Welcome to Market Flash – a communication authored by Arbuthnot Latham’s Co-Chief Investment Officers designed to give you time sensitive information regarding material events which impact markets around the world. We hope you find this message of value and would welcome your feedback.

Q: What happened with the Fed last night?
A: For the first time since 2008 the Fed (US Federal Reserve) reduced the interest rates by a quarter point (the Federal Funds Target Rate range was decreased from 2.25%-2.50% to 2.00%-2.25%). It also made minor adjustments to the way it manages its balance sheet. A cut was expected, but markets were paying more attention to the size of the cut and the language used to describe this decision.

Q: Why did they take this action?
A: The committee pointed to weak growth at home and abroad, the prolonging trade war and soft inflation. Generally speaking, central banks cut rates when an economy is slowing and needs a boost, and raises/hikes rates when things are going well and to prevent over-heating. In this case, the Fed was taking out an ‘insurance policy’ to protect the economy against a possible future deterioration. They wanted to demonstrate that they are being proactive.

Q: Will a quarter point cut really have an impact?  Will there be more cuts later this year? 
A: Realistically, this modest move down is largely cosmetic and designed to send a clear message to investors that the Fed is ‘awake at the wheel’. However, interest rate cuts tend to work best when there is scope for long term interest rates to fall and asset prices are cheap at the time (both conditions do not exist today). Expectations are that the Fed will lower rates by another quarter point later in the year. We are sceptical.

Q: It appears that the Fed sent mixed signals last night?
A: In the past, the committee has been criticised for not communicating their intentions; this is no longer the case. The new normal is to telegraph policy so that corporations, households and investors can plan better. There remains the possibility that they may be over-communicating.

Q: Was it a policy misstep to lower the borrowing costs by quarter point?
A: Only time will tell, but it appears that the Fed has caved in to political pressure from the White House. This is concerning, because the Fed is supposed to be independent from the Executive Branch (the US President). US employment is rock solid, there are very few cracks in the housing façade, the S&P500 is at an all-time high and leverage seems largely in check (with the exceptions of some pockets of higher yielding debt). The bottom line is that very few alarm bells are signalling a downturn at the moment, so we need to question the rationale behind such a move.

Q: Will this impact the monetary policy of the other central banks? 
A: All the other major central banks, especially the ECB (European Central Bank), are now expected to ease with the notable exception of the BoE (Bank of England) which is probably trying to keep its powder dry in the event of a hard Brexit. Who’s next? The PBoC (People’s Bank of China) may cut rates as well, as part of their dual monetary and fiscal stimulus efforts to counteract the impact of trade wars and to shore up support for President Xi.

Q: Did all the Fed officials agree with the move to cut?
A: No, not all voting members supported this decision.

Q: How will this impact my portfolio?
A: The theory is that when the Fed cuts rates, it lowers the cost of borrowing for the US government, corporations and households. Leaving aside the government, if corporations have variable rate debt outstanding, the cost to service this debt will decline, translating to higher earnings and better growth.  Also when corporations issue new debt, it will in theory offer a lower yield, thus saving the company money. Similar scenarios exist for households, when borrowing becomes cheaper, the theory is that families have more disposable income and they can further support the economy by increasing consumption (assuming they don’t increase savings). For markets, lower interest rates encourage asset allocators (such as our investment management team) to purchase risk assets (such as equities), however, if the rate cut is motivated by concern about the state of the economy, risk assets may react poorly as investors interpret a rate cut as bad news to come. The modest change in US equities following the rate cut reflected the balance between easier monetary policy and the prospects for further economic decline. Some would chalk it up to the confusing message communicated by the Fed. It was unclear whether this is the beginning of a major shift in policy or it is a ‘one and done’ adjustment.

Q: Why does the White House keep criticising the Fed?
A: Generally speaking, softer or more “dovish” monetary policy (such as lowering interest rates) is good news for equity markets, and a high S&P would certainly help President Trump’s hopes of re-election. He has said it himself, he wants the stock market to perform strongly during his tenure and will use this as a key selling point when seeking re-election.

Q: Are we making changes to portfolios on the heels of the Fed decision last night? 
A: We have a very structured methodology which we use to manage client portfolios and in this case, the move has not triggered a readjustment in our asset allocation, stock selection nor currency exposure.

Arbuthnot in the press

Please find below a link to the Bloomberg radio Interview during which we discuss trade wars, global bank earnings and the impact of the new Prime Minister on UK assets:

Listen here

Gregory Perdon
Co-Chief Investment Officer
Arbuthnot Latham & Co., Limited

Eren Osman
Co-Chief Investment Officer
Arbuthnot Latham & Co., Limited