference:
Powell’s term du jour is “recalibrate.” That replaces “data dependent” and before it “transitory” in the Federal Reserve Bank lexicon. It’s an acknowledgment that monetary policy needed to change to reflect a change in conditions. But which conditions? Fed Governor Chris Waller tried to reassure by saying it was progress on disinflation; he shared that the Personal Consumption Expenditures (PCE) price index was "softening much faster than I thought it was going to” which “put me over the edge to say, look, I think 50 (basis points) is the right thing to do."2 However, markets don’t seem entirely convinced, especially since Powell indicated concerns about maintaining the health of the labor market in explaining the Fed decision.
While the Fed was busy kick-starting its easing cycle with a jumbo cut, the Bank of England decided last week to keep rates as is after starting its easing cycle last month with a normal-sized cut.
The Bank of Japan also held rates steady last week, declining to hike more after market turbulence last month. Bank of Japan Governor Kazuo Ueda explained the need to pause, “The outlook for overseas economic development is highly uncertain. Markets remain unstable. We need to scrutinize such developments carefully for the time being.”3
Also last week, Norges Bank decided to defer the start of its easing cycle while the Bank of Brazil decided to hike rates, concerned that its economy is heating up.
So where do we go from here?
Most Western developed economies have begun easing or will begin it soon. The Fed’s start of easing is critical in terms of adding to the environment of monetary policy easing beginning in much of the world. This creates an accommodative climate that is typically supportive of risk assets. However, asset class performance in the next several months will likely depend on whether markets think the US and other major economies can avoid a recession and experience an economic re-acceleration.
There are legitimate concerns about recession. Monetary policy was very restrictive for some time. FedEx, one of those bellwether stocks that can give us insight into the state of the economy, recently guided expectations downward. And the S&P Global PMI Survey for the US shows a manufacturing sector that has moved deeper into contraction.
However, I’m in the camp that believes that the US will avoid a recession. The Citigroup US Economic Surprise Index, while still in negative territory, has risen materially since late August. And credit spreads are suggesting that a recession is not in the offing. The ICE Bank of America US High Yield Option-Adjusted Spread hit a recent peak of 3.93% on Aug. 5.4 Since Sept. 10, spreads have fallen significantly, down to 3.1% on Sept. 19.5 This is a very low level relative to history. It tells me that the Fed is not far behind the curve and that its 50 basis point cut has increased confidence that the US should avoid a recession.6 And the S&P Global US Services PMI reading remains strong.
As a case study in how this could potentially play out, I previously wrote about the 1995-96 playbook and I’m doing it again today because I find it so instructive – it was the last time the Fed tightened and successfully avoided a recession. As a reminder:
My conclusion is that economic conditions were different back in 1995, with unemployment higher relative to today and a less resilient consumer. So while tightening was more aggressive in the most recent Fed cycle — hiking rates by 525 basis points in 2022-2023 versus 300 basis points in 1994-1995 — today’s economy has been more capable of withstanding the pressure. Also, rate cut expectations are very different today — there is an expectation of 150 basis points in cuts through the end of 20258 — and perhaps far more than that given Chicago Fed President Austan Goolsbee’s comments that he expects “many more” rate cuts over the next year — which would likely provide a far more powerful boost to risk assets in coming months than the tepid 75 basis points in cuts provided by the Fed from July 1995 through January 1996.
I expect Canada, the UK and the eurozone to also avoid recession. Not all data is positive, but I still believe real wage growth and monetary easing can help slowing economies to soon re-accelerate. And despite recent weakening in the eurozone, the ICE Bank of America Euro High Yield Index Option-Adjusted Spread is at a relatively low level, suggesting the economy will avoid recession. As far as can be seen in the data, these economies are getting the policy prescription they need based on their respective economic conditions.
However, despite accommodative monetary policy, markets are swimming in a sea of uncertainty over the next several months. There is the US presidential election on Nov. 5 — and the very real potential for a US government shutdown in December. We have the UK nervously awaiting the release of the Budget next month, having been warned by the new Labour government that the financial situation is more dire than had been expected. (In fact, the GfK UK Consumer Confidence indicator fell sharply to -20 in September from -13 in both August and July, and is now at its lowest level in six months, with the autumn Budget seemingly the driver of this drop.9) And we have significant political uncertainty in the eurozone and even Canada; we also can’t forget a new leader must soon be chosen in Japan. We also have the Middle East hurtling towards a full-blown war after a serious escalation in hostilities last week. At the same time, we have seen an escalation in hostilities in the Russia-Ukraine War. Add to that uncertainty about when and how much central banks will cut, and we have a recipe for heightened volatility in the next several months.
So now, more than ever, is a time for diversification, in my opinion. Yes, I believe we are likely to see equities perform well, but I anticipate significant volatility given all the unpredictability in the near term. So I favor exposure to a variety of fixed income sub-asset classes such as investment grade credit, high yield and municipal bonds, which may benefit from the solid economic backdrop and the falling rate environment. And I also favor exposure to alternatives, which can offer diversification benefits through lower correlations to traditional stocks and bonds. Areas like real estate offer income and upside potential as rates fall. And gold can serve as a hedge against geopolitical risk as well as government budgets that are increasingly strained. As we brace for the next several months, the best approach may be to simply keep calm, stay diversified and look for mispricing opportunities.
The potential for significant deregulation and tax cuts has excited many investors, leading US stocks to “climb the wall of worry” despite immigration and tariff risks.
We expect significant monetary policy easing to push global growth higher in 2025, fostering an attractive environment for risk assets as central banks achieve a “soft landing.”
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1 Source: Federal Reserve Board of Governors, Sept. 18, 2024
2 Source: Reuters, US inflation data cemented big cut for one Fed official, dissent for another,” Sept. 20, 2024
3 Source: Reuters, “BOJ Governor Ueda's comments at news conference,” Sept.20, 2024
4 Source: Bloomberg, as of Sept. 23, 2024
5 Source: Bloomberg, as of Sept. 23, 2024
6 Source: St. Louis Fed Research Department, as of Sept. 20, 2024
7 Source: Bloomberg, L.P., as of Sept. 33, 2024. Data represents performance from July 6, 1995, to Jan. 5, 1996, which were the first six months after the Fed began to ease on July 6, 1995.
8 Source: Federal Reserve Board of Governors Summary of Economic Projections, Sept. 18, 2024
9 Source: Bloomberg, as of Sept. 23, 2024
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