Optimism about imminent rate cuts is stirring animal spirits – and unease – in equal measure at the end of a turbulent quarter in markets.
Prominent money managers have stopped chasing the latest stock rally, reasoning that expectations for easier Federal Reserve monetary policy are overblown with inflation still running hot. Should any rate cuts come, they would be intended to halt an economic downturn that also would bode poorly for equity returns, their thinking goes.
Barclays Wealth Management just closed out an overweight position on developed market stocks two weeks after initiating it. Legal & General, which manages $1.4 trillion, has cut its equity exposure down to the biggest underweight since the pandemic, concluding that the hit from aggressive tightening will continue to play out on the US economy for months to come. After the bank turmoil this month, asset managers shifted their stock exposure from close to neutral to a level halfway toward historically low underweight measures, according to Deutsche Bank AG.
“Market-implied estimates may be exaggerating rate-cut potential before year-end,” said William Hobbs, chief investment officer at Barclays Wealth Management. He favors defensive positioning.
Their caution stands against a 20% advance in the tech-heavy Nasdaq 100 during the first three months of this year – its best quarterly gain since 2020. Speculative fervor has also boosted the price of Bitcoin by more than 70%.
Markets determined to leave worries about banking sector contagion behind have put falling bond yields and rosy reads of a looser Fed balance sheet in their sights. It’s a view that directly contrasts with the latest messaging from Federal Reserve officials.
Boston Fed President Susan Collins Friday said that more needs to done to bring inflation down, while Fed Chair Jerome Powell has insisted that officials don’t anticipate cutting rates any time soon.
Markets have priced in a sanguine scenario where cooling inflation triggers 60 basis points of rate cuts by the end of the year. The two-year breakeven rate, a measure of the market’s inflation expectations, is hovering closer to the Fed’s target that before the banking turmoil. The argument that easing inflation will allow the Fed to wind down its rate-hiking cycle was helped by a report Friday showing US inflation rose last month by less than expected and consumer spending stabilized.
Still, such priced-for-perfection sentiment can quickly turn around. At a gathering of economists by Lake Como this week Nouriel Roubini, chairman of Roubini Macro Associates, summed it up: “We cannot achieve price stability, maintain economic growth, have financial stability at the same time.”
Fund flows underscore jitters about the risk rally. Investors flocked to cash with $60 billion entering money market funds while they withdrew $5.2 billion from global equity funds in the week through Wednesday, according to Bank of America, citing EPFR Global data.
For Legal & General, the turning point came when the wobbly balance sheets of US regional lenders like SVB Financial Group were exposed, and a liquidity crisis swamped Credit Suisse Group AG.
The full impact of the Fed’s aggressive rate increases has yet to be fully absorbed by the American economy, warned John Roe, the head of multi-asset funds at Legal & General. He’s both cut his exposure to equities and added recession hedges in the form of long-duration government bonds.
‘Never Only One’
“There’s never only one cockroach,” said Roe. “The SVB case isn’t isolated. It’s about the growing risk that the hikes so far in the end restrict lending – the standard lagged effect of monetary tightening.”
While Wall Street strategists haven’t changed their year-end targets, both systematic and discretionary managers have decreased exposure rapidly since March 8. The equity exposure of systematic investors fell to the lowest since 2021 as trend-following quants were caught in wild swings of the early days of the banking turmoil. Discretionary funds have now cut back exposure to underweight after hovering close to neutral levels at the beginning of March, according to Deutsche Bank.
“Our positioning measure had fallen from near neutral when the SVB shock hit to about half-way back to the bottom of the historical band,” said Parag Thatte, a Deutsche Bank strategist.
Meanwhile, Fed officials continue to push back on the pivot narrative and have reiterated that more monetary tightening may be needed to fight inflation even after the collapse of three US banks earlier this month. Echoing Boston’s Collins, Richmond Fed President Thomas Barkin sees room for rate increases if price pressures persist.
It’s not the first time traders have been caught in wrong-way bets that rate cuts would start earlier than indicated by the Fed. In August traders rushed to buy duration-heavy assets, convinced that an economic slowdown would bring disinflation. Since then the Fed has raised its benchmark rate in five consecutive meetings. BlackRock Investment Institute strategists warned this week investors are wrong to believe US rate cuts are coming.
A recession should in theory vanquish inflation, but that’s not a given. In the 1970s the Fed eased policy only to watch as inflation ran rampant and growth flat-lined.
“Looking at the price action across asset classes over the last fortnight, the inference seems to be a Goldilocks growth hit for the stock market,” Hobbs said. “Something a bit more difficult to square so neatly feels more likely.”