Insights

Tactical Positioning Amidst Imminent Rate cuts in the US

Global equities began August 2024 with a sharp decline as a series of global macroeconomic risks unsettled markets, sparking a widespread sell-off. The CBOE Volatility S&P 500 Index (“VIX”), often referred to as Wall Street’s “fear index”, surged past the critical 65 mark on 5 August 2024 [1], an event that has only occurred twice before in history: during the 2008 financial crisis when it peaked at 89.53, and in March 2020 at the onset of the COVID-19 pandemic when it reached 85.47. This latest market turmoil has been driven by a confluence of factors: weakening economic and employment data stoking recession fears in the US, the unwinding of significant yen carry trades leading to widespread sell-offs, disappointing earnings reports and guidance from major tech companies undermining market sentiment, and escalating geopolitical tensions in the Middle East adding to investor anxiety.

Despite the rocky start to August 2024, global equities experienced a robust rebound by mid-month, recouping nearly all the losses incurred since mid-July 2024. Performance was driven by a series of positive economic indicators, including favourable data on producer prices, consumer prices, retail sales, and jobless claims, released throughout August 2024. These developments helped alleviate concerns of a market slowdown that had been ignited by the July 2024 jobs report. Notably, inflation metrics met or fell below expectations [2], initial jobless claims came in lower than anticipated [3], and the control measure of retail sales exceeded forecasts by threefold [4], providing a strong boost to investor confidence.

Rate cuts in the US now appear imminent. The minutes from the Federal Reserve’s July 2024 meeting revealed that a majority of officials are strongly leaning toward a rate cut in September 2024, with some even advocating for an immediate reduction in July 2024 [5]. This sentiment was further reinforced at the Federal Reserve’s annual Jackson Hole Symposium, where Chairman Jerome Powell signalled a shift in policy. In his address, Powell stated, “The time has come for policy to adjust,” and expressed growing confidence that inflation is on a sustainable trajectory back toward the central bank’s 2% target [6]. These remarks have solidified market expectations for imminent rate cuts.

Views on Equity

With a controlled economic slowdown and simultaneously declining inflation and thus an intact prospect of interest rate cuts, there continue to be a constructive fundamental backdrop in the US. Based on expectation of a cycle of interest rate cuts, we advise investors to position into interest rate-sensitive sectors such as real estate, utilities. Furthermore, we have observed that these sectors that are typically primed to thrive in a low-interest rate environment are currently under owned relative to historical norms. The current underweight positioning could present an opportunity for investors to capitalise on the potential for price appreciation and improved returns as market sentiment shifts and the benefits of a low-interest-rate environment become more apparent.

Amidst the recent volatility in the stock market, it is crucial to understand where the valuations stand for the stalwarts of the US stock market, The Mag 7. Across the 3 most common valuation metrics – P/E, P/FCF and EV/EBITDA – Mag 7 valuations are now 40% off the trailing 5-year peak, 3% below the trailing 5-year average, and 160% above trailing 5-year trough valuations (Table 1). Although the Mag 7 currently trade at a slight discount to historical valuation average, the stocks are not so cheap to put them in a “no brainer territory”. To mitigate risk and enhance potential returns, we continue to advise investors to diversify their stock portfolios beyond tech names by incorporating a mix of other sectors such as healthcare, consumer goods, and financial services.

Fed rate cuts and a weakening US dollar have historically been strong tailwinds for Asian equities. In the past six Fed easing cycles, the MSCI Asia ex-Japan index has delivered median returns of 10% in the 12 months following the first rate cut, with regional equities often outperforming the US when the dollar weakens by 5-10% [7]. We anticipate a similarly favourable economic environment this time, supported by strong earnings growth. Notably, around 60% of Asia ex-Japan companies have exceeded expectations midway through the second-quarter earnings season [8], further strengthening the outlook for the region’s markets. More specifically, we prefer lower-rate beneficiaries, including high-dividend yielders in ASEAN and Singapore Real Estate Investment Trusts (“REITs”).

