Fed signals rate cuts could begin in September

Executive summary:

The U.S. Federal Reserve appears likely to lower interest rates next month
The Bank of Japan increased its benchmark lending rate to 0.25%
U.S. small cap companies are reporting solid Q2 earnings growth

On the latest edition of Market Week in Review, Investment Strategist BeiChen Lin and ESG and Active Ownership Analyst Zoe Warganz discussed key takeaways from recent central bank meetings. They also provided an update on how U.S. small cap companies are performing during second-quarter earnings season.

Fed poised to cut rates amid continued slowdown in U.S. inflation

Warganz and Lin began by unpacking the highlights from the U.S. Federal Reserve’s (Fed) 30-31 July meeting, which ended with the central bank leaving interest rates unchanged at 5.25%-5.5% but signaliing a potential rate cut in September. At the meeting, the Fed pointed to the additional progress that’s been made in the fight against inflation, Lin said, setting the stage for a potential rate cut as early as September. “Core inflation rates today are around 2.6% on a year-over-year basis, which is drastically lower than the 5%-6% range they were running in during 2022 and the first half of 2023,” he stated.

Lin noted that in the ensuing press conference, Fed Chair Jerome Powell said the central bank’s progress in taming inflation has allowed it to be a little bit more balanced in managing both of its goals: price stability and maximum employment. “By most measures, U.S. job growth has generally remained pretty resilient in the face of higher rates, but the Fed wants to make sure this can be sustained. The idaea here is that with inflation easing, the central bank can lower rates gradually over time toward a more neutral setting in order to maintain both of its policy objectives,” Lin explained.

He said he expects the Fed to likely begin the rate-cutting cycle at it September meeting with a 25-basis-point (bps) cut, stressing that above all else, the central bank’s decision about the timing and magnitude of changes to the Fed funds rate will be informed by the totality of economic data.

Bank of Japan and Bank of England also hold meetings

Broadening the scope to other recent central bank actions, Lin said that the Bank of Japan (BoJ) and the Bank of England (BoE) also announced rate decisions the week of 29 July. Starting with the BoJ, he said Japan’s central bank opted to increase its benchmark interest rate from a range of 0%-0.1% to 0.25% at its July meeting.

Lin explained that unlike most other developed market countries, which have been struggling with high inflation the past few years, Japan has been dealing with persistently low inflation–or deflation–for decades. However, in the past year, inflation has become more entrenched in the Japanese economy, he said, which led the BoJ to hike rates for the first time in 17 years in March.

“The BoJ is now in a position to start normalising interest rates over time, and the 31 July rate increase is reflective of this,” Lin said, stressing that he expects the BoJ to take a relatively measured approach to lifting rates. “I do expect there will be more rate hikes to come, but I think they’ll occur at a relatively slow pace. In other words, I don’t anticipate a rate hike at every single BoJ policy meeting,” he stated. The BoJ’s decades-long experience with inflation never getting up to target likely means it’ll take a very careful and measured approach to sustaining inflation at its target rate, Lin remarked.

Moving over to the UK, he noted that the BoE would also meet that week, and that some economists were expecting the BoE to reduce its bank rate from 5.25% to 5.0%. This would be the bank’s first rate cut since the onset of the COVID-19 pandemic in March 2020, Lin noted.

How are U.S. small caps faring during Q2 earnings season?

Warganz and Lin concluded with a look at U.S. second-quarter earnings season, which continued the week of 29 July with several mega cap names reporting results. Lin said that the more interesting storey for the season is how companies outside of the Magnificent Seven group of high-tech stocks are faring–particularly, small cap companies.

He explained that small cap earnings are seeing double-digit growth so far–a feat which Lin said is particularly impressive considering that small cap earnings growth was flat to slightly negative just one quarter ago.

What’s more, analysts expect a swift recovery in U.S. small cap earnings by the end of the year, with consensus expectations calling for a year-over-year increase of 90% in earnings growth by the fourth quarter of 2024, Lin said. “To be sure, this is a very, very high bar for small caps to be able to meet, and it’s possible there could be some downside risk for companies not able to achieve such lofty expectations. Nevertheless, the expectations show that many analysts expect the tide to turn more in favour of small caps in the months to come,” he concluded.

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Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.