The US economy recently recorded the 121st month of economic expansion, the longest on record. The US unemployment rate at 3.7% is at a 50-year low while the US consumer confidence is high. This should help drive consumption, which is the largest driver of the US economy. Despite the low unemployment rate, inflation seems well contained.
On the face of it, this is a 'Goldilocks economy'. The expectations of a rate cut by the US Federal Reserve appear counterintuitive. However, the economic outlook for the coming year is more nuanced. The case for loosening monetary policy is driven both by uncertainties. In the US as well as global economic outlook, it is important to remember that the US Federal Reserve has a dual mandate, targeting inflation as well as unemployment rate.
To understand the impact of a rate cut, one must understand why the US Federal Reserve may cut rates. One of the most frequently watched in the US is the yield curve (the difference between the 10 year and 2 year rates). The yield curve has flattened considerably and is a cause for concern. Similarly, the US ISM manufacturing indicates that the US economy is losing momentum. The most recent GDP data shows that the US economy grew at an annualized pace of 2.1% in Q2, down from 2.9% for 2018. A countercyclical policy would begin easing monetary policy a bit before the peak of the business cycle, since monetary policy works with a lag of six to 12 months.
The US Federal Reserve is concerned about the global economy on account of the spill over it can have on the US economy. The Chinese economy has slowed down since early 2018, even before trade wars started. It recently recorded the lowest growth rate in 30 years at 6.2% for Q2 CY2019. A weakness in China can impact the US as well. Trade wars have increased uncertainties for the global economy.
In this backdrop, the market has priced in a 100% probability of a 25 basis points cut at the Fed meeting later this month. However, the probability of a 50 basis points cut has dropped from 48% a month back to 17% now. OIS curves indicate that Fed Funds rate could drop to 1.74% by the end of the year, and 1.395% by end of 2020. The quantum of cuts expected by money markets over the next year is significant. There are market participants who expect the Fed to halt its balance sheet reduction program, and if needed embark on a round of quantitative easing.
If the low probability event of a no cut were to materialize, financial markets reaction would be painful for investors of all asset classes. One can expect a 25 basis points rate cut later this month. The pace and quantum of future cuts is uncertain, but the easing bias is likely to continue.
Action by the US Federal Reserve would impact the world economy and world asset markets. Beginning of a rate cut cycle in the US could potentially restart a reflation trade in risky assets. However, it is dependent on a steepening of the yield curve. This would firstly be good for economic growth as it would enable financiers to borrow short and lend long. Credit growth and corporate earnings growth in the US would get a boost that would increase the attractiveness of US equities. A steepening yield curve is good for banks, and should be reflected in their stock prices. Cyclical sectors like consumer discretionary, industrials, real estate could benefit as well.
The impact wouldn’t be limited to the US alone. The average US investor is the marginal investor and their investing decisions impact the direction of global capital flows. A looser monetary policy in the US would result in depreciation of the US dollar, thus increasing the attractiveness of investing overseas. Commodity prices can also rally in such an environment.
Markets with strong structural growth stories like Indonesia, India and Philippines are likely to benefit. Also, countries with a current account deficit could gain. Capital would flow to emerging markets both in fixed income as well as equities. However, one consequence could be the appreciation of their currencies, which can impact their trade competitiveness.
Increase in capital flows can help improve economic growth prospects, and therefore emerging markets are likely to grow faster in the coming quarters compared to the baseline scenario. In case the inflows are very high, they can cause overheating of these economies. However, the probability of such a scenario is low.
World growth prospects should look better by the end of the year, though we would caution that on account of structural weakness in economies like China, the world economy may not expand at the same rate as 3.8% in 2017. However, the prospects for 2020 look brighter. (The author is CEO - Stock Broking, Karvy)