Views on Fixed Income

Following Jerome Powell’s Jackson Hole speech, which cemented expectations for an interest rate cut in September 2024, traders are now pricing in 102 basis points of easing in 2024. This projection suggests rate reductions at every remaining policy meeting in 2024, including a potential jumbo 50 basis point cut [9]. With inflation rates in the US continuing to decline, the Fed is likely to shift its focus toward supporting economic growth. In light of this global rate-cutting cycle, we advise investors to prepare for lower rates. As the returns on cash diminish, the attractiveness of cash as an asset class is waning. Instead, we recommend that investors consider reallocating cash and money market holdings into high-quality bonds and diversified fixed income portfolios. These assets have recently demonstrated their value by cushioning the volatility in equity markets.

Although 10-year yields have already declined by nearly 90 basis points from this year’s peak, absolute bond yields remain at compelling levels, offering attractive investment opportunities. Historically, purchasing bonds one month before the first rate cut of a cycle has delivered nearly 300 basis points of excess return compared to waiting until one month after the Fed has begun cutting rates. We maintain our preference for investment grade (“IG”) bonds, given that the credit fundamentals on the US IG corporate side remain solid and expect limited credit quality deterioration.

Views on FX

In August 2024, the rapid unwinding of yen carry trades and proximity of the Federal Reserve’s shift to interest-rate cuts battered the US dollar, sending the world’s reserve currency slumping and igniting rallies in major peers around the globe. By 28 August 2024, the greenback had plummeted by 2.8 percent through the month, marking its steepest drop since November 2023 [10].

Meanwhile, Asian currencies rallied to their highest level in seven months as ebbing US recession concern, bets on Federal Reserve rate cuts in September 2024 and an improving domestic backdrop lifted sentiment in the region [11]. Singapore’s dollar advanced to its strongest in almost a decade as traders weighed the difference between the local monetary authority’s relatively hawkish policy outlook compared with that of the Federal Reserve [12]. The local dollar hit levels last seen in 2014 against the greenback and fluctuated around the 1.30 per dollar.

Here is our perspective on the currencies market:

• Japanese Yen (“JPY”): The majority of the fast money yen shorts have likely been fully liquidated, according to UBS [13]. In the near term, we expect yen to stabilise in a 143.50 – 149.50 range against the dollar. However, at the special parliamentary hearing on 23 August 2024, Bank of Japan Governor Kazuo Ueda stood by the decision to keep hiking rates if the central bank’s median economic forecasts were met or exceeded [14]. Over the longer term, as Japan’s economy continues to normalise, we expect USDJPY to decline.

• British Pound (“GBP”) & Euro (“EUR”): Swap markets are pricing in about two more 25 bps rate cuts from European Central Bank (“ECB”) and Bank of England (“BOE”) by end-2024, compared to 100bps for the Fed [15]. With narrowing yield differentials, we expect the pound and euro to gain grounds against the US dollar.
  
  
• Swiss Franc (“CHF”): Given the easing monetary policy stance from the Swiss National Bank, we continue to favour the CHF as a carry currency in the long term. Furthermore, we value the franc’s defensive qualities amid political uncertainty in the US.

Source:

[1] Wall Street’s famous ‘fear gauge’ isn’t what it used to be as funds shake off VIX spike (yahoo.com)
[2] Rate cuts likely as July CPI report shows lowest inflation in 3 years – The Washington Post
[3] Weekly jobless claims fall to 233,000, less than expected, in a positive sign for labor market (cnbc.com)
[4] US retail sales rise more than expected in July | Reuters
[5] Fed steaming towards September rate cut, minutes from meeting show – CNA (channelnewsasia.com)
[6] Powell says ‘time has come’ for Fed to cut interest rates | The Straits Times
[7] UBS Daily Outlook 26/08/24 – CIO
[8] Asian firms’ earnings outlook improves as chip sector shines | Reuters
[9] Bond Traders are Vindicated as Powell Sets Up September Fed Cut – Bloomberg
[10] US dollar advances on month-end demand; focus on economic data – CNA (channelnewsasia.com)
[11] Asian currencies hit 7-month high on ‘Goldilocks’ US scenario, led by ringgit and won | The Straits Times
[12] Singapore Dollar Trades Around 10-Year High on Policy Outlook (yahoo.com)
[13] ING sees limited movement in dollar amid bearish consolidation By Investing.com
[14] BOJ’s Ueda signals readiness to raise rates if growth, inflation on track | Reuters
[15] Monthly FX & Rates Strategy – UOB