Transcript
Amada Agati:
October heralds the beginning of my favorite season, with its changing leaves, plentiful pumpkin spice lattes, Saturdays packed with college football, and did I mention falling interest rates? In this month's "Adding Alpha", we fall into the Fed's first rate cut of the cycle and share some insights into what it means for financial markets.
After months of speculation and angst among investors about the expected start of interest rate cuts, the Fed finally delivered in mid-September with a 50 basis point cut.
Ahead of the FOMC meeting, there was a strong consensus that a rate cut would finally happen, but market sentiment was divided into two camps, one that expected a 25 basis point rate cut and one that expected 50.
Those expecting a smaller cut viewed a change in policy as a nod toward the Fed's progress on inflation and a return to pre-pandemic economic trends, while hopes for a larger cut stemmed more from recent labor market weakness.
Ultimately, the Fed took the more aggressive approach with a 50-basis-point cut. However, it was not accompanied by a bearish economic outlook. Instead, Fed Chair Powell described the action as a recalibration of monetary policy.
The Fed also updated its dot plot, which shows individual policymakers' expectations for the future path of interest rates. While the long-run median expected Fed funds rate was similar to the last dot plot in June, their revised estimates suggest a faster pace to get there.
With a rate cut now official, as well as confirmation of the Fed's plans to continue rate cuts into 2025, we expect financial conditions to continue to ease from here.
Financial conditions have actually been easing since last October, when the Fed first signaled its openness to thinking about, cutting rates. Meanwhile, the Fed's $7 trillion balance sheet and permanent repo facility should continue to provide a strong liquidity backstop for global financial markets.
Just like a venti PSL, there's a lot to digest from the Fed's recent update. The key takeaway is the Fed appears to recognize that recent changes in economic data reflect more of a normalization back to pre-pandemic trends, rather than a case where economic growth is falling fast, like the leaves off the trees.
In terms of the equity market reaction to the Fed's announcement, the rate cut has boosted investor sentiment and supported valuations. In fact, US large, mid, and small cap price-to-earnings ratios are all back up to 12-month highs. In fixed income markets, clearly long-term rates didn't get the message that it's fall season. Instead, the 10-year Treasury yield has risen by 10 basis points in the week since the FOMC meeting.
To us, this suggests the market is finally on the same page as the Fed in terms of its view on the business cycle. While that's fine for the short term, in order to get sustainable market appreciation we still need to see supportive monetary policy flow into a broader earnings growth acceleration beyond a small subset of mega cap tech companies.
Inflation is still elevated and if long-term interest rates stay higher due to positive economic data, then companies will need to prove they warrant their premium valuations by growing sales organically and expanding profit margins.
Until then, we are continuing to opportunistically focus on quality-oriented equity and fixed-income exposures. The 50 basis point rate cut was a welcome surprise to jumpstart the recalibration of monetary policy, but it needs to flow through with a recalibration of the business cycle, too. We hope to get more insight into that, as, believe it or not, third quarter earning season will ramp up in just a few short weeks.
Stay tuned.
