At Human Financial, we remain of the view that we are in the midst of an economic regime change: from growth into slowdown. Some data points are already signalling a recession.

The outlook largely depends on the level of interest rates. We’ve already started to see interest rate adjustments across much of the Northern Hemisphere, while in the US and in Australia central bankers are signalling that they will start cutting in a matter of months.

Figure 1. Central Bank interest rate cuts as at 5 Sept 2024

Lower interest rates are referred to as “looser policy” because, seen in isolation, they bring down the cost of borrowing as well as the income from savings: this, in turn, increases the demand for investment vehicles that offer more attractive returns than reduced interest rates at the bank.

The conundrum lies in the context. When central banks bring down interest rates, they are trying to stimulate additional economic activity. This is normally in response to a deterioration in economic outlook. The size and frequency of interest rate cuts usually tell us something about the central bank’s view of the scale of the problem.

Of all the finance professionals, fixed interest investors are most focused on the future path of interest rates, since their asset class (bonds) is the most explicitly impacted by changes to interest rates, especially unexpected ones. Currently they (in aggregate) are expecting significant interest rate cuts over the next year. For the US, they are expecting interest rates to be lower by 2% while in Australia they are expecting a fall of 0.85%.

Over the past three decades, this magnitude of rate cuts has only been seen in response to economic crises: Tech bubble, GFC, COVID.

Figure 2. Historical 12m rolling US interest rate changes

Meanwhile, equity investors continue to view the world through rose-coloured spectacles. With major indices near all-time highs, they see the signalling of rate cuts as positives for corporates: lower debt costs and increasing consumer demand driving higher margins/profits; and lower savings rates will drive investors into equities.

Looser policy is indeed likely to be stimulatory, but the underlying drivers for materially lower interest rates are almost certainly negative.

At some point, as central banks rapidly reduce rates by large amounts, investors will ask themselves “What do Central Bankers know that we don’t?”

This is usually a sign that investors will swing from greed to fear, initiating sell-off of growth assets, often exacerbating the softness of a market already labouring under the weakening economic outlook.

In summary, fixed interest investors are expecting major interest rate cuts, in a magnitude not seen outside historical crisis, while equity investors are viewing the lowering of interest rates as a positive, improving business conditions and profitability.

We suspect the reality is somewhere in between, with current fixed interest prices too pessimistic and stock markets too optimistic. We therefore aren’t adding to our defensive tilts today, but are retaining our current positioning of higher allocations to income-generating assets, a tilt which has been driving our higher returns.

As we undergo this economic regime change, we remain underweight growth assets, which we still view as overpriced and liable to create unwanted downside volatility.