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Central banks begin rate cuts: Impacts and Opportunities – June 2024 CIO Market Commentary

Market Context

The European Central Bank, Swiss National Bank, and six other central banks have started to cut interest rates.

  • Stock markets: Boosted by rate cuts and positive earnings
  • EUR and CHF: Lower following interest rate cuts
  • Currency volatility: Increasing as military, economic and political unrest is ramping up
  • Long-term bond yields: Adjusted higher
  • Gold and Bitcoin inflows: Well supported ahead of the summer European political shift and the US presidential election
  • Copper momentum: Fueled by electric vehicle production and the energy transition race

Global Macro: The start of the interest rate cutting cycle is boosting sentiment

Eight central banks have already started to reduce interest rates, including the European Central Bank (ECB), which brought its deposit rate down from 4.00% to 3.75%, and the Swiss National Bank (SNB), which lowered its key rate from 1.75% to 1.50%. These actions reflect a broader global trend where central banks are adjusting their monetary policies in response to evolving economic conditions, including declining inflation, and to support economic growth.

In the US: Resilient but slowing economy

Recent data indicates an economic slowdown, aligning with a projected soft landing. Inflation decreased to 3.4%, driven by service prices, while goods prices also declined. The ISM Services Purchasing Managers’ Index (PMI) in the US rose to 53.8, marking a nine-month high, whereas the ISM Manufacturing PMI fell to 48.7. The US trade deficit expanded to USD 74.6 billion, the largest since October 2022, amid surging imports. Additionally, US job growth surpassed expectations, with 272,000 jobs added in May, significantly higher than the revised number of 165,000 in April.

In Europe: Lower interest rates

The ECB reduced its deposit rate from 4.00% to 3.75% as inflation trends towards the target rate of 2%. In the first quarter of 2024, the Eurozone economy grew by 0.3% quarter-over-quarter, slightly exceeding expectations. Germany’s seasonally adjusted unemployment rate remained at a three-year high of 5.9%. Meanwhile, German exports increased by 1.6% month-over-month to a 14-month high of EUR 136.5 billion in April 2024, up from a revised EUR 134.4 billion the previous month, surpassing market estimates of 1.1%.

In China: Growth on track at 5% for 2024

China’s full-year GDP growth is on course to meet Beijing’s ~5% target. Inflation increased to 0.3% year-over-year in April 2024 and is projected to average around 0.4% for the year. In May 2024, Chinese exports surged 7.6% year-over-year to USD 302.35 billion, exceeding market expectations and accelerating from a 1.5% rise in the previous month. Additionally, the Caixin China General Manufacturing PMI rose to 51.7 in May 2024, up from 51.4 in April, marking near two-year high growth in manufacturing activity.

Financial Markets: Sentiment boosted by rate cuts

Equity: The May performance of global equities was positive across sectors and regions: S&P 500 +4.8%, Nasdaq 100 +6.3%, Euro Stoxx 50 +1.3%, HSCEI +1.9%, Nikkei 225 +0.2%.

Fixed Income: The 10-year US yield decreased by 17bps to 4.51% and the 10-year German yield rose 8bps to 2.67%, while the 10-year China yield edged down 2bps to 2.36%. Meanwhile, High-Yield bond prices lost 2.1% in USD and gained 3.8% in EUR on ECB rate cuts.

Currencies: All major currency pairs were muted in May ahead of the European election and the US presidential election.

Commodities & Crypto: Gold was also muted in May as the US Fed is delaying rate cuts. In contrast, Bitcoin rallied on lower rates globally and increasing military, economic and political unrest. Oil prices declined 6.6% amid softer global growth.

Equities: Boosted by rate cuts and positive earnings

In May, global equities surged to new all-time highs following a pause in April, driven by a strong Q1 earnings season and declining yields. Continued earnings recovery is expected, led by the technology sector. Digital transformation, including artificial intelligence (AI), is a significant growth driver, suggesting further upside for tech stocks, which should be integral to long-term equity portfolios. Semiconductors, crucial in the AI value chain, trade at a 10% discount to the broader tech sector, with anticipated sector profit growth of 50% this year. While inflation remains a short-term risk, it is expected to decline in the medium term, presenting a constructive equity outlook.

