It’s been a hectic week of central bank meetings, with the US Federal Reserve delivering some festive cheer in hinting that 2024 may well see several interest rate cuts
With the statement and press conference suggesting that ‘higher for longer’ will not prevail too far into 2024. The European Central Bank (ECB) and Bank of England (BoE) meetings sent a different message in terms of rates remaining on hold for an extended period.
The Federal Reserve meeting was much anticipated given the shift in market sentiment over the past six weeks with expectations building that the Fed was not only done in hiking rates but was soon to shift to an easing bias. This was the opportunity for the Fed to push back on that market thinking, and the fact that they chose not to do so was taken by the market as a signal that investors were correct to price in rate cuts next year. Rate policy for this meeting was unchanged but the Fed sent a dovish signal to markets via the ‘dot plot’ which indicates individual Fed members expectations of future levels of interest rates. The dot plot indicated the median level of expectation of 75 basis points of cuts over 2024, up from 50 basis points in the previous forecast. In itself this was not a huge shift, but the accompanying language was seen as confirmation the Fed is moving towards the market consensus on the path for rates, rather than persisting with ‘higher for longer’ Fed Chair Jay Powell noted in the press conference that participants no longer expected further rate hikes but did not want to take the possibility off the table. He said rates were “well into restrictive territory” and noted a “preliminary discussion” took place around rate cuts.
Powell also noted the Fed would need to start cutting rates “way before” inflation reached its 2% target because failing to do so could lead to an overshoot and slow economic activity too much. He said the Fed was “very focussed” on the risk of keeping rates too high for too long. This is a huge shift in language from a few months ago and is effectively calling time on ‘higher for longer’. While the jury is still out on the impact of rate hikes – given the lagged effect we still don’t know how much they will weigh on the US economy in 2024, it is clear the next move for the Fed is lower, and it won’t be too long before we see the easing cycle begin.
Equity and bond markets rallied on the news, with US treasuries seeing significant gains, and the US Dollar weakening sharply. Small cap stocks, to which we have significant exposure, led the equity rally. Markets are now fully pricing a 25 basis point rate cut next March, with a further 125 basis points of cuts expected over the course of the year. Hence the market is still ahead of the Fed in terms of how many rates we see next year, and that gap may need to be closed, but this meeting was a clear signal of a policy shift. We won’t know for a while if the Fed has pulled off an almost incredible ‘soft landing’ but that’s the market view for now, and this means risk appetite may well be robust until we see economic cracks emerging.
The Bank of England and European Central Bank failed to match the more dovish tones of the Fed but the more hawkish stance this side of the pond failed to derail the market mood. The BoE kept rates on hold at 5.25% but three monetary policy committee members voted to raise rates by 25 basis points, with the statement still saying monetary policy would “need to be sufficiently restrictive for sufficiently long” to bring inflation back to target. Governor Andrew Bailey pushed back on market expectations for a policy pivot, saying “we are more cautious because we need to see those more persistent elements of inflation, which we see in things like services prices, turn in the right direction quite decisively”. The European Central Bank also kept rates unchanged, and while they dropped the line on inflation staying “too high for too long” and trimmed their inflation forecasts, Bank president Christine Lagarde said “we should absolutely not lower our guard… we did not discuss rate cuts at all”.
The economic headlines have been dominated by the latest US employment report, with non-farm payrolls increasing by 199,000 in November, slightly ahead of expectations. The unemployment rate fell back to 3.7%. The continued strength of the US labour market gives weight to the ‘soft landing’ argument. That said, we should bear in mind that unemployment is a lagging indicator with companies reluctant to let go employees that they have struggled to hire in the post pandemic environment where there have been far more vacancies than potential employees. The temporary staffing data, which is a leading indicator, continued to deteriorate. The US inflation data published on Tuesday showed CPI at 3.1% year on year in November, unchanged from the previous month, with core CPI at 4.0%.
The slowing in the pace of easing in the inflation data may cause some concern, but the Federal Reserve appears relaxed in the knowledge that falls in housing costs should feed through to lower CPI prints in the coming months. The UK also saw unemployment data published and while payrolls as measured by HMRC fell by 12,000, the unemployment rate was unchanged at 4.2%. Vacancies fell back to 949,000, which is still well above pre-pandemic levels. Wage growth remained strong, and above inflation, at 7.3% year on year. More sobering was the UK GDP Data for October, which unexpectedly fell by 0.3%, led by weakness in the services sector. China reported the economy falling further into deflation, with prices dropping by 0.5% year on year, the biggest decline in 3 years. The annual Economic Work Conference failed to deliver any new stimulus initiatives from the Chinese authorities, but softness of economic data suggests that further stimulus may be necessary if China is to seek growth of 5% next year.
We have our monthly asset allocation meeting next week but the prevailing mood is not to stand in the way of strong risk appetite on the back of the signals from the Fed this past week. While we are already benefitting from this rally with our small cap and government bond exposure, we have added some risk to the portfolios this week by removing some of our futures positions. In doing so we have reduced our equity underweight back towards neutral, which means our market exposure is increased. We remain cognisant of the risks to markets posed by slowing earnings as economic growth weakens in 2024, but until we see more significant cracks in the economic data we need to be pragmatic. This means accepting that with the Fed moving closer to cutting rates, risk appetite is likely to be robust for some time yet, and we need to be flexible in our positioning given the expectation that markets that want to shift higher as the year draws to a close.
Next week is likely to be relatively quiet – though we do need to keep an eye on the Bank of Japan meeting for hints of policy change. There won’t be an update next Friday so this will be the final weekly commentary of 2023. We shall return in early 2024 with some thoughts on what is expected to be a very busy year but, in the meantime, on behalf of the Columbia Threadneedle Investments Multi-Manager team, I hope you, your families, and your clients have a very Merry Christmas and a Happy New Year.
Kind regards,
Anthony.
