Charting the turning points

Markets, politics, economics, sport and life. Things are never static. Headwinds become tailwinds or vice versa. Leaders become losers; laggards become victors.

There are some notable changes underway, and there are areas where changes lurk, but it is too soon to tell for sure. But there are also areas of frustrating inertia, such as the wars in Gaza, Ukraine, Sudan and elsewhere that show no sign of ending.

One example of change is from the US presidential race, where in the space of two weeks, we’ve gone from a near-inevitable Donald Trump victory against Joe Biden to a much tighter contest between Trump and Kamala Harris. If this was a spectator sport, viewers would be inching closer to the edge of their seats. But this is unlikely to be the last twist in a campaign that still has four months to run.

From a purely investment point of view, the most important turning point is that of the global interest rate cycle. As chart 1 shows, most central banks are now in cutting mode, with only a few outliers hiking (Nigeria and Russia were the only hikers in the month of July, while nine central banks cut rates). As rates decline, there is relief for indebted households and businesses, while new borrowing becomes cheaper, supporting both capital and consumption spending. As for financial markets, all else being equal, lower rates support higher equity and bond valuations. The important caveat is that rates can fall for good and bad reasons. Lower rates in response to lower inflation is positive for markets, but not if rates are cut in response to an economic contraction. Fortunately, unlike in 2020, the current cycle is largely a case of the former.

Chart 1: Central bank interest rate changes

Source: cbrates.com

The most important central bank, the US Federal Reserve, is unlikely to cut this week, but should start laying the groundwork to start easing in September. US inflation continues to move lower gradually, and while some categories remain elevated, it is never the case that the prices of items in the basket rise and fall at the same pace or even the same time. The Fed’s preferred inflation measure, core personal consumption expenditure deflation (PCE) was 2.6% in June.

It is not at the 2% target yet, but is moving in that direction. As the Canadian ice hockey legend Wayne Gretzky (aka “The Great One”) famously said, ‘you stake to where the puck is going’ and not where it is now. Similarly, central banks need to make policy today for what the economy will look like 12 or so months down the line. This is because it takes time for interest rates to impact the economy.

The US labour market is cooling, and this means it is unlikely to be a source of upward inflation pressure. Importantly though, the pace of jobs and wage growth remains sufficient to support consumer spending, even if it grows at a slower pace. This all suggests a soft landing is underway.

The Fed (and other central banks) are unlikely to launch into aggressive rate cuts, however, there will be lingering concerns that inflation could flare up again. They will be wary of declaring victory too quickly. For one thing, global supply chains are still very tightly wound and subject to disruptions. The recent global IT outage grounded several large airlines and was a foretaste of what could go wrong, though it was thankfully brief.

Therefore, it is likely to be a modest interest rate cutting cycle, unless there is a sharp slowdown in which case rates will be reduced quickly. The good news is that there is substantial room to cut rates and provide support should this be necessary. It is unlikely that inflation fears will prevent a response to recessionary conditions, which was not the case 12 to 24 months ago.

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