Understanding the Fed's rate cut: How should we allocate our investments?

No wonder the Federal Reserve, which has been dominating financial headlines for years, thinks the gimmick of the first rate cut in four years is not enough and wants to give the market a big one-time satisfaction.

On the 18th local time, Federal Reserve Chairman Powell announced a 50 basis point cut in the benchmark interest rate target range to 4.75%-5%, the first rate cut by the institution since March 2020. It is worth mentioning that such a large rate cut is very rare at the beginning of a rate-cutting cycle in history. Since the 1990s, there have been only three such instances: January 2001, September 2007, and March 2020.

Without exception, these three were either responses to major crises or precursors to major crises.

For this reason, Powell is really trying to justify himself from all angles this time and also sending hawkish signals to the market. He said that launching its historic tightening policy with a major move while the U.S. economy remains strong will help limit the possibility of a recession; but he also cautiously admitted that the Federal Reserve may not necessarily take similar steps in the future, depending on subsequent economic data performance.

To sum up, Powell's series of operations is "actions speak louder than words, but the mouth still has to be reserved." Although he has already given the market the largest expected rate cut, he still insists on a cautious outlook for the future. This "split," or somewhat tangled attitude, is actually the key signal of this round of rate cuts.

An obvious signal is that Federal Reserve Governor Michelle Bowman voted against the 50 basis point rate cut, the first "dissent" in a Federal Reserve rate-setting meeting since 2005. Clearly, there is a lot of disagreement both in market expectations and within the Federal Reserve over whether to cut by 25 or 50 basis points. The post-rate-cut trend of first rising and then falling across the asset side also reflects that, although it is a long-awaited large rate cut, the risk of a U.S. economic recession has not been ignored by the market.

Therefore, major assets such as U.S. stocks, U.S. bonds, and gold will still be dominated by volatility. Comparatively, before a U.S. economic recession is confirmed, U.S. stocks will perform relatively better. On the periphery, property stocks in the AH market have finally got a breather, while tech stocks have been troubled by liquidity, becoming a rare valuation 洼地 for tech themes in the global market, and will perform well in the short term.

01 A Tangled Rate Cut

Starting with the keyword "tangled" for this rate cut, we can better understand the current macro environment in the U.S. and the possible future path of rate cuts.

Nasdaq Index Trend

In early August and early September this year, U.S. stocks experienced two major plunges, with the bubble anxiety accumulated behind the surge in the first half of the year erupting. Behind this, apart from so-called arbitrage trading, the bad signals shown by the U.S. economy brought back the discussion of soft landing versus hard landing. Anxiety about the macro environment became the main bearish factor in these two plunges.

And this bad signal is actually employment.

Average wages and unemployment rate, source: U.S. Bureau of Labor Statistics, Bloomberg

According to data from the U.S. Bureau of Labor Statistics, both average wages (first row) and unemployment rates (second row) have deteriorated in the first half of 2024. Among them, the average wage in March was the lowest since mid-2020, and the broadest unemployment rate was the highest since October 2021. Moreover, the U.S. unemployment rate in April and May reached the trigger line of the "Sam Rule," which, based on historical data, is considered a precursor to an economic recession.

After a series of bad labor market data releases, price data is no longer so eye-catching. In August, more than 50% of the categories in the total market basket and core market basket had annualized monthly inflation rates below 2.5%, and the core commodity price index had returned to mild deflation. It can be said that inflation is no longer the core factor troubling the U.S. economy.

As the central bank of the U.S., the Federal Reserve's primary concern is not inflation but the macro economy; whichever data has a greater impact on the macro economy and is more 直观， the Federal Reserve will use it as the basis for action. After the U.S. massive monetary easing in 2021, this data was the price index; for a considerable period after this year, this data is labor.

However, unlike price data, although labor data reacts more 直观 and timely to the macro economy's rise and fall, it is not an ordinary mirror but a multifaceted "kaleidoscope." Different statistical calibers can lead to vastly different conclusions.

For example, on August 21 this year, a report disclosed by the U.S. Bureau of Labor Statistics showed that in the year from April 2022 to March 2024, the U.S. economy created 818,000 fewer jobs than initially reported. Actual job growth was nearly 30% lower than the initially reported 2.9 million, the largest revision since 2009. Real-time employment data can easily mislead decision-making and even have the opposite effect.

Since this major downward revision of employment data, the market has begun to question the Federal Reserve's failure to cut rates in time. Labor market figures show that the U.S. economy is far less optimistic than previously disclosed, and indicators such as the unemployment rate suggest a risk of entering a recession.

However, observing employment data from another perspective may lead to completely different conclusions.

Sam Rule Trigger Line

According to the Sam Rule, if the three-month moving average of the unemployment rate is 0.5 percentage points or more higher than the lowest point in the past 12 months, it indicates that the U.S. economy may have entered or is about to enter a recession. However, the red line in the above chart shows that employment in the primary working-age group of 25 to 54 years old is very strong, completely opposite to the trend of the Sam Rule trigger line.

According to data from the U.S. Bureau of Labor Statistics, the employment rate for the primary working-age group of 25 to 54 years old is very close to the historical high in the U.S.—the end of President Clinton's term, when there was no doubt about a recession in the U.S. economy. Therefore, from the perspective of the primary working-age population, the U.S. has no recession worries, and the Federal Reserve has no need for a large short-term rate cut.

