Starter for 50

The much-debated soft landing scenario looks increasingly likely - and markets love it. The Federal Reserve (Fed) was bold in cutting interest rates by 50 basis points (bp); the move prompted equity markets to soar, in some cases to record highs. Bond markets continue to price rates going down over the next year. Bond returns might not be quite as strong into year-end as they were over the third quarter (Q3), but equities look set for a good run for the rest of 2024. Historically shares tend to do well in the final quarter of the year, though past performance does not guarantee future returns, and this year there are election uncertainties to contend with. Rates lower, the inflation battle won, growth remaining positive…what could go wrong?

Good job – The Fed is doing a fabulous job. It took the fully justified decision to cut interest rates by 50bp on 18 September and did nothing to shake medium-term expectations that see a pathway to neutral interest rates in 2025. This approach has allowed bond yields to fall across the curve but remain well above levels that prevailed before 2022. This is great for bond investors. Returns have been spectacular over the summer; the yield on fixed income remains quite attractive and should become more attractive compared to cash in the months ahead. Finally, steering inflation lower and beginning to cut borrowing costs will create a more stable environment for consumers and businesses. Bravo!

Efficient markets – Market pricing should reflect the weighted probability of all potential outcomes. There will always be different views and economic data shocks. If investors have a different expectation of inflation or growth, and consequently of the path of interest rates, the market gives them lots of opportunities to express those views. For those who believe the Fed is being too optimistic on inflation and that eventually it will not be able to cut rates by as much as priced in, there will be an expectation that markets will eventually price in higher rates. We do not know the probability of abrupt shifts in market sentiment, or rogue economic data or, indeed, of the impact of the upcoming US election. If markets are rational, then today’s pricing is the best of the outlook. Bet against it potentially at your peril.

Good for bonds – Markets liked the Fed rate move. While yields did not move much after the news, they performed well into the decision. Across the US Treasury curve, yields are lower compared to the start of September. The end-of-year implied level for the Fed Funds Rate is also lower, by 20bp. Overseas bond yields are down as well. Equity markets also really liked it. Why not? Easier monetary policy reflects less concern about inflation and lower rates make a significant slowdown less likely. Borrowing costs in the US mortgage market are falling. According to Bankrate.com , the average national 30-year mortgage rate has dropped from a peak of 8% last October to around 6.5% today. Further declines will spark additional remortgaging activity and increased home purchases. That is good for consumer spending. And, to repeat a comment from last week, corporate financing costs are coming down.

Good for stocks – Most investors should be happier owning growth equities with interest rates heading to 3%, rather than when they were potentially going to hit 6% - and especially when inflation is returning to target rather than looking like it’s going to be stuck in a new secular higher range. It is better to be owning equities when analysts are confidently revising up their expectation for earnings per share than when recession-threatening rate hikes were cutting forecasts, as was the case in 2022. Optimism is abroad and equity markets are marking new highs. The frenzy around artificial intelligence (AI) may have faded but the revolution is unfolding, and we should not rule out upside surprises to technology earnings in Q3 and into 2025.

Stable framework – Do not fight the Fed. It is incredibly important and, in my opinion at least, makes the right calls. It is steering markets to an equilibrium level of interest rates different to the one that was needed in the years following the global financial crisis. Betting that it would lose control of inflation was wrong. Betting that it will lose control of growth is also likely to be wrong. It is important to recognise the Fed’s importance, especially in times of volatility. And there will be volatility – likely driven by the US presidential election and its aftermath - as well as ongoing geopolitical events. But for long-term investors, having a strong monetary framework is especially important – long-term targets that do not change very much (low inflation and low unemployment) provide an evergreen roadmap of what will determine the path of global interest rates.

Powerful trends – I would also suggest not fighting technology. The world has changed fundamentally over the last 50 years and digitalisation has played a major role. It will continue to change as greater computing power and AI deliver even more productivity gains. Nor would I fight the green revolution. No matter one’s views on climate change (and most people are unqualified to have a view worth listening to), being able to electrify increased volumes of economic activity with power sources which have significantly lower financial, environmental, and social costs than fossil fuel-based sources is undoubtedly a good thing. Lower costs, more decentralisation and lack of reliance on the political-energy industrial complex will allow more investment, different patterns of trade, less conflict and greater opportunities for countries and regions that have been energy deficient.

Optimism or delusion – We are on the brink of a potential golden age of more stable macroeconomic conditions, an abundance of clean and low-cost energy, and technology which can contribute to better living standards for billions of people. The forces at play are powerful because there is economic rationale for them. That means they should provide potential for long-term investment opportunities. Of course, things can go wrong. There are plenty of Cassandras warning of World War III, an environmental disaster, a demographic time bomb, and political fragmentation that is undercutting social cohesion in numerous countries. Some of these fears can, from time to time, hit markets. But putting a probability on scenarios that will profoundly undermine market returns is not easy. Some of the risks might crystalise after the US hits the polls on 5 November but the outcomes are not clear. Best to deal with them when they come along, or as I like to say, “don’t worry about things you can’t control”.

Hedge if you like – It will take a lot to fundamentally shift the rate profile currently priced in markets. The core reason this could happen would be because inflation responds quickly to the (so far) modest easing of monetary policy. This is not priced into either markets or most economic forecasts. Inflation hedging is quite cheap as a result, with five-year US inflation swaps at 2.3%. This is a market worth watching, because if the US election does usher in the potential for more inflationary policies there, swap rates will start to move higher, as will interest rate expectations. In the absence of that, the bull market could extend well into next year.

Goals galore – Scoring 10 goals in the last two games is worth celebrating at any time. The fact these came from Manchester United against newly promoted Southampton and League One club, Barnsley, does not diminish the achievement in my eyes. Winning games breeds confidence and United will need it as they revisit the scene of a 4-0 (embarrassing) loss to Crystal Palace towards the end of last season. Gradually the weaknesses in the side are being addressed, and the Uruguayan player Manuel Ugarte looks like a huge midfield addition. I am hoping for good news from South London this weekend.

(Performance data/data sources: LSEG Workspace DataStream, Bloomberg, AXA IM, as of 19 September 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.