334. Fed cuts, China rebounds, UK equities: what’s next for investors?

7 October 2024 (pre-recorded 3 October 2024)

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[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. I’m Staci West, and today I’m joined by Darius McDermott and Juliet Schooling Latter for our quarterly market update. Thank you both.

Darius McDermott (DM): Good afternoon.

Juliet Schooling Latter (JSL): Hi Staci.

[INTERVIEW]

SW: Now typically we would start this podcast by looking at the best and worst performing regions and sectors, but given that there’s been quite a lot of financial headlines, I’m just going to jump straight in with interest rates. So in August, the Fed cut rates by 50 basis points in the US. This was their first cut in four years, and with more rate cuts on the way data seems to point to a soft landing. So would you both agree with that?

JSL: Well, it is what we’re all hoping for. Many think that the Fed should have cut sooner, but it’s a delicate balancing act. The reality is that soft landings are quite hard to negotiate. It’s the Goldilocks scenario. You need the economy not to run too hot and consumer confidence not to run too cold. But so far, so good, wage inflation has come down. And the savings rate rose back to 5.2% in the second quarter, which tends to indicate that the consumer isn’t overextended.

DM: Is that US or in the UK?

JSL: It’s in the US. But you know, there’s a possibility of a resurgence in inflation, which the Fed’s obviously gonna be watching out for. And the US economy is less interest rate sensitive than the UK due to their sort of long-term mortgages. And if you can fix your mortgage rate for 20 years, you don’t really need to worry so much about the rate fluctuations that we’ve seen in the past couple of years, which does make it a little bit harder for the Fed to control inflation.

DM: Yeah, well I’m hoping that this is the last time I’m gonna agree with Juliet on this podcast <laugh> it’s no fun at all if we agree, but I totally agree with your Goldilocks soft landing. Wouldn’t it be nice and the fact that it’s now becoming a bit consensus probably means it’s almost definitely not going to happen. I was with a manager this morning who said in the US they’re now pricing in between seven and eight cuts to the bottom of the cycle. They think that’s more than will actually happen. I mean it clearly is slowing down in the states, but whether it slows to recession is a critical question. And if they have to do cut, you know, substantial 50 basis points cuts to a much lower end level, that will be probably because we’ve had that hard landing and they need to re-stimulate the economy.

So I think we need to just remove the last decade’s zero interest rate policy from our mind. That 10 year period was the non-normal period. Normal period is rates between three and five. Zero to half ones, that’s the not normal. So why can’t we get to a soft landing position where say rates have a lower value of three and a half, four, you know, that’s normal market gives them a bit of scope to raise a bit of scope to cut. If market conditions change, we don’t have to go to the bottom. Which is where I think people have become used to over the last, since the GFC

SW: And myself excluded as the American on this podcast. But why should, or why do, so many people look to these Fed rate cuts as a significant marker even when we are sitting in the UK?

JSL: Well, we live in a global world and whether we like it or not, the US economy and the health of the US consumer does impact the rest of us. There’s sort of several factors at play. So a cut in the US makes sterling more attractive and sort of boosts the pound. So that means effectively that imported goods here become cheaper for us, and it’s also handy for going on holiday. But it also helps to boost the stock market because US companies can borrow debt for less money and reinvest it. And also lower savings rates means that the people tend to take money out of savings and put them into the stock market.

DM: Yeah, I mean, the US is the biggest market, I think, you know, it’s the biggest market in the world and if the direction of your interest rate travel is opposite to the US, that will affect your currency. So you’ve already stolen my answer but from that side, but I think the trajectory of both the UK and the US is in the same way. If there is a substantial US recession, there is generally a global recession because it is the biggest market.

So it’s very unusual, particularly with Europe, UK and US to see a strong divergence. Japan is slightly divergent at the moment and that their rising interest rates caused that big Japanese wobble and that led into the tech and the long duration assets that we saw in that what now looks quite a short wobble in July. So yeah, I would expect them to move in the same direction, but possibly not at the same pace and maybe not ending up at the same lower level.

SW: And then what are you expecting in terms of UK monetary policy?

DM: Well, all central bankers change their minds almost every week. There’s a headline today where the governor of the Bank of England suggesting that it’s gonna cut rates more aggressively, yet when they didn’t cut rates in September, ie two weeks ago, he said he was minded to cut rates at a much slower pace. Frankly, the answer is the data should tell them if inflation does drop, particularly consumer inflation or is it customer service? I get that mixed up. But that has been stubborn and if that comes down then I think there is scope for rate cuts, but as I said, you don’t have to expect big half percent, just do it incrementally and let’s see where it takes us. So one, maybe two more this year, where are we? In October. There’s only really scope for one two more this year, and if not one this year, probably one early next year.

