Is this the end of U.S. rate cuts? If not, should it be?

By Laura Catterson, Hottinger Investment Management

In an anticipated move, the Federal Reserve delivered its third 25 basis point rate cut of 2019 at the end of October. Notably accomplishing the “mid-cycle adjustment” alluded to by Chair Jerome Powell in July when rates were first cut and prompting comparisons to Alan Greenspan’s similar 1990s playbook. The latter, termed “the great moderation”, rejuvenated the economy with continual steady growth, decreasing unemployment, stable inflation and strengthened stocks. Will Powell follow precedent with a pause or will the cuts continue?

The Federal Open Market Committee will meet again in December and as yet there is no clear indication as to how they will act. Many anticipate a “wait and see” approach, allowing the Fed to remain data dependent. Powell stated that he is “not against further rate cuts – if developments occur that change their outlook, they will respond”. Although the Fed did not outline what would prompt them to cut again, the considerable headwinds facing the US economy include slowing global growth, the US–-China trade war and deteriorating job market.

March 9th, 2019 marked the 10-year anniversary of the longest-running bull market in history, however the cracks are beginning to show. With the manufacturing PMI hitting its lowest point since June 2009 at 47.8 (Figure 1), slowing GDP growth (1.9% in the third quarter, 2% in the second and 3.1% in the first), weak job and retail sales reports and geopolitical tensions still present, many believe a 2021 recession to be a plausible threat.

Figure 1: ISM Manufacturing PMI Index

For major stock indices, rate cuts are typically goods news; and the most recent is no different. Immediate reaction saw the S&P 500 climbing 0.3% to 3,046.77, the Dow up 115.27 points and the Nasdaq ending the day up 0.3% to 8,303.98(i). Sentiment that US equities have been riding a bullish wave is supported by 2019’s steady stream of IPOs, which also highlights investors’ insatiable appetite. The interest rate cuts of the 90s also saw stocks soar, most notably driving the S&P 500 more than 20% higher within a year(ii). The Fed may be following suit in a bid to avert a downturn, however – in contrast to the adjustments made 4 years into a period of economic expansion, these cuts occur at 10 years plus. Another notable distinction is the pause in cuts that came after the “mid-cycle adjustments” of the 90s. Data shows that when the third cut is not the last, stocks tumble. (Figure 2)

Figure 2: Average 1-year S&P 500 returns after the Federal Reserve cut rates at least three times

Of similar concern, in conjunction with this collective 75 basis point cut, is the Fed’s commitment to expanding its balance sheet by way of quantitative easing. These moves indicate that, in conditions now categorised by the International Monetary Fund as a “synchronised” global slowdown, any effort by the Fed to “normalise” monetary policy is, at least for now, over(iii).

Looking to 2020, tariffs are among the variables that could see the outlook turn to the downside and increase the risk of further cuts. If President Trump carries out all threatened hikes, rates on US imports of Chinese goods will be approximately 24%, an increase of 21% in 2 years. Similarly, the rate on Chinese imports of US goods will be nearly 26%, in comparison to an average tariff rate of 6.7% for all other countries(iv). If current trends continue, experts predict a total loss of 900,000 jobs by the end of 2020(v).

During a year of economic turbulence, one pillar of support is strong corporate earnings. Q3 profits registered a better-than-expected small decline, which has helped shares reach record highs in recent days. Nevertheless, this failed to satisfy Wall Street analysts who predict a bleaker Q4 – earnings growth forecasts have been slashed to just 0.8%, down from 4.1% at the start of October. Similarly weak, Refinitiv predicts S&P 500 earnings growth for 2019 as a whole at 1.3%, the slowest rate of growth since 2015, when it rose just 0.2%(vi). This is a strong indication that the trade war is beginning to put strain on the US economy.

The Fed has much to consider when calibrating the underlying health of the economy. If there is deterioration, it is clear that further action has not been ruled out. With inflation at 1.7%, there is no justification for raising rates. This leaves the Fed with 2 options: pausing or pressing ahead with more cuts. There will most likely be pressure from President Trump’s administration to perform the latter going into a presidential election cycle which itself brings additional uncertainty. Whilst the current rate adjustments would reduce the odds of an economic recession in 2020, there are a number of reasons for investors to exercise caution going into 2021.

[i] https://www.cnbc.com/2019/10/30/stock-market-fed-rate-decision-and-earnings-in-focus-on-wall-street.html

[ii] https://www.cnbc.com/2019/10/30/when-the-fed-cuts-rate-three-times-and-pauses-history-shows-it-works-out-great-for-stocks.html

[iii] https://www.wsws.org/en/articles/2019/10/19/pers-o19.html

[iv] https://www.foreignaffairs.com/articles/asia/2019-10-08/unwinnable-trade-war

[v] https://intpolicydigest.org/2019/11/11/tariff-impact-and-what-to-look-for-in-2020/

[vi] https://www.ft.com/content/b5a2ac58-00ac-11ea-b7bc-f3fa4e77dd47