This September, the US Federal Reserve (Fed) cut its benchmark interest rate by half a percentage point. Following the cut, the central bank signalled there was more to come.
The first cut in four years, the action marked the end of an unprecedented tightening cycle. Between March 2022 and July 2024, the Fed lifted rates from near-zero to a range of 5.25–5.5% to combat spiralling inflation.
Many economists and strategists were taken by surprise, as the cut went deeper than expected. They’d expected the Fed to start with a 0.25 percentage-point reduction, firing the starting gun for progressive easing of around 2% over the remainder of 2024 and into 2025.
Why is this jumbo cut significant?
So why is this deeper-than-expected cut such a talking point?
Firstly, it’s unusual to see ‘emergency style’ monetary policy when the US economy isn’t in recession. US growth is positive. Far from contracting, an annualised rate of 3% GDP growth is in line with the US’s economy’s long-term trend. Meanwhile, consumer confidence surveys are positive, and inflation is moving closer to the Fed’s 2% target. Headline inflation is currently at 2.5%, compared with a post-pandemic high of 9.1%.
Secondly, while lower interest rates usually help boost the labour market by reducing the risk of redundancies and providing greater job security, there are interesting dynamics surrounding increasing US unemployment. Unemployment is up slightly, at 4.2% compared with a 50-year low of 4%. But rather than a result of mass lay-offs, this pickup mainly comes from more people entering the labour market (including many who retired early post Covid and want to reverse this decision).
Is this a pre-emptive strike?
With this supportive economic backdrop, the Fed appears to have initiated a pre-emptive strike to stabilise the economy. With inflation nearing the 2% threshold and interest rates at 5.5% at the upper end, interest-rate policy in real (inflation-adjusted) terms could possibly prove too restrictive.
Interest-rate changes can take time to show their impact. Armed with evidence of weaker labour numbers, the Fed opted for a decisive cut to get ahead of future weakness and engineer a so-called ‘soft landing’ – decelerating growth and relatively benign inflation, while maintaining a robust employment backdrop.
What does this mean for your portfolio?
In this environment, we believe there are a broad range of compelling investment opportunities. Broadly, our models currently favour neutral risk assets and are overweight to government bonds. However, we continue to monitor and rebalance portfolios to ensure consistent, risk-adjusted outcomes for investors.
Here’s how we believe key asset groups are affected:
- Equities: opportunities for smaller companiesThe rate cut was well received by markets. US companies continue to display very attractive profit margins, and there are tentative signs of earnings upgrades broadening out from the ‘Magnificent Seven’ technology stocks that made such huge gains in 2023. As we anticipate lower economic growth into 2025 (as opposed to outright contraction), there could be benefits for other businesses too. Small and mid-sized companies are anticipating some relief from lower interest rates, which should benefit them even if the US economy slows down.
- Infrastructure: supportive for rate-sensitive parts of the portfolioRate-sensitive assets such as global listed infrastructure and global real estate investment trusts (REITS) were among the best performers in August, as it became clearer that rate cuts were on the horizon. While it’s unlikely that gains on this scale will be repeated, the backdrop for these asset classes – which play an important role in portfolio diversification – is supportive.
- Bonds: new rate environment a positive2024 was billed as the ‘year of the bond’ amid forecasts of decelerating inflation and interest-rate cuts. So far, government bonds haven’t lived up to this, with muted returns over the year. Inflation has proved stubborn, and rate cuts from the European Central Bank and Bank of England are more a result of inflation moving gradually towards target than a resounding ‘mission accomplished’. However, returns picked up from August, benefiting lower-risk portfolios. As long as inflation stays within range, the Fed’s commitment to easing means a positive environment for bonds. With a ‘soft landing’ finely balanced, maintaining an overweight to bonds is a useful hedge for investors. in case a growth shock tips the economy into recession. In the meantime, a solid income stream provides a good cushion across the portfolios.
The beginning of the end
The Fed’s first rate cut marks the ‘beginning of the end’ of the latest tightening cycle. We believe the current backdrop should prove favourable for risk assets, but success still rests on a razor’s edge.
As we optimise and continually monitor investment opportunities that provide consistent, risk-adjusted outcomes for our clients, we are still taking a conservative position compared with our long-term average.
Our dedicated investment team’s focus is to anticipate, monitor and respond to the changing economic conditions and market events. With their experience, we’re able to harness the power of institutional-grade investment capability to deliver superior client outcomes.
abrdn Portfolio Solutions Limited offers a range of portfolio strategies for adviser firms, with a choice of management styles and risk levels to meet clients’ investment needs. To find out more, go here.
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The views expressed in this blog should not be regarded as financial advice.