Against a backdrop of slower growth and easing inflation, the US Federal Reserve is widely expected to kick off a significant rate cutting cycle this week, with at least three 25 basis point cuts forecast by year end (with the option of more if needed).
This monetary policy support, combined with what still seems to be an orderly slowdown in the US economy (a soft landing), appears a supportive backdrop for global and domestic equities over the next six to 12 months.
More Jitters Around the US Slowdown
Investor nervousness around the US economy has bubbled up again in the past week. This volatility closely mirrors the start to August, when US recession concerns, alongside selling pressure from the Yen carry trade unwind, pressured markets.
Volatility may well continue in the near term. September and October are typically seasonally weaker months for equities, and the early November US election will also likely keep investors on edge, even with the upcoming Fed rate cut. However, beyond some potential short-term choppiness, in our view the backdrop for global equities remains reasonably supportive, despite the recent pickup in volatility.
US Slowdown Appears Orderly
The slowdown in the US labour market has been the focus of recent concerns around the US economy. It is now quite clear that job growth has slowed over the last few months, as the post-Covid rebound has faded. But is the labour market stalling, or just slowing to a more gradual pace?
While the nonfarm payroll data for August painted a picture of a softening US economy, the report did not suggest the US economy is in major trouble and is unlikely to be enough to persuade the Fed to ease by 50 basis points this week.
Headline job growth in August came in slightly below expectations (+142k vs. +165k), but the more notable elements of the report were broad downward revisions to prior months (-85k net). Given the revisions, we are now seeing a picture where headline job growth has been below 125k in four of the past five months, with a three-month moving average payroll growth of just +116k. This is well below average monthly growth over the past 20 years (~160k) and is the slowest since 2012.
In terms of the unemployment rate, we saw a modest improvement in August, with a fall from 4.3% to 4.2%. However, the unemployment rate has still risen significantly since hitting a 54-year low of 3.4% in April 2023.
It is important to note that while unemployment has been rising, layoffs remain at historically low levels, suggesting that this deterioration may simply be a correction from the ultra-strong labour market of 2022 and 2023. If so, the economy could quite conceivably settle into an unemployment rate of just over 4%. However, the rise in the unemployment rate over the past year still bears watching.
Importantly, unemployment claims/layoffs are not spiking the way they do in a ‘typical’ US downturn. Over the US summer, it did seem to suggest some reason for concern, with the four-week moving average of initial claims climbing from 210,000 at the end of April to over 240,000 by the start of August. However, some of this appears to have been due to weather effects and seasonal plant closings in the auto industry. By the end of August, the four-week moving average had fallen back to 231,000, with a similar improvement in continuing claims. Overall, initial claims for unemployment benefits are running below long-run average trend levels, suggesting a generally tight and healthy labour market.
Another perspective on the US job market comes from looking at the rest of the economy. Real GDP growth accelerated to 3.0% in the second quarter of 2024.
The Atlanta Fed’s “GDPNow“ model is predicting 2.1% growth for the third quarter, largely in line with most forecasts of trend growth. This does not appear to be a backdrop that would correlate with the aggressive retrenchment of labour that marks the beginnings of most recessions.
In summary, our overall assessment of the US labour market is one of cooling rather than sliding. More generally, it appears the US economy is, for now, settling into a slower expansion rather than anything more sinister.
Inflation Still Noisy but Trending Down
Alongside evidence of a cooling economic activity, last week delivered somewhat mixed news on the inflation backdrop. US headline CPI eased from 2.9% y/y to 2.5% in August, in line with consensus predictions. However, core CPI unexpectedly accelerated from 0.2% m/m to 0.3%.
The somewhat esoteric “Owners Equivalent Rent” category (OER) mainly drove core CPI in August. It increased by 0.5% m/m from 0.4% in July. OER is unusual in the sense that literally no one pays it. It is the rent that homeowners estimate they would be paying themselves if they had to rent the home they lived in.
Encouragingly, the “super core” measure (core services ex-shelter) otherwise grew at a stable 0.2% m/m, while goods prices continue to decline in absolute terms. It is interesting to note that the CPI without the rather esoteric Owner’s Equivalent Rent has been at the Fed 2% target for a year now.
Overall, there is nothing really in the August CPI release that materially alters the ongoing disinflationary trend in our view.
Valuations Will Likely Constrain Equity Return Potential
While the macro backdrop and policy backdrop appear supportive, global equity valuations look somewhat full, most notably US equities. This is largely a function of full valuations in US tech. However, we don’t believe tech valuations are in a bubble given the strong earnings growth outlook. We see full valuations as suggesting more moderate returns from global equities over the coming year as the tech sector cools, but performance broadens out beyond the US mega cap tech trade. Global small and mid-caps, as well as quality large cap stocks in sectors other than just US tech, offer opportunities in our view.
Closer to home, Australian equities have also performed well over the past year, but have lagged the tech-driven performance of global equities. Performance has been better from a relative perspective over the last two months, as US tech leadership fades.
A key feature of the Australian equity rally this year has been the underperformance of resources versus the rest of the market. Rather than cause a significant drag on market performance, investors seem to have pushed harder into the ex-resources portion of the Australian market, with big sectors such as banks looking particularly stretched at present. Stretched valuations in the ex-resource market combined with an uncertain outlook for resources leaves us expecting low single-digit gains in Australian equities over the next six to 12 months.
Fixed Interest and Floating Rate Credit Still Appeal
Both global and domestic bond yields have declined over the past year, albeit with a fair degree of volatility. Easing inflation and decelerating economic growth has been pushing US yields lower in recent months. This has also been dragging domestic long bond yields lower, despite sticky domestic inflation and the prospect of the RBA holding the cash rate steady into the first half of next year at least. Australian yields have fallen less than US yields and are still looking reasonably good value in our view. RBA rate cuts in 2025 should drag the long end at least moderately lower, resulting in moderate capital gains in addition to reasonable starting yields. With the RBA on hold into next year, and economic conditions that are soft but still relatively benign, floating rate credit continues to look attractive. We remain moderately overweight fixed interest and floating rate credit.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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