JSL: Yes, I think that the market was pricing in sort of rates to come down to about four and a half percent before Andrew Bailey spoke today about, as you said, about rates possibly coming down faster. But so yeah, the UK’s slightly tricky because we’ve got energy bills going up and there’s talk of the minimum wage increasing by over 5%. So will that boost inflation and make make the Bank of England less likely to cut sooner? As Darius says, I think it’s just a question of watching the data.

And the other thing we’ve got in the UK, which is slightly tricky, is we have to declining labour force participation unlike other developed markets where they’ve seen their labour force participation increase. And we’ve got 7% of our population not working due to ill health. So that obviously makes for a tighter labour market too, which comes into play as well.

SW: On that cheerful note, you did tell me a few weeks ago, Juliet, that you were really optimistic about the UK and I did warn you it would come back to haunt you. So tell me, why are you so optimistic on the UK today?

JSL: Oh dear. Yes. Well, I’m normally the optimistic one and Darius will testify to that. And I have been optimistic about the UK on this podcast. And largely because the market has just been so cheap, I have become a little more nervous recently, sorry, Staci. <Laugh> The new government has done its best to frighten us with the impending budget. You know, and as a result the UK consumer has sort of pulled in its horns and stopped spending. There’s been talk of capital gains tax increases and the aim market losing its inheritance, tax relief benefits, both of which would hit the sort of beleaguered UK market. So I’ve got everything crossed that that doesn’t happen. On the plus side, if these, if these measures aren’t introduced, we will see a relief rally in the UK market and hopefully foreign investors returning.

SW: You mentioned it there. We have the autumn budget at the end of the month, end of October. So just briefly, what is on your sort of watch list for investors? You named a few things, but what should investors be aware

DM: With our slightly narrow lens on it is all around savings and investments. So is there any change to the ISA rules, caps, subscription limits, things like that will be front and centre, capital gains, maybe that’s when you don’t have your investments in an ISA or a pension and you know, if they ever go up, you will, your tax take on that share will will definitely increase. Pensions. We are big supporters of people saving privately for their pensions, either via a work scheme or self invested person or some a pension or something similar. What sort of tax changes are they going to make to pension regime? So it’s that type of thing. And then as Juliet’s alluded to, is there a possibility of some short term damage to the UK stock market by having capital gains too high, potentially doing substantial damage to the AIM market, which I think would read a cost into the smaller companies in the listed market. So that’s more of a stock market phenomenon.

But you know, the new government says it’s pro growth. I suspect we will see on the 30th of October whether that growth feeds through to the stock market or if they’re trying to stimulate the economy. And whilst they’re not necessarily correlated, I think they are connected. You know, if companies and the economy is doing well, stock markets at least have a fair chance of doing well. But if there are things overhanging the stock market, then it makes one feel slightly unsettled and less likely to invest. So I think they are connected, if not correlated.

JSL: Yes. Well I do love a bit of anecdotal evidence as Darius well knows. And you know, the government has rather frightened people because I’ve heard of one investor who sold all his London properties and moved himself to Monaco in anticipation of increased taxation. So increasing taxes doesn’t necessarily raise revenue. But the advice, the only advice I can give to investors who can’t move to Monte Carlo is make the most of your ISA and your pension allowances as Darius says you know in case they do change.

DM: And if sitting on capital gains outside of a pension or an ISA, and you’re gonna be taxed either at 10% if you’re a basic rate taxpayer or 20%, if you are a higher rate taxpayer, I think it is commonly held you that those rates are going up. So if you’ve got some gains, you can potentially sell them and then reinvest in the future.

SW: Well, another topical area is of course China. For the past sort of almost year we’ve talked about the underperformance of China, but the past few weeks the performance has really started to turn around. So are we at a turning point for China?

DM: Now, this is my favourite question of the day. Whenever we’ve done these podcasts, we’ve generally said UK smaller companies and China are the cheap assets. And China was cheap, I think after a really, really strong rally. China is still cheap. Now, what caused the rally? Well there they announced a huge stimulus of their economy. A fund manager I met last week described it as sort of the Mario Draghi moment for Europe where they’re saying they will do what it takes if that is true and the market is cheap. So we’ve all known the market is cheap, it’s cheap relative to its own history, cheap relative to other emerging markets and really, really, really, really cheap versus India, which is the other major emerging market and Asian market.

So Fidelity China Special Situations, a trust which is rated by FundCalibre was trading in the 170s about 10 or 11 days ago. It’s trading above 230. And so 30 to 40% increase in 10 days.

So now then, have we missed it? Is it all gone? And I would suspect not because they just had a bit of a very gentle re-rating being an investment trust and a geared play. It has outperformed the China market. And I would think if this is a do whatever it takes moment and there is some genuine restructuring within the Chinese economy, even after a very small but noticeable blip upwards, I think it could very much be a time for people to revisit China as long as they’re comfortable investing in the region.