Thus, behind the Federal Reserve's tangle is the shift in primary reference data from the price index to employment. The multifaceted nature of the latter makes it difficult for the market and the institution itself to have a consistent judgment on the macro economy, leading to internal contradictions in the Federal Reserve not seen in nearly two decades.

Looking ahead, each subsequent rate cut is likely to repeat the tangle of this one until new data emerges that allows the market to form a relatively unified judgment on the macro environment.

02 How Will Assets Perform

In essence, a 50 basis point starting rate cut is relatively rare in history. In the short term, it will make the market worry whether the U.S. economy is facing major difficulties that require such a large easing to rescue. Therefore, in the short term, safe-haven assets such as U.S. bonds and gold still have good room for growth, as do small- and mid-cap stocks (such as the Russell 2000), banks, property, etc., as well as U.S.-listed Chinese stocks and Hong Kong tech stocks.

But if analyzed carefully, different assets will perform differently under different forms of rate-cut paths. Therefore, to understand future asset trends, we first need to understand the path of rate cuts.

Market and policymakers' interest rate forecasts, source: Bloomberg

After the Federal Reserve signaled a 50 basis point rate cut, the market began pricing in another 70 basis point cut by the Federal Reserve at the remaining two meetings this year, while according to policymakers' forecasts, 2024 will see only a further 50 basis point easing. This reflects that the market's stance is much more aggressive than that of policymakers, and its worries about the economic situation are much higher than those of policymakers.

In addition, the overall rate-cut path shows a typical "fast first, slow later" trend. The market expects the Federal Reserve to cut the policy rate to the 4%-5% range this year and quickly 探至 3% 以上 by the third quarter of next year. This means that by the third quarter of next year, the market expects the Federal Reserve to cut rates by a total of more than 250 basis points, bringing the policy rate back to around 3% in a short time.

Of course, you can interpret this as the market having very poor expectations for the future economy; but such a large rate cut also reflects, on the other hand, that the Federal Reserve will use "thunderous means" to avoid a hard landing for the U.S. economy.

After announcing the rate cut, Powell made it clear that this decision was not a rate cut in response to a crisis, but a "loosening" of monetary policy from an extremely tight state back to normalization, while still not ruling out the possibility of further adjusting policies based on future economic trends. Given that both the market and policymakers expect further rate cuts, some interest-rate-sensitive risk assets are likely to lead during this period.

For U.S. stocks themselves, small-cap stocks, value stocks, and cyclical stocks, property stocks, and bank stocks that benefit from rate cuts will perform relatively well after the rate cuts begin. For other assets, such as crude oil and copper, which benefit from rate cuts but have performed poorly recently, there is a high probability that they will regain momentum and have a good run.

Traditionally, safe-haven assets such as U.S. bonds and gold perform well at the beginning of a rate-cut cycle. However, as the market has already fully priced in the rate cuts in the previous period, and concerns about the U.S. economy have eased somewhat after the 50 basis point rate cut, although there is still room for 上涨 after the rate cuts begin, their performance and elasticity will be weaker than the aforementioned risk assets.

Of course, a very important topic is how large-cap tech stocks with high weightings in the Nasdaq, such as NVIDIA and Microsoft, will react to the current rate-cut environment. In our view, this is an excellent opportunity for sector rotation. Large-cap tech stocks still have fundamental support, but in the short term, taking profits in these sectors and switching to more interest-rate-sensitive small-cap stocks will be the choice of many funds.

Compared to large companies, small companies generally perform poorly in high-interest-rate environments because their debt levels are generally higher than those of large companies, and they rely more heavily on floating-rate loans. Cheaper financing and better returns may boost their fundamental performance and thus their stock prices.

In addition, in contrast to U.S. large-cap tech stocks, Chinese tech stocks have performed relatively poorly for most of the period from 2023 to the present, and only this year has there been some degree of valuation 回归. But compared to the quality of these companies' performance, the current valuations are generally still relatively low, especially for Hong Kong stocks, which are more sensitive to external liquidity, and their elasticity will be greater than that of A-shares. Companies such as Alibaba, JD.com, and Tencent, which still have good fundamentals, will be good investment targets.

Of course, the real factor that can further warm up the stock market is whether domestic liquidity can be further released. The U.S. has already set a good example. Further easing will not only push up the stock market but also boost overall market confidence. For China, the effect of external easing will truly achieve all-round 信心好转 only with support from its own policy side.

03 Conclusion

The era of rate cuts has begun, and global asset allocation will enter a redistribution phase. During this period, how to allocate investments and further optimize the current investment structure is something every rational investor needs to 深思熟虑。

It must be emphasized here that the 盲目 belief that external easing will inevitably lead to hot money flowing into the AH market and that we can lie back and enjoy the 上涨 without doing anything extra is already outdated. Nowadays, for most foreign capital, emerging markets are not just China; India, Vietnam, Brazil, South Africa, etc., all economies are looking forward to welcoming funds flowing out of the U.S.

"To forge iron, one must be strong oneself." From a national perspective, the initiative in economic development must be in one's own hands, and relying on other countries can only be a drop in the bucket. From an investment perspective, it is essential to choose those "good companies" that can continuously create growth and 盈利动能 regardless of changes in the external environment. $JD-SW(9618.HK) $BABA-W(9988.HK) $TENCENT(700.HK)

Disclaimer: This article is for learning and exchange only and does not constitute investment advice.