With the Fed likely holding rates higher for a bit longer—but signaling cuts ahead—and with the US economy on course for a soft landing, thier investment outlook remains unchanged after the FOMC meeting. (UBS)

The FOMC statement was changed to remove the tightening bias as the committee judged that risks to achieving its employment and inflation goals are moving into better balance. Fed Chair Jerome Powell added that “rates have likely met a peak” and opened the door to rate cuts.

But equities fell and expectations for a first cut in March were reduced after the FOMC said rates would not be lowered until it had gained greater confidence that inflation is moving sustainably toward its 2% target. At the press conference, Powell said a March cut was “unlikely.” The S&P 500 declined 1.6% on the day to 4,846, 85 points away from its all-time high.

We believe the market is still too optimistic about the timing and pace of easing, with around 140 basis points of cuts still priced in for 2024 and a 37% probability that the cuts will begin in March. Our base case remains that the Fed will reduce rates by 100 basis points in 2024, most likely beginning in May and depending on the data. To keep the Fed on track for 100 basis points of cuts or more, economic data need to cool further, in our view.

The FOMC wants more evidence inflation is falling sustainably. Core PCE data has cooled from the peak, and on a six-month basis is close to the Fed's inflation goal. Yet the Fed said it “does not expect it will be appropriate” to cut rates until it “has gained greater confidence” that inflation is moving sustainably toward 2%. An update to the FOMC's Summary of Economic Projections will be made at the March meeting, with Chair Powell noting that the inflation forecasts are likely to be lower than those presented in December.

The still-strong US labor market is slowing. The Employment Cost Index report for the fourth quarter of 2023—a data series the Fed watches closely—showed wages and salaries for private industry workers rose at the slowest pace since 2020, and edged closer to the average seen between 2010 and before the start of the pandemic. While employment costs are heading closer to levels compatible with the Fed's inflation target, wage growth remains elevated and the labor market has not softened enough to provide the FOMC with the comfort to begin cutting its policy rate. The next key data point on the labor market will be the release on Friday of the official employment report for January. Thus far, labor supply and demand appear to be in better balance.

Fourth-quarter economic growth topped expectations. Overall, “economic activity has been expanding at a solid pace,” according to Chair Powell. The 3.3% quarter-over-quarter annualized increase in fourth-quarter US GDP was far above consensus expectations, marking the sixth straight quarter of growth exceeding the Fed’s estimate for the sustainable trend rate of 1.8%. As inflation eased and the jobs market remained strong, consumer spending was resilient. For 2023 as a whole, the economy expanded 2.5%. The continued strength in economic activity and anticipation of lower interest rates ahead led US consumer confidence to jump to a two-year high of 114.8 in January. The Conference Board’s gauge of sentiment marked the third straight monthly increase, suggesting momentum in household spending is likely to endure.

So, with the Fed likely holding rates higher for a bit longer—but signaling cuts ahead—and with the US economy on course for a soft landing, our investment outlook remains unchanged after the FOMC meeting. We continue to advise investors to brace for further volatility given potential macroeconomic uncertainties. We still believe the US economy should slow and inflation will fall this year, presenting a positive backdrop for quality bonds and equities. For investors looking to capture more potential equity gains in a Goldilocks scenario of robust growth, falling inflation, and preemptive Fed cuts, we like US and European small-caps, European and Swiss mid-caps, and emerging market equities.

Main contributors – Solita Marcelli, Mark Haefele, Brian Rose, Jennifer Stahmer, Daisy Tseng, Giovanni Staunovo

Read the original report : Equities fall as Fed pushes back on March rate cut, 1 February 2024.