In the US: Strong momentum

The S&P 500 reached an all-time high in May, driven by softer inflation data in April, lower interest rates, and a strong first-quarter earnings season. The market outlook remains positive, supported by several key factors: solid and expanding profit growth, disinflation, an anticipated shift by the Fed towards rate cuts, and increasing investment in AI infrastructure and applications.

In Europe: Boosted by rate cuts

The improving economic outlook and expectations of easing interest rates create a favorable environment for Eurozone equities. The European equity market is supported by accelerating earnings, declining inflation, easing monetary policy, and increasing global manufacturing activity. Additionally, valuations remain reasonable, with the MSCI EMU Index trading at 13.4x forward P/E. As the region emerges from a near-recession state, we anticipate a further acceleration in earnings growth.

In China: Equity market rebounds and normalizes

We expect the market to outperform its regional peers in 2024. Mixed PMI, retail sales, and export data should improve as China moves away from deflationary territory. Credit growth is expected to be bolstered by special central government bond issuance. The recently announced housing purchase program aims to reduce inventory and address structural issues in the property market. Positive earnings from internet and e-commerce giants support further upward revisions and a broader market re-rating. Near-term price momentum has been strong from a technical perspective.

Currency outlook: Volatility is increasing as military, economic and political unrest is ramping up

In the second half of 2024, the European political shift towards the far right and the US presidential election, particularly if former President Trump wins, are expected to introduce uncertainty and increase currency market volatility. The USD is not anticipated to rally significantly but is likely to depreciate once the US Fed begins its rate cutting cycle later this year. A rapid decline in US GDP growth poses the most considerable risk to the USD, potentially highlighting structural weaknesses and its elevated valuation. The rate at which the US economy decelerates will be crucial.

EURUSD: At 1.0750, trading within the [1.05; 1.10] range with downside risk

The EUR is weakening as the ECB initiated its rate cutting cycle ahead of the US Fed. We see downside risks to EURUSD in the coming months, particularly as the Fed is now less likely to cut rates in September. This scenario could significantly depreciate the EURUSD, potentially returning to parity. The increased risk premium on the euro, driven by escalating geopolitical tensions from Europe’s involvement in the Russia-Ukraine conflict, adds to this risk.

USDRMB: At 7.2650, stuck in the [7.00; 7.30] range  

We expect the People’s Bank of China (PBoC) to continue closely managing the RMB. With daily exchange rate fixings around 7.20, the upside in USDRMB should remain limited. Year-to-date, the RMB has weakened by approximately 2% against the USD, compared to an average decline of 4.10% for Asia ex-Japan currencies. The yuan’s resilience is largely due to the PBoC’s strong commitment to anchoring its daily USDRMB fixings and maintaining the upper bound of the trading range around 7.24. Political motivation to maintain RMB stability appears to be a priority.

USDJPY: At 157.35, all-time high downside risk

Short JPY carry trades remain dominant. Narrowing yield spreads suggest a lower USDJPY in the second half of 2024, with the Bank of Japan (BoJ) expected to hike rates in July while the Fed is likely to cut rates by year-end. However, capital outflows by Japanese investors may mitigate the decline. USDJPY has reached levels that concern Japanese policymakers, prompting more serious efforts to address yen weakness.

Fixed Income: Opportunity to lock high interest on cash deposits or high bond yields before central banks cut rates further

Bond yields remain elevated as inflation declines. Central bank rate cuts have commenced, and robust economic growth is maintaining low default rates. This environment presents an opportune moment to increase active fixed income exposure.

We believe there is a window of opportunity that we have not seen in the past 20 years where it is still possible to receive substantial income from cash deposits, with duration of 3 to 6 months (5.25% in USD and 4.00% in EUR). High interest rates can be locked for longer periods by investing cash in bonds from large Investment Grade banks, which can provide an income per annum of close to 6.00% net in USD or 4.50% net in EUR, with a duration of 2 to 10 years.

