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Rethinking US Rate Cuts | skip to SGD/CNY
Based on the minutes from the Federal Open Market Committee's meeting on December 12-13, Federal Reserve officials are leaning towards the belief that interest rates may have reached the peak of the current monetary policy tightening cycle. However, their actual course of action will be contingent on the unfolding developments in the U.S. economy in the months ahead.
The minutes indicated that nearly all officials anticipated a reduction in the federal funds rate by the end of 2024, citing the recent downtrend in inflation. Nonetheless, a few members acknowledged an "unusually high level of uncertainty" and did not entirely rule out the possibility of further rate hikes.
Certain members of the Federal Open Market Committee (FOMC) hold the view that economic data indicates the 11 interest rate hikes executed by the Federal Reserve since March 2022 are achieving the intended impact. This impact is perceived as a slowdown in consumer demand and a moderation in the labor market, contributing to the expectation that inflation will gradually return to the Federal Reserve's 2% target over time.
"Most participants noted that, as indicated in their submission to the Summary of Economic Projections (SEP), they expected the Committee's restrictive policy stance to continue to soften household and business spending, helping to promote further reductions in inflation over the next few years," the minutes showed.
However, although inflation has declined, it remains above the Fed's 2% target. At least some Fed officials still see a risk that progress toward stabilizing inflation could stall before reaching the central bank's target.
Many Fed policymakers have emphasized that maintaining a tight monetary policy stance could also pose risks to the economy, especially given the current level of uncertainty about how long interest rates will need to remain high.
As Chairman Jerome Powell has previously noted, committee members believe the risks of too much tightening are becoming more balanced against the dangers of doing too little. Some members noted that in the coming months, the Fed may face "trade-offs" between its dual goals of maintaining price stability and maximum sustainable employment.
The minutes further validated that observers in the market accurately interpreted the inclusion of the word "any" in the Federal Reserve's December statement. In that statement, the Fed alluded to "any additional degree of policy tightening," which was seen as an indication that the central bank might have concluded its series of interest rate hikes.
The minutes revealed that committee members held the belief that incorporating the word would communicate their assessment that the federal funds rate is probably "now at or near the peak of this policy tightening cycle, while also laying the groundwork for the potential for additional increases within the target range." There exists the potential for further rate hikes, contingent upon the most recent data, the evolving outlook, and the overall balance of risks justifying such increases.
As expressed in our prior market insights, our stance persists that the Federal Reserve acknowledges the descent of inflation, and their reliance on data now tilts more towards inflation than growth. The emphasis has transitioned from apprehension about heightened growth to the acknowledgment that inflation can diminish even in the presence of a robust economic expansion.
Expected is the Federal Reserve's commitment to maintaining elevated interest rates, signifying an extended period of higher rates until the initial quarter of 2024. This aligns with the Fed's consistent reliance on a data-dependent approach. We anticipate the Fed meticulously scrutinizing economic conditions and risk fluctuations, with the potential initiation of official interest rate cuts around the midpoint of 2024.
Looking back, 2023 concluded with a remarkable resurgence in stocks, bonds, and gold, marking one of the most robust rebounds in years. The prevailing sentiment is characterized by a notable degree of complacency, as evidenced by the Greed and Fear Index reaching levels of "extreme greed." The market's resurgence was fueled by optimistic expectations surrounding inflation and anticipations of a significant interest rate reduction by the central bank. The pivotal question now is: What can investors anticipate for 2024?
Can we expect a decline in the S&P 500 on the equities front? In the near term, we don't foresee a correction or a bear market. The market operates like a rollercoaster, where a minor catalyst can trigger an equity market downdraft. Historically, there have been downdrafts every year, and we anticipate multiple occurrences in 2024. Just a bit of concern or comments from the Fed can suffice to initiate a downdraft; data is not essential for justification.
The risk arises when the market experiences disappointment. If inflation doesn't decrease as expected or, worse, if it shows a slight increase, it could be a significant disappointment given the current market pricing. The core PCE serves as a crucial data point that both markets and investors keenly watch. Any upward movement in it might signal fear in the market.
Our perspective is that now is not the time to invest in the index, and we do not advocate championing the S&P 500, which has experienced a 24% increase in 2023. In our opinion, opting for the index is an intellectually lazy approach that does not result in superior performance. Paradoxically, maintaining some distance from the index tends to lead to better performance. We adopt a contrarian view that this is a market favorable for stock pickers.
