Identifying opportunities within the easing cycle

After holding interest rates steady for more than a year, the US Federal Reserve (Fed) finally delivered the interest rate cut investors had been so eagerly awaiting. Moreover, the Fed opened proceedings with a super-sized 50 basis point cut. And according to many forecasters, in doing so, all but confirmed a soft-landing.

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To be sure, a soft landing remains our base case, and by delivering faster reprieve to the US economy, the Fed has increased this probability. Nonetheless, challenges remain, and a soft landing is not yet guaranteed.

Still, the global easing cycle is now officially underway, with the US central bank joining developed market peers including the ECB, BoE, the RBNZ and the Swiss National Bank in delivering interest rate reprieve. Pleasingly, rate cuts have been delivered against a macro backdrop that while undoubtedly soft, has yet to deteriorate completely. While Europe, Japan, Australia, and the UK are all close to, or have briefly entered technical recession; so far, the damage appears contained. Remarkably, following weaker first quarter growth, the Atlanta Fed’s GDP tracker points to annualised third quarter GDP growth of 3 per cent – the same as the quarter prior, where improvement was driven by a pick-up in consumer spending and business investment.

Indeed, a closer look at the macro shows why investors have cause for enthusiasm. Inflation has largely returned to or appears sustainably on its way towards target across most developed markets; at the same time, labour markets have remained resilient with unemployment sitting below the 20-year pre-pandemic average across most major economies. Lower interest rates, and healthy labour markets should bode well for consumer spending, and by extension corporate earnings and equity markets.

Still, there are challenges ahead. Geopolitical tensions in the Middle East and Europe, civil unrest in the US and economic uncertainty in China are all possible headwinds for risk assets.

Furthermore, while labour markets currently appear healthy at the surface level, some lead indicators paint a more concerning picture. Pandemic aside, US temporary employment has fallen to its lowest level in almost a decade. Moreover, the three-month average unemployment rate has risen by more than half a percentage point from its previous 12-month low, triggering a recession indicator known as the Sahm rule; once the Sahm threshold has been breached, unemployment has historically risen sharply.

The Sahm rule has historically signalled recession

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Then of course the November US election shapes as a further source of volatility for markets – both in the lead up and immediate aftermath. Rather than position for a binary outcome, we instead look for pockets of volatility as an opportunity to adjust portfolios.

Now that an easing cycle has commenced, provided fundamentals remain sound, we expect to incrementally add risk to portfolios over the coming months.

And fundamentals are an important qualification. An easing cycle alone does not translate to higher equity market returns. History shows that over the past 50 years, on average the S&P 500 bottoms some 200 days and more than 20 per cent lower following the first rate cut. Moreover, on average, earnings decline more than 10 per cent in the 12 months following the commencement of an easing cycle.

However, a closer look at the past five easing cycles offers some hope that if a soft landing can be delivered then equities may continue to climb the wall of worry.

Like today, the 1995 soft landing also followed a 20 per cent climb in US shares over the 12-months prior. Perhaps more importantly, earnings remained robust in the 12-months following the cut, helping to drive further gains.

As we have been speaking about for some time, this cycle is like few that have preceded it. Where previous rate hiking cycles have been induced to curtail growth – and the subsequent easing cycle to resuscitate it – this cycle has been driven by a need to tame inflation.

Given the resilience of the economy to this point, it is therefore not unreasonable to suggest that earnings can continue to grow.

Easing cycles aren't always conducive to equities

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While we point to previous periods to demonstrate the potential for equities to continue climbing during this easing cycle, we believe investors will need to be selective when deploying capital.

Looking ahead we continue to place a strong importance on equity market valuations, and this informs our positioning both now and as we look to add risk in the months ahead.

The broader US market appears expensive from both an outright and historical perspective, as does the Australian market. In the case of the latter, we expect earnings growth to be modest and position with a mild underweight as a result.

In the case of the US, as 1995 demonstrated, expectations of double-digit earnings growth are not unreasonable should a soft-landing be achieved. Nonetheless, analyst expectations of more than 15 per cent earnings growth are too rich for our liking; US shares appear priced for perfection and susceptible to larger pullbacks in the event of an earnings miss.

Instead, European shares – where we already hold a modest overweight – and where valuations are cheaper on both a historical basis and relative to the US, remain our preferred tactical trade. Similarly, the earnings outlook appears favourable for Japan, and should the yen find some stability this may offer attractive entry points in the months ahead.

What this means for our diversified portfolios

Over the quarter, we made tactical changes to reflect this sentiment, including a reduction in our broad unhedged global equity exposure, with the proceeds invested in European shares and hedged global equities – taking our currency positioning back to benchmark.

Across broader emerging markets, valuations remain attractive, but with continued economic uncertainty in China, following the recent stimulus announcements and subsequent rally, we took the opportunity to close our modest overweight to Chinese shares. We remain at benchmark to emerging markets overall.

Across fixed income, we have reduced our underweight to high yield credit, though remain mildly underweight. Investment grade and sovereign bonds remain our preferred exposure across portfolios, and we hold a modest preference for long duration assets as a continued hedge against recession risks.

Elsewhere, the outlook for gold appears favourable, with geopolitical risk and falling yields acting as potential tailwinds in the months ahead.

Overall, we remain defensively positioned across portfolios, with our modest overweight to equities offset by our mild overweight to duration. In the near-term, the addition of further portfolio risk would likely be accompanied by a similar lengthening in duration until such time as we have greater conviction that the soft-landing will be delivered, and near-term volatility has subsided.

With the easing cycle underway and an expectation that seasonality may soon prove favourable, we look ahead to the final quarter of the year with a constructive view for risk assets and towards 2025 with a healthy level of excitement.