First US rate cut in 10 years

Global sharemarkets bounced back fairly strongly in June and into July, after the May correction. The root of this recovery was been a surprising change in direction by the US central bank.

Big policy changes that can affect the enormous US economy have the power to shape markets. So when the US Federal Reserve (or Fed, as the central bank is known) indicated it was open to cutting rates for the first time in more than a decade, investors got excited and that fuelled a sharemarket upswing. And then it made the move on August 1.

The Fed Funds Rate (FFR) has been held at its target of 2.25 per cent to 2.5 per cent only since December, but the Fed has now moved that range down to 2 to 2.25 per cent. In the past this has left equities at a crossroads:

• Looking at the experience of the past 35 years, interest-rate cuts in an economy heading for recession have seen equities fall by 15 per cent on average in the 12 months following the first rate cut.
• However, interest rate cuts that merely cushion a still-growing economy have in the past led to substantial gains of around 20 per cent over the same period of time.

What we’re going through now has some parallels with 1995 when low inflation and slowing economic growth gave room for the Fed to cut rates by 0.75 per cent, followed by a further 0.75 per cent in 1998. The sharemarket then rallied for a further two years.

Unhealthy signs in the US economy

So far, a number of different indicators point to weak growth in the rest of 2019, but not a recession.

A strong indicator of US economic health, the ISM manufacturing index, suggests we’re not on the eve of a recession. (Recessions typically reflect imbalances in the economy and growth is usually well past its peak in the lead-up to a recession, which is not the case this time.) History suggests growth in the US may remain weak into the first half of 2020 before picking up.

This conclusion is also supported by the US yield curve. To put it as simply as possible, when the yield on long-term US treasuries is higher than short-term US treasuries, it indicates investor confidence in continued economic growth; when that yield curve switches and short-term treasuries are higher it is an ominous sign for economic health.

Currently, the yield curve is consistent with a no-recession outcome but slower growth. While the curve has been quite flat for a period of time, the Fed this time appears to have avoided over-tightening rates.

And for the global economy?

The story is pretty similar if we take a more global perspective.

The growth of credit in China relative to the size of its economy looks consistent with increasing stability over the next 12 months. Efforts so far by the government have broadly stabilised credit but not much more to date.

Shorter term guides to growth such as our indicator of global activity and companies’ earnings revisions have started to stabilise this year. However, it is still early days and ANZ’s Chief Investment Office is cautious about the outlook for sharemarkets in the near term. The continued US-China trade dispute remains an ongoing threat to global economic growth.

Indeed, indications of global activity lag behind the strong gain in markets during June.

The strong rally during June may raise concern about higher share valuations. However, in our view, international shares are not that far from ‘fair value’, but the Australian market is looking stretched at the top of our ‘fair value’ range.

A recession looks unlikely

A cut in US rates has many investors questioning whether the Fed’s decision is the start of a rescue mission to keep the US economy out of recession or whether it is providing a cushion to what will ultimately be only a slowdown in growth.

An initial indication came from Fed chairman Jerome Powell, who emphasised the cut was "a mid-cycle adjustment to policy" and "not the beginning of a long series of rate cuts". Investors were discouraged by that sentiment, and the sharemarket dipped about 1 per cent.

While we expect a recession to be avoided, the strong rebound in equity markets in June seems inconsistent with our latest data making us cautious on the near-term outlook.

More positively, international shares are close to fair value, so even if equities reverse some of this year’s gains in the months ahead, a sustained correction seems unlikely.