Commodities

In light of increasing geopolitical risks, when appropriate with respect to the risk profile, investors may consider including a moderate amount of gold, energy (e.g. oil) and copper in investment portfolios with the objective to mitigate these risks and increase diversification.

Gold: Reached a new all-time high at USD 2,450

Gold set new records in May, rebounding due to a dovish US Fed stance and weaker-than-expected US CPI data. Gold reached a new high of USD 2,450/oz, and we anticipate continued demand and momentum potentially driving the price to USD 2,600/oz by year-end. Additionally, robust central bank purchases, averaging approximately 1,000 metric tons per year, are likely to sustain this demand.

Oil: Currently at USD 76.40/bbl, prices are well supported

Oil demand remains robust. Despite cautious sentiment due to the risk of prolonged high interest rates affecting the soft-landing outlook, real-time mobility data indicates healthy oil demand growth. OPEC+ voluntary production cuts are expected to be extended, likely keeping the oil market undersupplied. Consequently, we anticipate oil prices rising above USD 90/bbl by year-end.

Copper: Fueled by electric vehicle production and the energy transition race

Copper prices reached all-time highs on the COMEX and SHFE exchanges in end-May, with a year-to-date rally exceeding 20%. The strong fundamentals of copper persist, with ongoing supply challenges keeping the physical market tighter than expected. Additionally, China’s renewed policy focus on stabilizing housing in order to improve consumer sentiment and thus prop up domestic demand should have a positive impact on the price of copper, given its general correlation with China’s domestic consumption. Based on these factors, we anticipate that copper prices will continue to rise by year-end.

Risks

  • War escalation in Ukraine or the Middle East: These conflicts hold significant implications for Europe. Specifically, if Russian forces were to advance across the Belarusian border, 150 kilometers north of Kyiv, this could precipitate a rapid devaluation of EURUSD, potentially driving it towards the 0.90 threshold. Furthermore, statements made by former US President Donald Trump concerning the US’ potential withdrawal from NATO commitments have notably undermined the confidence of US allies.
  • US-China tensions: US-China friction remains strong, with increasing tension around Taiwan and the South China Sea.

Opportunities

  • Geopolitical risk mitigation basket: Gold, Energy (e.g. Oil), AI and Bitcoin. As military and economic wars are mounting, these four assets are in increasing demand. With the new US sanctions on Chinese electric vehicles, the most sophisticated chips recently developed in China, and maintained US sanctions for EU products, the dedollarization is here to stay. We believe moderate exposure to these assets calibrated with respect to investors’ risk tolerance and preferences may help preserve both performance and capital in the long run.
  • Income from safe cash deposits: Cash can be safely placed in cash deposits and earn annualized net interest, e.g. over a period of 6 months: 5.25% in USD, 4.00% in EUR, 5.00% in GBP, 4.00% in AUD.
  • Income from Investment Grade bank bond issuers: Major banks are implicitly protected by central banks as demonstrated in the Credit Suisse crisis where actual bonds (not AT1) remained secured. Investors can benefit from the substantial yield of a diversified bank bond portfolio of 2 to 10-year duration: close to 6.00% in USD, 4.50% in EUR, 5.50% in GBP.
  • High coupon (10%+) on structured deposits: Opportunity from market volatility.
  • All-time high, compelling “risk premium” for Chinese stocks: We believe that historically low prices for China stocks are an opportunity for long-term investors looking for asset growth, substantial income and de-correlation with Western markets. Given attractive equity valuations and earnings upgrade expectations, we believe mainland Chinese and Hong Kong equity valuations are likely to increase significantly within the next 12 months.
  • Nuclear energy: We believe the nuclear sector will be instrumental in the world’s decarbonization efforts. To achieve fossil fuel reduction targets, the nuclear power industry’s safety standards need to be brought to the next level, for instance by using new technology to recycle uranium. New “green” nuclear energy is the number one priority of President Macron in France, while being high on the agenda in the US and China, which will build 150 nuclear power plants in the next 15 years.
  • Defense and security: The wars in Ukraine and Palestine have triggered massive investment in military defense and the overall security sector – including cyber, food, energy, and semiconductor supply security – in Europe and around the world.