Fed’s Last Stand
What happened last week?
- The S&P 500 rose 0.87%
- The Dow Jones climbed 0.86%
- The Nasdaq composite increased 1.28%
Investors looked past slower-than-expected first quarter real GDP growth of just 1.1% as companies exceeded previously lowered earnings estimates ahead of what could be the final Fed rate increase of its tightening campaign.
This week, the market expects the Fed to raise rates by 0.25% on May 3 to 5.00%–5.25% before pausing.
3 Things to Know
One more rate hike?
The US central bank is continuing to tighten even as the US broad money supply is contracting for the first time since the late 1940s. The Fed is determined to blunt the post-Covid recovery and secure a period of disinflation ahead.
With the release of bank earnings this week, the likelihood that banks will lend less and raise costs for borrowers has risen materially. Many depositors are thinking more deeply about T-Bills and money market funds due to the uncertainties around bank balance sheets.
The end of dollar dominance
In 2022, the Fed’s unusually abrupt tightening cycle and the Russian energy shock sank many currencies to record lows against the US dollar.
But looking more broadly, the US exchange rate had already enjoyed more than a decade of net gains previously. Powered by the US dollar rally, US equities rose to as high as 62% of global market cap last year on an unusually high relative valuation.
What does this mean for investors?
The strong decade of outperformance behind us now suggests a return to value for global diversification. We do not know if this greater diversification will help portfolios in the few key months ahead.
Yet with today’s much lower valuations for non-US shares, some positive growth developments away from the US, and a pending turn in an aggressive Fed tightening cycle, there is a chance it will potentially support investor returns measured in USD over the coming year. In fact, positive currency-linked returns from global diversification may likely persist much longer.
Where foreign currencies may rise
We believe the ECB and other central banks will likely withhold from rate cuts deep into 2024 while the Fed eases.
After more than a decade of US dollar appreciation and the extreme USD spike of 2022, this should contribute to ongoing US exchange rate weakening. We would also expect some emerging markets, including China and Brazil, to ease monetary policy.
Given the backdrop of US rate cuts in the coming year, this should have positive consequences for local markets.
For Europe, the recent key pain point was the surge in natural gas import costs last autumn as Russian supplies were cut off. This generated a brief economic contraction. While Europe will not become a growth paradise, we expect upward revisions to consensus views of European growth in the coming year just as we do for China.
The US is unlikely to benefit much from these modestly positive external developments until US labor markets weaken and the Fed eases.
See our weekly CIO Strategy Bulletin for more details