by Tim Sharp
September and October are historically the most challenging period for financial markets as participants return from summer breaks and we enter the final quarter of the year starting with the anniversary of 9/11. Markets have been data dependent ever since central banks announced that they were relying on the data to signal the beginning of the easing cycle, having already suggested that we had reached peak rates over the summer. Following the Jackson Hole Symposium speech by Fed Chair Powell speculation had moved from when the first cut would materialise to whether the cut in September would be 25bps or 50bps and – to the surprise of some – the FOMC voted for a 50bps cut at its September meeting. It is not unusual for the Fed to start an easing cycle with a larger-than-normal cut in rates, but then it is unusual to start easing when the underlying economy is as resilient as it is currently showing, so this is an important shift in momentum. Financial markets are now pricing in another 50bps before year-end and a neutral R-Star rate of approximately 3%i. R* or R-Star is the real short-term interest rate that would prevail if the economy was at equilibrium. It is by nature difficult to calculate and largely notional but would neutralise the business cycle.
There have been many economists predicting a recession for most of 2024 following the steep rise in interest rates during the prior year, and western economies led by the US have largely shown their resilience, but as we see August Personal Consumption Expenditure (PCE) falling close to the 2% target, US unemployment above 3.2%, and consumer confidence beginning to flag despite strong revisions in corporate earnings and margins, concerns that the momentum may deteriorate sharply have motivated the Fed to assert that it is ahead of the curve.
In our opinion the indicators of a looming recession such as overleverage, credit market stresses, high default rates, and other signs of growing imbalances in the economy are currently absent outside of the US Treasury yield curve which dis-inverted during September and currently sits at +17bps 2yrs-10yrs, a strong historical indicator of a recession. We are also wary of deteriorating employment figures and consumer balance sheets, although these pressures are most acute in lower wage cohorts that have a limited impact on aggregate consumption. As we have stated previously, the environment still favours risk assets and – after a short show of nerves at the Fed’s decision – equity markets have gone on to post a positive September after another shaky start on the back of poor data. The S&P500 gained 2% and the NASDAQ 2.7%, while major European and UK bourses are flat on the month.
Germany’s IFO survey of business sentiment fell again in September for a fourth consecutive month to 85.4 from 86.4 in August after the economy contracted in the second quarter. A contraction in the third quarter would indicate that Germany is in recession, if it is not already, with the business climate index in manufacturing falling to its lowest level since June 2020. The European Central Bank (ECB) followed the Fed’s move in September, but many economists are pushing for another cut in October in line with the ECB’s “meeting by meeting” approach after September’s Purchasing Managers Index Survey (PMI) data continues to point to economic weakness.
Europe relies heavily on its relationship with China, its largest trading partner, and Chinese exports have flooded European markets as the region tries to stimulate its lagging economy. The Chinese Central Bank (PBoC) in an unusual western-style announcement on September 24 lowered bank reserve requirements, cut interest rates by 0.1%, and stated that it will provide funds to brokers to buy stocks. The announcement pushed Chinese stocks higher, leaving the Shanghai SE up 17.4% on the month. The commitment to further action if needed may be enough to lift sentiment as well as asset prices and deliver a rebound in consumer demand and the ailing property sector, although growth still appears to be tracking well below the 5% target. There remains a reluctance for corporates and consumers to increase their borrowing due to already highly-leveraged positions after the property slump, so, in our opinion, making more stimulus available without addressing these concerns in the longer term may not be enough.
Inflation in the UK is proving a little stickier than elsewhere, as referenced in Bank of England (BOE) Governor Andrew Bailey’s Jackson Hole Symposium speech leaving expectations that rates would be left unchanged in September by the Monetary Policy Committee (MPC), and they duly were. The MPC would like to see inflation “squeezed out of the system” entirely before embarking on an easing cycle. This has been good news for sterling, which has gained 1.8% versus the dollar over the month rising to 1.34 and 1.1% versus the Euro climbing to over 1.20. Labour supply remains very tight following Brexit, and 7% of the UK workforce is not working due to long-term sickness[i], which leaves the UK workforce with bargaining power, despite a surprising drop in consumer confidence in September. Forecasts suggest a more gradual 150bps decline in UK rates by the end of 2025 with the next cut expected at the November meeting.
Falling interest rates, a weaker dollar, and a worsening geo-political back drop is a good environment for gold as a safe-haven asset, and the price has continued to strengthen to as high as $2,670 /oz during September, a 30% rally this year. Since the economic sanctions imposed on Russia by the US, many central banks have been keen buyers of gold to boost reserves and reduce their reliability on fiat currencies – not least the dollar and US Treasuries. China and India reportedly have added significantly to their gold reserves this year and central bank buying has generally added a significant tailwind to the price[ii]. It is difficult to justify the rally in gold this year without the involvement of central bank demand leaving the price extremely overbought unless the global economy is heading for a deep recession or a prolonged period of uncertainty, which we currently doubt.
In summary, there are signs that the US economy is slowing, bringing renewed calls for a pending recession from parts of the market. However, as we expected, we see an economy that seems to be heading for a soft landing and a broadening out of returns and we therefore continue to favour risk assets.
[i] Ward Karen _ JPMAM _ My Key Question This Month _ Should the BOE follow the FED _ 2024.09.25
[ii] Authers John _ Bloomberg Opinion _ Points of Return _ All That Glitters _ 2024.09.27
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