Thought of the day

Equity investors were in a cautious mood on Tuesday, with the S&P edging 0.1% lower, as markets braced for the Federal Reserve's latest guidance on the outlook for rate cuts. With markets pricing a roughly 2% chance of a reduction in rates at this meeting, the focus will be on the tone of Fed comments in the statement accompanying the decision and from Chair Jerome Powell at the subsequent press conference. We expect the Fed to acknowledge the recent progress toward taming inflation and open the door to easing policy, which would be consistent with our base case for around 100 basis points of easing through 2024, probably starting at the May policy meeting.

Markets have been scaling back expectations for a spring rate cut, with the implied probability of a move at the March gathering down from around 73% a month ago to 45% at present, based on the CME's FedWatch Tool.

But, in our view, 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. Economic data still need to cool to keep the Fed on track for 100 basis points of easing, or more, in our view.

Recent signals from the US labor market remain robust. Job openings hit a 3-month high of 9 million in December, according to the Job Opening and Labor Turnover Survey (JOLTS). That topped the forecast for 8.7 million, pointing to continued strength in demand for labor. While this is down from the record of 12 million in March 2022, it remains higher than pre-pandemic levels. And although both the quits rate (2.2%) and the number of job openings for each unemployed person (1.4) are also lower than their peak, they did not decline over the prior month. The next focus will be the release on Friday of the official employment data for January. Overall, we think the Fed would like to see some additional softening of the labor market before cutting rates.

Evidence of cooling consumer demand is still missing. US consumer confidence jumped to a two-year high of 114.8 in January on easing inflation, a strong job market, and anticipation of lower interest rates ahead. The Conference Board’s gauge of sentiment on Tuesday marked the third straight monthly increase, suggesting momentum in household spending is likely to endure.

Economic growth in the fourth quarter topped expectations. The 3.3% quarter-over-quarter increase in US 4Q23 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%. For 2023 as a whole, the economy expanded 2.5%.

So, given the potential for disappointment on the outlook for Fed policy, we advise investors to brace for further volatility ahead. The risk remains that any sign of hawkishness from Fed Chair Jerome Powell could lead to a further pullback in market expectations over the trajectory for rate cuts, contributing to a more cautious mood among investors. We still believe that the US economy should slow this year with falling inflation, presenting a positive backdrop for quality bonds and equities. For investors looking to capture more stock upside in a Goldilocks scenario of robust growth, falling inflation, and preemptive Fed cuts, we like US and European small-caps, Swiss mid-caps, and emerging market equities.