The FOMC met 30-31 July and announced a rate cut of 25 basis points. This is the first rate cut by the Federal Reserve since 2008. For financial markets the fly in the ointment was Chair Powell’s observation that the move was a “mid-cycle adjustment in policy” rather than the first in new cycle of rate cuts.
Exhibit 1: US Federal Reserve announces the first cut in its key federal funds rate since the financial crisis in 2008
Source: Bloomberg and BNPP AM, as of 01/08/2019
The rational for this rate cut
We continue to believe that the Fed is sending a clear message about its concern over stubbornly low inflation rather than immediate domestic growth concerns, albeit they did stress external growth risks. Distinguishing between these two drivers is absolutely key. Our analysis suggest that when growth concerns are the trigger for Fed easing (as was the case in many prior rate-cutting cycles), risk assets tend to do poorly and safe-haven assets rally. If, on the other hand, Fed dovishness is more of an ‘insurance’ move, the market outlook can be very different.
In Exhibit 2 we highlight equity market returns in historic episodes when the Fed was dovish, but data weakness was confined to manufacturing, with the services sector robust. In our view, the historic take-away is clear, if – as we believe is currently the case – Fed easing should be viewed more as an “insurance cut” against the backdrop of a still robust domestic economy, equity markets (and the economy) can continue to perform well over the medium term.
Exhibit 2: In times when the Fed turns dovish as ‘insurance’ equity markets can perform well
Source: Bloomberg and BNPP AM, as of 31/07/2019
That said, the tactical short-term risk-reward has started to look less attractive in equities, as markets have priced in a lot of good news. We have thus taken profits on our equity overweight, but remain buyers on renewed dips given the medium-term backdrop detailed above.
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