The world economy has proved to be quite resilient, a positive element that is all too often overlooked in the negativity-savvy news headlines. It is worthwhile remembering that central banks have their foot on the brake and have plenty of room and time to take it off. The current environment is usually positive for equities and negative for gold. However, given today’s politics-soaked world, the potential for surprises remains high and gold continues to be in demand.
Gold: Rate-cut-driven record highs
The focus of the gold market has fully shifted away from Chinese investment demand and central bank buying to the outlook for interest rate cuts in the West. Prices reached a new record-high last week after the ECB cut interest rates a second time. The link between interest rate expectations and the gold market is twofold, via the futures market and via the physical market. Sentiment in the futures market is already very bullish as short-term speculative traders had positioned themselves for lower interest rates. Meanwhile, activity in the physical market has picked up as the prospect of more interest rate cuts prompts safe-haven seekers to stock up.
Looking back at previous US interest rate cutting cycles reveals that lower interest rates alone are not sufficient to push gold prices higher. Instead, these cuts need to happen in a recessionary environment: when the first rate cut of a cycle is followed by a recession, gold prices have risen by an average of 15.5% after 12 months. If a recession does not follow, they have fallen by an average of 7%.
Equities: Impact of the rate-cutting cycle
Historically, US equity markets have shown strong performance during Fed rate-cutting cycles, particularly in the absence of a recession. Since the 1980s, the S&P 500 has delivered an average return of 14.2% over the 12 months following the initial rate cut, outperforming the average 12-month return of 10.4% over the entire period. This suggests that Fed rate cuts, when not accompanied by an economic downturn, generally create a ‘risk-on’ environment, driving equity gains.
While the macroeconomic environment generally remains favourable, we expect volatility in equity markets to stay elevated given uncertainty around the upcoming US election, lingering fears of an economic slowdown, as well as seasonal factors. That said, we view the recent volatility as an intermediate correction in a primary uptrend in the secular bull market. While the risk/reward profile for investing into cyclicals has become more compelling, long-term investors should nevertheless stick with US large-cap growth stocks, which are expected to remain the leaders of the secular bull market.
Emerging markets: Implications from the first Fed cut
Historically, Fed easing cycles have been particularly supportive for emerging market (EM) equities when they were not followed by a recession. US elections are potentially more relevant for this asset class outlook, as protectionist measures by candidates could be particularly harmful. We see no need to rush into EM equities and wait for further evidence of a soft landing, fading US election risks, and a weaker USD.
With the US Fed’s first rate cut, investors are increasingly looking at the potential of EM equities. Historically, since 1989, EM stocks have outperformed developed markets (DM) during easing cycles, particularly in non-recessionary environments. While the initial performance may not show drastic differences, a clearer picture typically arises about one quarter after the initial rate cut. This period has been crucial, as it has allowed investors to assess whether the economy is heading for a soft landing or into a recession.
In fact, during past soft landings, EM equities have outperformed DM equities by an impressive 27% in the year following the first Fed rate cut. However, while these historical trends are compelling, we highlight that this information should not be used in isolation, particularly since the macroeconomic environment and market fundamentals today are quite different from those in previous cycles.
We see no need to rush into increasing EM equity exposure at this stage. Yet EM bonds have yielded superior returns, on average, across all economic scenarios during Fed easing cycles and thus potentially offering a more appealing entry point while US growth uncertainty persists. We believe a more favourable opportunity may arise once there is clearer evidence of reduced election risks, coupled with a soft landing and a weaker USD.
What does this mean for investors?
As our strategists point out, the current environment is usually positive for equities. Of course, the US presidential election offers lots of fuel to keep markets emotional and jittery. For gold, history suggests that the current environment is rather negative, however we remain constructive on gold.
Gold prefers it when central banks shift to the gas pedal instead of lifting their foot from the brake pedal. That said, no cycle is identical, and in today’s geopolitics-soaked world, some central banks might be willing to pay more than usual to use gold as a diversifier. In brief, be relaxed about the rate cuts.