“Historical Insights on Fed Rate Cut Cycles and Asset Class Returns”

Marco

In today’s outlook, we will examine past Federal Reserve (Fed) cut cycles and their effects on various asset class returns. Since the 1980s, there have been more than nine rate cut cycles, which can be broadly categorised as pre-recession cuts or insurance cuts.

Pre-Recession Cuts: These occur when the Fed cuts rates but fails to prevent the economy from entering a recession.

Insurance Cuts: These happen when the Fed cuts rates in response to slumping equity markets (1987), international financial stability risks (1998), or to bolster sluggish growth (1984, 1995). In these cases, the Fed’s actions successfully prevented a recession.

Over the last 40 years, there have been five pre-recession cycles and four insurance cycles. On average, each rate cut cycle delivered significant rate reductions (greater than 4%) and lasted over a year.
Currently, markets are pricing in two 25 bps rate cuts to happen this year, starting in September. We believe the Fed is on track to engineer a soft landing by lowering rates and inflation without causing a recession, leading us to anticipate the upcoming rate cut cycle to be an insurance one.

The analysis done by Allianz Global Investors of historical aggregated excess returns of various assets versus cash across all rate cut cycles provides insightful trends.

All Rate Cut Cycles:

• US Treasuries were the best performers, with 12.5% excess returns against cash.
• US Investment Grade Corporate Bonds outperformed cash in 7 out of 9 cycles with an excess return of 11%.
• We have reiterated our preference to lock in bond yields since Q1, given the increased total returns resulting from rate cuts.

Insurance Cycles:

• Global equities outperformed fixed income when the Fed cut interest rates and economic growth remained positive, with excess returns of 18.7%.
• On average, growth stocks outperformed value stocks, and large-cap stocks outperformed small caps.
• Given the current macro environment, we have reiterated our preference to remain invested in quality large-cap US equities.

Pre-Recession Cycles:

• On the currency front, the USD typically fell against other currencies when only the Fed was cutting rates.
• However, when both the Fed and other central banks lowered rates, the USD, JPY, and CHF rose.

In summary, historical data suggests that US Treasuries and Investment Grade Corporate Bonds perform well across all rate cut cycles, while equities, particularly growth and large-cap stocks, excel during insurance cycles. The currency response varies depending on global central bank actions. Given the current market conditions and the Fed’s trajectory, we believe positioning in bonds and quality large-cap equities remains prudent.

Bonds

Over the past 2 weeks, Treasury yields retraced to their lowest levels since March. The recent data allay concerns that inflation is reaccelerating, and leaves the door open to lower policy rates later this year. However, the FOMC is in no rush to ease, with the median 2024 dot showing one cut, and 15 of 19 participants projecting one or two cuts this year. With markets pricing a deeper magnitude of rate cuts than the shallow easing projected, it will be challenging for yields to decline further over the near term. Meanwhile, the US presidential election is shifting into focus. Trump’s policies overall imply significant upside risks to inflation expectations and US Treasury issuance, while current yields show little risk premia for the implications of a Trump win. We are inclined to trim duration of bond portfolios.

Markets Price Deeper Cuts Than Fed This Year and Next

Source: Bloomberg Finance L.P.

Should Indonesia fiscal expansion occur, a moderately higher deficit that generates higher levels of growth could be viewed positively by the markets and by the rating agencies; conversely, additional borrowings that have relatively limited impact on growth could be a source of concern. Furthermore, investors may begin pricing in more supply of offshore bonds. In the near term however, deterioration in Indonesia’s credit profile is unlikely. First, debt increases will take several years for a 2 ppt/annum increase in debt-to-GDP ratio. Second, Indonesia’s external position is strong. The government’s external indebtedness represents around 29% of GDP, and the current account has improved in recent years, with a modest deficit of 0.1% of GDP in 2023. To benefit from the wider premiums available recently in Indonesia credit, we look to increase positions in Indonesia corporates and quasi-sovereigns.

Indonesia Credit Spreads Widened vs Southeast Asia Peers

Source: Bloomberg Finance L.P.

Macau May visitor arrivals climbed 22% year-on-year to 2.69 million, reaching 79.3% of the figure in the same month of 2019. Sequentially, the May figure was up 3.5% month-on-month. May gross gaming revenue (GGR) increased 29.7% year-on-year to MOP 20.2 billion, making the highest tally since January 2020 at the beginning of the pandemic. The result is quite impressive, especially given lingering investor concerns on consumption elsewhere in China. Since end-May, eight major cities became active members of China’s exit visa system for independent travellers wishing to visit Macau and Hong Kong, the Individual Visit Scheme, known as IVS. June is seasonally the weakest month of the year for GGR which may result in 2Q earnings being modestly lower quarter-on-quarter but does not materially alter the medium-term outlook of strong cash flows driving deleveraging. In the event of a broader spread correction, that presents an opportunity to increase positions in Macau gaming operators.