Don’t fight the Fed

One of the most commonly accepted investment advice is “Don’t fight the Fed”, or any central bank for that matter. If the US Federal Reserve signals an interest rate hike, investors should look to lower risk assets. On the other hand, if the central bank sends a “cut” signal, it is time to increase your position in riskier assets.

And that is happening right now, reflected in the handsome positive returns from several asset classes this month. This is due to two important positive factors: the truce in the trade war between the United States and China, with new negotiations due to open on Tuesday, and signals from the Fed that it will cut interest rates. at its meeting next week, as the market desired. for.

The resulting positive sentiment led to greater liquidity in risky assets. As a result, many stock market indices, especially in the United States, are reaching record highs. In contrast, safe assets such as bonds also perform well. The bond yield is generally down (implying a higher price).

On the trade war front, we see a pause in tariff escalation between China and the United States as expected. The presidents of the two countries, who met briefly in Japan last month, realized that the two economies would suffer if Washington imposed tariffs on an additional $ 300 billion of Chinese goods this month, as threatened. earlier.

‘INSURANCE CUP’

On the rate cut front, despite the easing of trade tensions, the Fed chairman said “cut insurance” would help support the US economy. We are witnessing a global economic slowdown, as inflation is relatively low and events such as war, trade and Brexit threaten to affect the economy.

That said, we think the Fed’s decidedly accommodative stance indicates that it is listening to the financial sector. Although the US economic data remains strong, the Fed appears to have chosen to cut interest rates. This is to bring the inverted yield curve, a leading indicator of recession, back to a normal curve.

Currently, the yield on short-term three-month bonds (at 2.11%) is higher than the 10-year yield (at 2.08%). This indicates that the market perceives that the short-term financial costs are greater than the long-term inflation and the growth potential of the economy. In short, the bond market is telling the Fed that the interest rate is currently too high.

To correct this, the Fed must lower its key rate to restore economic confidence. This should lower the yield in the short term and increase the outlook for economic growth and inflation going forward, causing the bond yield to rise in the long term.

If the Fed justifies a cut using this logic, we think it may need to cut interest rates twice this year (bringing the Fed funds rate to a range of 1.75% to 2.00% ) to push the 3-month yield below the 10-year yield level.

DON’T EXPECT TOO MUCH

Nonetheless, even if interest rates start to fall, we believe investors should not expect too much from this stimulus. Indeed, the underlying fundamentals of the global economy are still facing the risks of the following factors:

End-of-cycle economic conditions (where growth tends to decline). Economic stimulus measures at such times will only moderately support the economy but cannot supercharge the economic engine;

Trade tensions and geopolitical issues are still looming on the horizon; and

The impact of lower rates is, in our view, already reflected in today’s asset prices. Therefore, the probability that prices will appreciate greatly may not be that high.

Nonetheless, we believe that investing in risky assets such as stocks is still worthwhile. An increase in liquidity due to falling interest rates will cause prices to rise relative to the multiple price / earnings (P / E) of stocks.

However, given today’s relatively high valuations, combined with an increasingly fragile global economy, we advise investors to carefully select assets with strong fundamentals. In the medium to long term, we always recommend investing in the US, Chinese and Thai stock markets.

As for bonds, we think they are still quite expensive. Therefore, we recommend investors to underweight bonds in their portfolios, but overweight corporate bonds with good credit.

In the commodities markets, we recommend increasing gold holdings to avoid the risk of increased economic uncertainty. The price of gold normally has a good chance of recovering in a situation where the real interest rate is falling, as we see today.

In short, given the fragility of the global economy but the abundance of global liquidity, what should investors do? The answer is in the title of this article.


About Rodney Fletcher

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