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Fed Buys Economic "Insurance" With Rate Cut - Wealth Managers React

Tom Burroughes, Group Editor, 2 August 2019


The world's most powerful central bank has cut rates. Wealth managers give their reactions.

The US Federal Reserve has cut interest rates by 0.25 per cent, or 25 basis points, to a target range of 2 per cent from 2.25 per cent. This is in spite of what is, as far as data seems to suggest, a strong economy without much slack in the system. Economists argue, however, that fears about an escalating trade war may require an “insurance”-style cut now and the markets appear to be pricing in further reductions.

The decision was not unanimous: Kansas City Fed chief Esther George and Boston Fed president Eric Rosengren dissented on the decision to cut rates, instead preferring an unchanged stance on interest rates.

Older investors may scratch their heads about how the world’s most powerful central bank thinks it is necessary to loosen monetary policy when – according to the Trump administration and official figures – the US economy is in such good shape. It is important to remember that when inflation (which is low) is factored in, real interest rates are barely positive. Over time, lousy returns on cash and cash-like investments hold down savings, and that’s bad for the kind of long-term investment that drives productivity growth and real wages. It has been argued that one of the reasons why wage growth has been sluggish in recent years is precisely because of low real savings rates in the US (and to some degree, other parts of the West). There is also the argument that the Fed has so massively expanded its balance sheet post-2008 that it has limited room to keep rates higher even if the economics warranted it.

Low interest rates also mean, as wealth managers know, that investors must go higher up the risk spectrum than they might otherwise like to get returns. It also explains some of the hunger for alternative investments, such as private capital, equity, forms of real estate, infrastructure, commodities, and precious metals. The environment has prompted investors to be willing to take the pain of less liquidity because they need the returns. Sooner or later, this equation is not going to add up any more.

With these thoughts out of the way, here are some reactions from wealth managers in Europe from yesterday’s cut by the Federal Reserve. We may update with reactions from US managers as they come in. To add your voice to the debate, email tom.burroughes@wealthbriefing.com

UBS Global Wealth Management Chief Investment Office, UBS
Over the coming months, the progress of trade talks between the US and China will influence the outlook for the economy and the Fed. While we do not expect a breakthrough leading to a reduction in tariffs, we believe that talks are likely to continue with no major escalation in tensions. This should, in our base case, permit a gradual recovery in business confidence, and a reduction in market expectations for Fed rate cuts.

Over the medium term, we will be watching how the Fed evolves its thinking around its statutory goals of "maximum employment, stable prices, and moderate long-term interest rates". Inflation has consistently fallen short of the Fed's 2% target despite interest rates being lower than in the past, and market pricing indicates scepticism that the Fed will hit the target in the future. The Fed may embrace a new interpretation of maximum employment, or somehow suggest that inflation will be encouraged to rise above 2 per cent to make up for the shortfall in previous years. It may also introduce new monetary policy tools to help reach its goals and to provide more support during economic downturns.

Investec Economics
Looking forward, we expect the Fed to sanction two further cuts in the Federal funds target rate range, effectively to provide ‘insurance’ against downside risks and in response to muted inflation pressures. We see the next 25bps cut occurring in September, followed by a further reduction in Q1 2020, which should see the Federal funds rate bottom out at 1.50-1.75 per cent. Although [Federal Reserve] chair Jerome J Powell didn’t deliver any firm commitments on interest rate cuts, he will get another opportunity at the Kansas City Fed Economic Symposium, better known as Jackson Hole, on 22-24 August, where he could provide updated guidance to markets.

The Fed’s decision was framed against an assessment of the economic outlook which was pretty much unchanged from the June meeting, in that the labour market was still assessed to be strong and that activity was seen rising at a moderate pace. Meanwhile inflation continued to be assessed as running below the Fed’s 2 per cent target. In light of the solid labour market and seemingly robust economy the rationale for last night’s cut came in the form of concerns around downside risks from the global backdrop (trade frictions) and muted inflation pressures. Indeed we very much view last night’s move as a precautionary cut given that the unemployment rate stands around a 50-year low and given our expectation that the US should see growth of 2.5 per cent this year.

