Lower Interest Rates and a Soft Landing in the USA: A Favourable Environment for Equities

Just as the French has to wait two months for the announcement of their new Prime Minister, investors have now been waiting what seems like an age for the first key rate cut in the United States. Markets expect that the Fed could cut its rate by 0.5% straight away, at the risk of losing some of its credibility. As we approach the 18th September meeting, the likelihood of a double rate cut is ever increasing. Market projections now indicate a probability of over 50%, following the publication of the employment report.

This strong measure has been used several times in the past in response to exogenous or sudden events such as the Covid crisis or various financial crises. However, such a strategy could imply that the Fed is anticipating a sharper-than-expected economic slowdown and is 'lagging behind' market expectations. By reacting too late, the Fed risks being unable to prevent a 'hard landing' for the economy or a recession.

Much of the major economic data for this autumn, ahead of the decisions by the FED and ECB, has now been published. The results from Nvidia and Broadcom showed no major slowdown in sales or production of semiconductors, but did call into question investors' extremely high expectations for the outlook and margins of these companies. The fall in margins underlined the difficulty for Nvidia to sustain levels above 75% over the long term, causing the stock to fall by more than 20% and a record $279 billion in valuation lost in a single day.

The employment report showed no significant deterioration in the situation in the United States, apart from the downward revision in non-farm payroll numbers. The fall in the unemployment rate to 4.2% validates the seasonality of the previous month's rise, which had rebounded from 4% to 4.3% and generated the fears that led to the "flash crash" in early August.

The publication of inflation figures should now reassure the most pessimistic of investors about a potential rebound, and at the same time, support the four rate cuts anticipated by the market between now and the end of 2024.

The performance of the financial markets over the coming months will therefore depend entirely on this central question: will the "soft landing" lead to a recession or not?

All recessions have started with a “soft landing”. However, not all soft landings have ended in recession. Among the last five interest-rate cutting cycles since 1989, four ended in recession. However, only two of these resulted in negative returns for the S&P 500 over the 12 months following the first cut, and in one instance by -13%.? Nevertheless, in 1995, with Alan Greenspan at the helm of the Fed, the rate cuts did not cause a recession and the equity markets, despite having returned 23% over the previous 12 months, posted a gain of more than 50% over 24 months! As much as we can base predictions on these past situations, the occurrence or non-occurrence of a recession remains key to defining the optimal tactical allocation of portfolios for the months ahead.

A number of factors could influence whether or not a recession occurs, including the support of public spending in the United States (which should remain solid during the election and post-election periods), the resilience of consumption (which seems possible given the latest figures for US household consumption) and investment, particularly in the development of Artificial Intelligence (AI). Potential productivity gains are estimated at between 10% and 30%, depending on the sector, but with uncertain time horizons. This could enable companies to maintain their margins despite a slowdown. Coupled with a fall in inflation, which would restore purchasing power to households, this could help to keep the economy out of recession.

At present, our central scenario remains that of a soft landing, with corporate profits and margins on the rise primarily in the United States, a very slight deceleration in household consumption and government spending, the Chinese economy stabilising (albeit delayed by the absence of new government measures), industrial weakness in Europe and geopolitical tensions contained.?

This scenario, which is positive for equity markets as well as for government and quality corporate debt, is nonetheless accompanied by uncertainties, such as the outcome of the US elections and the pace of rate cuts by the Fed, prompting us to diversify our equity exposure.

The normalisation of earnings growth in the Magnificent 7 and the benefits of deploying AI to non-tech early adopters make sector diversification necessary. Despite a few weeks of style rotation in favour of small and mid-caps in July, the trend is still in favour of large caps. There are a number of reasons for this. These include the substantial flows into passive management, which primarily feed large caps, and the greater capacity of large companies to invest in AI. Additionally, large companies have made market share gains at the expense of small ones during the period of high interest rates. There are also fears that a possible recession would have a greater impact on smaller, more indebted, less diversified, and more cyclical companies. We therefore continue to favour large caps.

Nevertheless, we anticipate a significantly more volatile end to the year in the financial markets compared to the first half. We are keeping our strategic positions in sectors sensitive to falling interest rates, such as materials and property, and resilient sectors such as healthcare and the security sectors in the broad sense (defence, cyber security, health and personal safety, energy supplies and key components, etc.).

We maintain our slight overweight in US equities, which benefit from stronger earnings growth and margin expansion compared to European companies, as well as better stock market performance in most market phases. September is traditionally a rather disappointing month, with an average negative return of -0.7% over the last 20 years and -2.3% over the last 10 years. By contrast, the last three months of the year, and particularly November and December, remain historically positive months for equity markets, especially in election years. This holds as long as the Fed does not disappoint by being overly cautious and the US elections deliver their share of promises, bolstering consumer confidence and financial markets.

Nicolas Bickel | Group Head of Investment Private Banking