Seema shares her global markets outlook for the second half of the year following the recent Fed meeting.
Although the timing remains uncertain, investors can derive three key insights regarding the Fed’s outlook:
- Recent consumer and labour market survey data suggest that the next policy move will be a cut, not a hike.
- With just four FOMC meetings remaining in 2024 and inflation still above the Fed’s comfort zone, markets are unlikely to get more than two policy rate cuts this year.
- While inflation is likely to decelerate, the economy’s underlying strength, geopolitical tensions and several structural drivers argue against a meaningful drop in inflation. This is shaping up to be a short and shallow cutting cycle, with rates very unlikely to approach the zero bound.
A cooling U.S. economy…
2024 began with a burst of optimism. The U.S. economy seemed poised for further robust growth, inflation appeared on a clear downward path, and the Federal Reserve (Fed) was set to complement the picture with rapid and aggressive policy rate cuts. Risk assets, unsurprisingly, saw one of their strongest first quarters since the pandemic.
But since the first quarter, the economic landscape has deteriorated. U.S. economic growth halved in 1Q from the previous quarter, inflation has shown renewed strength, and market expectations for Fed rate cuts have plummeted from seven to barely two rate cuts by the end of 2024. So, while risk assets have continued to deliver positive gains, their upward trajectory has been interspersed with occasional pullbacks.
With markets losing some of their gleam and unrestrained optimism fading, a pressing question looms: can risk assets sustain their rally?
After an impressive acceleration in 2023, U.S. economic activity is now cooling. Pockets of weakness in the consumer are beginning to materialize and recent labour market surveys suggest some underlying softness is starting to develop. Interestingly, growth is only slowing very modestly—by and large, the resilience narrative remains intact.
The downshift in growth is not unexpected—tighter Fed policy was always going to inevitably weigh on various segments of the economy. In particular, lower income households have been the most vulnerable. Not only have they borne the brunt of elevated prices, but many have missed out on the significant wealth gains stemming from higher stock prices and higher home prices, as well as the rise in passive income that higher interest rates on savings and deposit accounts bring. As a result, many lower-income households have almost exhausted their excess savings, increasingly forcing them to borrow to fund their purchases. And with interest rates soaring on credit cards and auto loans, delinquency rates are now rising. Recent corporate earnings guidance has provided evidence of strains, with U.S. consumers extending their shift toward more deliberate value-focused spending and lower cost point retailers.
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The labour market is also showing signs of rebalancing. While overall jobs growth is undoubtedly solid, averaging 250,000 in the past three months as of May month end, surveys clearly indicate waning labour demand and deteriorating job security among employees. This trend is particularly evident among smaller businesses, where high input and wage costs have made it more difficult for them to hire new employees, leading many business owners to reconsider their hiring plans. At the same time that labour demand has been slowing, there has been a significant increase in labour supply due to a surge in immigration. As a result, new entrants into the job market are finding it increasingly difficult to secure employment.
… yet still a solid economy
It is important not to exaggerate the pockets of U.S. economic weakness. While lower-income households are showing strains, middle- and higher-income households, who are responsible for most consumer spending, remain in good shape. Indeed, most households were able to lock in low mortgage rates during the years before inflation began to surge and Fed policy was tightened. Coupled with gains from property and equity market exposure, broad household balance sheets have remained strong.
Equally, while small business confidence is struggling, large business confidence continues to move from strength to strength. Furthermore, as a record number of companies chose to issue/refinance their debt when rates were low in 2020 and 2021, interest payments by nonfinancial corporations, as a percentage of profits, have actually fallen to the lowest levels since 1957. With still-healthy profit margins, the prospect of mass job layoffs across the economy is highly unlikely.
The Fed’s dilemma
From an inflation perspective, slightly cooler economic growth and an improved labour demand/supply balance should lead to a softening in wage growth. It is doubtful that there will be enough of a softening to bring inflation all the way down to the Fed’s 2% target, but potentially enough to unwind the fears surrounding the series of upside inflation surprises in 1Q24. Once inflation is moving sustainably toward the 2% target, the stage will be set for the Federal Reserve to finally start reducing rates.
Nevertheless, the timing of the first Fed rate cut remains a difficult question to answer. The uncertainty surrounding the “last mile” of progress for stubborn and sticky inflation undoubtedly complicates the Fed’s decision-making, as does the continuing strong U.S. jobs growth. Even with a slight downshift in economic activity and with the soft May inflation print, it is not obvious that the economy requires policy easing, and it is no wonder policymakers have been steadfast in communicating their patience with their current policy stance.
