„THE FIRST CUT IS THE DEEPEST“ – Cat Stevens, 1967

This week’s Fed meeting will likely be one of the most important in recent years. For the first time since 2009, markets are expecting the Fed to cut rates four times in one year, with the first cut expected as early as September. What would warrant such an early cut when signs of an immediate recession are still limited? In our view, three elements would justify further Fed dovishness: first, US dollar strength has a monetary tightening effect, and shrinking the yield gap between the US and its trading partners should relieve this pressure. Second, the Fed could help smooth the impact of the White House’s trade war to the real economy. Finally, lower inflation pressures and expectations are freeing the Fed’s hands from the need to hike. We expect, at the very least, no further hikes forecasted by the Fed members in their “dots” for this year, but also volatility along the way given the extreme market pricing. A first cut in September would indeed have a deep effect on markets, bolstering equities and bonds over the medium term once more.

What’s Next?

Cutting rates without a recession

Investors are pricing a severe sequence of cuts across the next two years, with two of them occurring by the end of this year. Such a pricing happened six months prior to the last recession, in July 2007. Are there currently signs of a recession in the US? According to our Growth Nowcaster, the US economy moved from expanding significantly above potential in early 2018 to hovering around it today. The pace of this deceleration has been strong and steep, leading us to seriously consider the likelihood of a recession. Currently our growth indicator in the US is pointing to growth stabilisation at best, making us worried about the potential end of the current cycle for solid reasons. The housing sector started showing a deterioration early this year while expectations (essentially ISM numbers) continuously dropped in the meantime to reach levels that are flirting with the danger zone.

Yet, in spite of this deceleration, there is limited evidence that the US is in, or close to, a recession as employment remains solid while the housing market profited from the recent (and unexpected) drop in rates, which fell almost continuously over the past six months. There are pockets of weakness in the US macro situation (essentially durable goods consumption) but the macro dynamics described by the current data is marginally less worrisome for now, at least according to our systematic indicators. Indeed, the current levels are nowhere near where they were even two years before the GFC.

The 1995 comparison

If a recession is not yet on the cards, we see an interesting parallel with 1995: late that year, the Fed cut rates several times without the US being in a recession. At the time, emerging economies saw a severe economic slowdown, especially in Latin America. For example, Mexico went through a recession in 1995 that was around three times more severe than what it experienced in 2008. The Fed’s intention back then was to both limit US dollar upside against the other Latin American currencies while also smoothing the potential impact of the recession in the US’s major trading partners. How are emerging economies faring today?

Much better in level terms than in 1995, especially Latin America (and Mexico in particular). According to our nowcasters, the weakest link in this emerging economic chain today is China.
With the impact of the government stimulus at the beginning of the year behind us, the economy is showing further signs of weakness. Given the current trade war being waged between the US and China, this is one of the most solid leads to understanding why the Fed would cut rates so soon.

Without inflation, the Fed is a risk manager

Outside an expected recession, there are actually two reasons that could push the Fed to cut rates so soon. First, external risks: regarding the trade war between the US and China, the Fed could provide some relief from the price shock that will hit US consumers sooner rather than later. Exporters have not lowered their prices in spite of the tariffs, meaning that the tariffs’ bill will be paid by US consumers and companies, as highlighted in a previous note of ours. This will result in a negative demand shock that remains to be seen in the actual economic figures, dragging on growth over the next few quarters. By lowering its target rate, the Fed could help the US economy navigate this expected exogenous shock.

Strategy Behaviour

Our medium-term view is less defensive than previous months. We have neutralised our underweight in emerging assets because risk aversion has declined. Regarding the growth-oriented asset exposure, we are still complementing our equity position with options to protect the portfolio in the case of equity drawdowns.

Performance Review

Over the month so far, the Uni-Global – Cross Asset Navigator fund is up 0.47% versus 0.26% for the MSCI AC World Index, while the Barclays Global Aggregate (USD hedged) is up 0.10%. Year-to-date, the Uni-Global – Cross Asset Navigator has returned 5.39% versus 13.4% for the MSCI AC World index and 5.2% for the Barclays Global Aggregate (USD hedged).

Unigestion Nowcasting

Navigator Fund Performance

Past performance is no guide to the future, the value of investments can fall as well as rise, there is no guarantee that your initial investment will be returned.

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Unigestion UK, which is authorised and regulated by the UK Financial Conduct Authority, has issued this document. Unigestion SA authorised and regulated by the Swiss FINMA. Unigestion Asset Management (France) S.A. authorised and regulated by the French Autorité des Marchés Financiers. Unigestion Asia Pte Limited authorised and regulated by the Monetary Authority of Singapore. Performance source: Unigestion, Bloomberg, Morningstar. Performance is shown on an annualised basis unless otherwise stated and is based on Uni Global – Cross Asset Navigator RA-USD net of fees with data from 15.12.2014 to 17.06.2019.