The Federal Reserve’s Sept. 18 rate cut, the first time in more than four years, means the central bank has pivoted and investors' focus will now shift to inflation and the labor market.
The Fed slashed the fed funds rate by 50 basis points to a range of between 4.75% and 5% -- and also signaled further rate cuts this year and next, projecting the rate to drop to 3.375% by the end of 2025.
How are institutional investors and others positioning themselves in this new world of rate easing?
Portfolio impact
For institutional investors, lower interest rates means good news for private equity, real estate, and infrastructure investors, said Rich Nuzum, executive director-investments and global chief investment strategist at Mercer, “as it opens the door to more affordable financing opportunities.”
Mercer has $16.2 trillion in global assets under advisement.
Seema Shah, chief global strategist at Principal Asset Management, said that with a sequence of rate cuts on the way, recession risk has collapsed.
“This is a great sign for risk assets,” she said. “History suggests that the Fed’s success in piloting a soft versus hard landing will play a key role in dictating the path for U.S. equities. During easing cycles where recession has been avoided and, as a result, earnings growth remains fairly robust, equity markets generally react positively.”
From an equity market perspective, Shah said she “may consider shifting some allocation from large-cap to small-cap to take advantage of the more positive outlook.” Principal has $699 billion in AUM.
Tony Rodriguez, head of fixed income strategy at Nuveen, said ”this backdrop favors defensive equities, especially dividend growers, which offer more attractive valuations and have historically been less volatile relative to the overall stock market.”
With the Fed now cutting rates and the economic outlook pointing toward “slower but still-healthy growth,” Rodriguez believes investors should position “somewhat more defensively.”
However, he noted, it “should still pay” to have exposure to risk assets over the coming quarters.
“In taxable fixed income, we suggest taking advantage of higher-income sectors like preferreds, high-yield corporates and areas of securitized products,” Rodriguez said. “Within these asset classes, we favor an up-in-quality bias, that is BB- and high-B rated corporates within high yield. While Fed rate cuts may help the cash flows of more distressed, CCC-rated companies, we are cautious about downside risk in a slowing economy.”
With yields ranging from 6%-7%, higher-rated high yield corporates “provide plenty of income, which investors may lock in today before cash yields drop more sharply as the Fed cuts rates,” Rodriguez added. Nuveen has $1.2 trillion in AUM, including $571 billion in fixed income.
Bonds
With interest rates easing, Treasuries look “fair to richly valued at various points of the curve,” said Olumide Owolabi, head of the U.S. rates team and senior portfolio manager on multiple fixed income strategies at Neuberger Berman. As such, he is seeing value in alternatives to Treasuries such as agency mortgage-backed securities. Neuberger has $481 billion in AUM, including $216 billion in fixed income.
Michael Arone, chief investment strategist for the U.S. SPDR business at State Street Global Advisors, said that increasing allocations to bond proxies, defensive sectors and lower interest rate beneficiaries -- include real estate, banks, and homebuilders -- may now be prudent.
In addition, as yields on money market funds decline alongside Fed rate cuts, investors may seek greater yields in short and intermediate Treasuries, intermediate-investment grade corporate bonds, and below investment grade investments such as high yield bonds and loans, he added. State Street has about $4.3 trillion in AUM.
International
Carlos de Sousa, emerging markets strategist and portfolio manager of within fixed income at Vontobel Asset Management, said emerging market debt will benefit from this rate-cutting cycle by the Fed and most developed market central banks.
“Borrowing costs will decline for hard-currency issuers, (which) will lower refinancing risks for sovereign and corporate issuers alike, hence reducing refinancing risks and improving debt sustainability,” he said.
“Moreover, with lower hard-currency interest rates more investment projects will become viable and result in faster growth for emerging markets countries and increased profitability for corporates.” Vontobal has total client assets of $251 billion, with $6.7 billion in EM fixed income strategies.
Corporate pension plans, PE
The short-term impact of this rate cut for corporate pension plans is “generally positive,” said Jay Love, U.S. chief investment strategist at Mercer, “as long rates rose and short rates fell, meaning their liabilities came down while their return-seeking investments, like equity, will get a boost.”