In the FX space, we expect most Asian currencies to begin appreciating significantly against the USD for most of 2024, after taking a beating throughout 2022 and much of 2023. The persistent strength of the USD in 2022 and the first half of 2023 was supported by the Fed’s aggressive tightening and US economy resilience narrative. We see a soft USD profile to be favorable for equities.
We find ourselves embracing a Goldilocks narrative. In this scenario, debt growth, economic expansion, and inflation all align in a state that is neither excessively heated nor too tepid. Our perspective anticipates a synchronized global slowdown, although the likelihood of a recession or a hard landing in the U.S. during 2024 appears improbable.
China’s Factory Activity Contracts
China's manufacturing PMI has reached its lowest point in the last six months, with both domestic and external demand showing signs of weakening. This has raised concerns among investors regarding the manufacturing sector. The manufacturing PMI index persisted below the boom-bust threshold in December, signaling an increased downward pressure on the economy.
Manufacturing demand is on a continual decline, and the expansion of production is decelerating. In December 2023, both the manufacturing new orders and new export orders indices dropped below the boom-and-bust line, registering 48.7 and 45.8, reflecting a decrease of 0.7 and 0.5 points, respectively. Insufficient demand is constraining enterprises' willingness to produce to a certain extent. As per the China Federation of Logistics and Purchasing, the proportion of companies reporting insufficient demand reached 60.8% in December, marking a three-month consecutive increase. The manufacturing production index also dipped 0.5 points from the previous month to 50.2 in December.
Export-oriented manufacturing sectors are grappling with heightened pressure. In December, the PMI for the raw materials industry witnessed a slight rebound from its low, reaching 47.4. Conversely, the PMIs for the equipment manufacturing and high-tech manufacturing industries declined by 1.4 and 0.9 points, respectively, settling at 50.2 and 50.3. The consumer goods industry's PMI registered at 49.4, slipping below the 50-mark indicative of contraction. Ultimately, the equipment manufacturing, high-tech manufacturing, and consumer goods manufacturing industries exhibit a higher dependency on external demand compared to the raw materials industry.
Manufacturing inventories continue to experience downward pressure. In the context of subdued demand, corporate procurement and inventory management have adopted a more cautious approach. We believe there is a need to expedite counter-cyclical adjustments to macroeconomic policies, particularly by reinforcing the role of government investment in corporate production and investment.
Our perspective is that sentiment in China continues to be fragile and may further decline. We are skeptical that the numerous policies and slogans advocating economic development in China have sufficiently revitalized investors' risk appetite. A divide between the rhetoric of economic policy and actual actions has led to investor disillusionment, contributing to a prevailing sense of bearish sentiments in China.
Improvements in economic fundamentals or green shoots in economic data might not be adequate to entice foreign funds back into the world's second-largest economy. Ultimately, more appealing markets worldwide offer better opportunities for capital allocation and higher rates of return.
Regarding equities, we are of the view that investors should steer clear of Chinese markets in 2024, despite the ongoing affordability of Chinese valuations. Our perspective is that investor interest in China is waning, with government promises on reform falling short of impressing the investment community.
Should there be any prospective recovery in the equity market, it presents investors with a chance to exit at a premium compared to expectations. Noteworthy characteristics of the Chinese market that we would like to pinpoint include: (1) Abundance of retail investors (2) Potential for rapid market movements attracting fast money with quick entry and exit (3) Regulatory uncertainty makes China less suitable for long-term investors (4) The immature nature of the market discourages a buy-and-hold strategy.
In the FX space, we see the weaker USD (due to Fed’s explicit pivot towards cuts in 2024) to continue to contribute to the strengthening of the RMB. A further decline toward the psychological key 7 level in 2024 is likely as the RMB passively strengthens against the greenback. The recent RMB exchange rate has returned to the appreciation channel, mainly due to the continuous decline of the USD index and changes in market expectations.
Currently, the market perceives that the U.S. interest rate hike cycle has concluded, prompting a shift toward a more accommodative policy to bolster the U.S. economy. This is reflected in the continuous decline of the USD index, and the narrowing of interest rate spreads between China's 10-year treasury bonds and those of the U.S.
Looking ahead, as the unilateral strength of the USD index against non-U.S. currencies diminishes, coupled with robust backing from the steady recovery of domestic economic fundamentals, the RMB exchange rate is expected to gradually ascend to a reasonable price range aligning with its intrinsic value.
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