SW: Alright, Juliet, I know you disagree and you’ve been holding your tongue, so let’s hear your side of the argument.

JSL: Well, it is cheap. I’m just more of a China skeptic than Darius. And I largely agree with Dave Eiswert who’s manager of the T. Rowe Price Global Focused Growth Equity Fund, who I saw recently and he was talking about the fact that he avoids investing directly there because he doesn’t like investing where the rules of the game keep changing. And for instance, one highly successful CEO became nervous in light of the recent phenomenon of Chinese billionaires mysteriously disappearing. So in order to avoid government scrutiny, he made sure that the stock of his company plummeted. So the rules of the game are different there. I’m just not sure that’s a great environment for investing.

SW: Just to wrap up, this is our final quarterly update of 2024. So as we head off into the final stretch of this year and look ahead to 2025, what is your outlook for equities more broadly?

DM: No hard landing or deep recession. I don’t see why equities can’t trundle along gently appreciating not all regions at the same pace at the same time. Juliet and I have a colleague James, who’s just seen some news out of NVIDIA’s CEO, and he wants to go and buy much more technology. Let me tell you he’s even more enthused about the subject now than he has been for the last year.

SW: I honestly didn’t think that was possible.

DM: It is possible. I can tell you our pre-meeting you know, in the five minutes we had between the last one and recording this podcast, it was the only thing we discussed. So that AI phenomenon, I’m not nearly intelligent enough to try and quantify it. I’m not even gonna try, but the next wave of it is coming. Does that continue with that really narrow market leadership that we saw in 2023 Mag Seven, Fab Four, Terrific Three or whatever, I don’t care, but I do think US equities at a headline rate are at the upper end of their valuations, historically, not all sectors, not all companies, but at a market. Europe’s fairly valued. Japan’s fairly valued, UK’s a bit cheap, China’s really cheap. But if there’s nothing grey and murky on the horizon, why can’t we just bundle along bit of positivity? And I think broadly the same for bonds as well, a lot of the rate cuts are priced in, but you can still, if you shop around, get above 6% on on some bond funds and high yield bond funds, unless of course we have that hard recession, which all bets are off.

JSL: Yeah. And there’s one thing that we haven’t really talked about this time Staci – the US election in November.

SW: Well, I try not to get depressed on this podcast. <Laugh>

JSL: <Laugh> Well, yes indeed, but I mean that’s expected to cause volatility. And unfortunately it’s not likely to be resolved in November. So there’s that on the horizon and you know, there are those geopolitical risks out there that can derail markets. You know, there’s what’s going on in the Middle East and so forth. And those are obviously pretty difficult to predict really. I think Darius was talking about where the markets broaden out. I kind of hope we see them broadening out, ie not just driven by large AI stocks. I think small-caps globally still look cheap and hopefully will do better n next year.

And yes, despite what I was saying, I still think UK small-caps look good. If the government does hit the AIM market, well, you know, that would be a good buying opportunity. You know, markets always overreact on bad news. Emerging markets have been unloved and should benefit from interest rates falling, but obviously those often include China. So you just need to check under the bonnets too, depending upon whether you want exposure to China or not.

DM: Yeah. And maybe just on the US election, I believe the only topic on which the Democrats and the Republicans agree on is that there will be increased Chinese tariffs and that is clearly a negative. And one of the things that has been stopping the Chinese market over the last couple of years, so I’m not China’s the only story in town, please don’t let this podcast reflect that. It’s just, it has been cheap. There is now some catalyst, either stimulus and if things are okay, I think, you know, markets can do okay, just we’ve had the old inverted US yield curve for several years. There is a lot of political instability across the world still with Ukraine, Russia and Middle East being the obvious flashpoints. So yeah, just watch and you know, if you like China maybe have a bit or if you’ve already got a bit good, but yeah, I think we should be able to bundle along unless we have that hard landing or big recession.

JSL: Yeah. And on the sort of risk off scenario, you know, as in if it does look like we’re there’s going to be a recession all there’s sort of geopolitical shock the government bonds tend to do better in that sort of scenario, but with a caveat that a Trump victory and you mentioned tariffs, Darius, well, they’re inflationary. So that would be negative for treasuries. So maybe European government debt in a risk off scenario.

SW: Well, if you do want to hear more about US elections, I haven’t forgotten. If you go back one or two episodes with Bob Kaynor from Schroders, he gives an excellent look into the elections and the potential scenarios and outcomes. So it is worth a listen. But on that note, we will leave it there and we will be back in 2025.

DM: Looking forward to it already.

JSL: Thanks Staci.

SW: And if you’d like to get more of the team’s views or to get any manager insights, please visit fundcalibre.com and whilst you’re there, please don’t forget to subscribe to the Investing on the Go podcast.