Much of the rate cut had already been priced in by the decline in long-term rates since early July, Love noted, and the fact that “long rates actually rose indicates that markets have some concerns about the long term path of inflation.”
John Signa, founder and CEO of E78 Partners, an advisory firm with a primary focus on private equity firms, does not think the 0.50%t rate cut is sufficient to break the logjam in PE deals.
“We may start to see deal volumes and activity pick up, but even with a 50-basis point reduction, when you factor in the spreads from bank or non-bank lenders on top of SOFR (Secured Overnight Financing Rate) or prime, the cost of debt is still hovering near 10%,” he said.
“To really break the logjam and see a significant rebound in (deal) volumes I believe we’ll need at least a 100-basis point reduction (in rates). Until we hit that, progress will likely remain slow.”
Future Fed moves?
Shah of Principal found the 50 basis point rate cut “surprising,” given that “there is no financial crisis brewing, no asset price bubble bursting, no job losses, and an equity market that was already up some 18% year-to-date.”
And she expects more rate cuts in November, noting that this Fed will go to “historic lengths to avoid a hard landing -- so the election will not stop them from pressing ahead with a sequence of rate cuts.”
The chief of a pension fund, Donald C. Kendig, retirement administrator of the $6.61 billion Fresno County (Calif.) Employees’ Retirement Association, also was “surprised” by the 50 bps rate cut.
“If the Fed cuts again in November, it could be hard to separate whether it was politically motivated or motivated by economic indicators, unless the economic indicators are obvious at the time,” he said. “The cuts should mitigate, somewhat, any economic downturns they are meant to counter, helping the performance of our portfolio in the short term.”
Professing to be "modestly surprised" by the rate cut, George Ball, chairman, Sanders Morris, a Houston-based investment firm with $4.9 billion in assets, is concerned there is some risk that the Fed has declared “mission accomplished” on inflation a bit too prematurely.
“We expect the Fed to cut interest rates again in November because if they do not, it would be an admission that the large cut in September was premature and unwise,” he said.
Tim Tarpening, managing director and portfolio strategist at Pacific Income Advisers, said he was “disappointed” by the rate cut and in fact preferred no cut at all.
“Historically, contrary to public opinion, the Fed has implemented more rate changes in election years than non-election years,” he elaborated.
The 2024 presidential election, he noted, may be contentious, which “may create significant turmoil and uncertainty, making it potentially more challenging to introduce policy change,” he added.
For these reasons, he thinks the probability of another 50 bps rate cut in November is less than 25%. Pacific Income has $2 billion in AUM.
Labor market, election
Shah of Principal will be keeping a close eye on inflation and inflation expectations given the risk that aggressive rate-cutting into a still-solid economy does risk an overheating.
“The labor market continues to deserve close attention because it is such a lagging indicator - any sign of job layoffs may prompt the Fed to opt for 50 basis point cuts rather than 25 basis point cuts,” she said.
Ball is watching whether or not the economy is edging towards a recession over the next 6 to 12 months, adding “there are a growing number of signs, outside of the Fed's actions, that could portend that.”
Naomi Fink, chief global strategist at Nikko Asset Management, is concerned about how the newly-elected U.S. president will negotiate the debt ceiling and how that might impact bonds.
”Neither (presidential) candidate has espoused a platform of fiscal prudence, and Congress has, in the past, tended to raise the ceiling so long as political motivations of the negotiating sides are satisfied,” she said.
“If negotiations do not involve greater fiscal discipline, the risk that bond markets will experience dislocation at the hands of the US’s overseas creditors may rise.” Nikko Asset has $229.1 billion AUM.
Ironically, shortly after the Fed’s dramatic cut, the Bank of England decided to keep its bank rate steady at 5%, after cutting rates at its previous meeting on Aug. 1.
However, U.K. media reported that BofE governor Andrew Bailey said he is “optimistic” that inflation pressures will ease enough to permit further cuts to interest rates.