Mr Eli Lee, head of investment strategy, Bank of Singapore
Following this 25bps cut in July, another 25bps cut will likely follow sometime in Q4 2019, although a third cut will depend on further developments in trade and the economy.

We also expect rate cuts from other central banks in the next few months following the Fed, and note that some emerging market central banks, such as the Bank of Korea, Bank Indonesia and the South African Reserve bank, have already moved ahead of the G3.

With our baseline scenario of synchronised global easing and a limited likelihood of a recession over 12 months, we believe the overall environment continues to be supportive of risk assets and recommend that investors remain engaged with markets.

Olivier Marciot, investment manager, Unigestion
After a period of patience and economic assessment earlier in the year, the Fed is now taking action. Tonight’s [Wednesday’s] decision is probably the first step in a sequence of adjustments in monetary policy, aimed at reviving economic expansion and bringing inflation closer to the bank’s 2 per cent target.

With this in mind, our current dynamic assessment articulates around three risk factors:

Macro risk: Growth conditions as indicated by our proprietary 'nowcasters', have stabilised around potential and show only minimal signs of improvement. The latest GDP print in the US is reassuring but remains the exception in the developed world. On the other hand, disinflation is still at work and remains the main source of concern for central bankers. This in turn will warrant larger accommodation for longer from central banks, until fundamentals materially firm. In the medium run, this dimension will remain supportive and benefit growth-oriented assets such as equities and credit.

Market Sentiment: Risk appetite remained solid through July, and should remain so now that the Fed has provided clarity on its future course of action. It would require a shock to reverse current optimism, such as a rapid surge in trade war tensions or a poor earnings season, for example. In the absence of a trigger, momentum should persist as positioning does not seem extreme yet and leaves room for another leg of positive returns. The picture is less clear on this front though, as expectations and market pricing were high going into today’s FOMC meeting.

Valuation: Most assets have become rich as a result of central bank action. Currently, hedging assets are more expensive than risky assets, which could trigger correlation distortions and limit their defensiveness. This favours relative value plays over long beta exposures.

Tim Drayson, head of economics at Legal and General Investment Management
The Fed cut rates last night by 25bps, but the lack of forward guidance disappointed an aggressively priced market which has taken out 10bps of future cuts.

In the Fed’s Open Market Committee statement the description of the domestic economy remained the same, and forward guidance was slightly watered down as the committee stated its intent to continue monitoring incoming information rather than ‘closely’ monitor. There were two dissents in favour of no change: George and Rosengren. While both are regional Fed presidents, two dissents is unusual and suggests a split on the FOMC. However, nobody dissented in favour of a 50bps cut. The statement outlined that the Fed will conclude the reduction in its balance sheet two months earlier than previously indicated. It did not come as a surprise, as to continue shrinking the balance sheet would work at cross purposes to the rate cut (even though the balance sheet was originally supposed to be separate from active monetary policy decisions).

Gregory Perdon, co-CIO at Arbuthnot Latham, the UK private bank
If Powell wants a good book deal, he should stand-up to the President and tell him that the last time he (Powell) checked, the Fed was in charge of monetary policy not the White House. The S&P is at an all-time high, unemployment is rock solid, little cracks in the housing façade and credit is largely okay (except some low grade). Why did they do it? It doesn’t seem sensible to me.

Whatever happened to the theory that we need fuel in the tank to support us during a real downturn? There is no evidence of a material slow down, so why is the Fed cutting? Let’s face it, the trade wars will end before the next Presidential election regardless of what deal Trump can secure - and when that happens, international trade will come roaring back and confidence will rocket – at that stage, the Fed will be forced to backtrack and shock the market. Do markets like reverses? Of course not.

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