ECB cuts rates; solid US jobs numbers spook bonds
Author: Tom McGrath – Chief Investment Officer, 8AM Global
Market Review
It was a topsy-turvy week for financial markets, but in the end, most equity markets finished nicely higher, with the exception of the FTSE 100. The fixed-income markets had looked to be on course for solid gains until the release of US Jobs data caused investors to rethink their recent projections of increasing economic slowdown, and yields backed up sharply on Friday. Centre stage this week must surely go to the ECB, which, as widely predicted, became the first major central bank to cut interest rates on Thursday from 4% to 3.75%. To be honest – that’s not entirely true, as Canada, which is also a member of the G7, cut rates from 5 to 4.75% on Wednesday.
ECB Cuts Rates
I know it was popularly predicted, but let’s not underplay the significance of the move, as we have been waiting a long time for a rate cut from the ECB, BoE or Fed, and Europe had the confidence to move first. Since its inception in 1999, the ECB has only lowered rates when the Federal Reserve has done so first. Historically, when diverging from the Fed, the ECB adopted a more aggressive stance, such as the ill-fated rate hikes just before the Lehman Brothers’ collapse in the summer of 2008 and ahead of the peak of the Eurozone sovereign debt crisis, which led to Italian Prime Minister Silvio Berlusconi’s resignation in November 2011.
Now, by charting its course again, let’s hope the ECB will finally get a move right. Still, the announcement was peculiar, to say the least, as it simultaneously raised its inflation forecasts for 2025/6, albeit only by a tiny amount. There was also no big fanfare claiming victory, just a typically European matter-of-fact delivery with many caveats attached that suggested this is not the start of a steady procession of rate cuts, more one to test the water and then wait and watch to see the results play out in macro data in the future. There were no heroics from either equity or bond markets, as there was no surprise, and the ECB got 10/10 for ensuring that markets were prepared for the news.
There was a different tone from the Bank of Canada, who seemed to suggest that this is likely to be the first of a series of cuts, although that series is not going to be a straight line down by any means. The Bank’s summation of the move was more dovish than expected, but they still emphasised that every cut this year will require evidence that inflation is calming.
US Jobs Numbers
I can’t imagine that J Powell will feel under any pressure whatsoever to follow the moves in Europe and from its northern neighbours; it is still all about the data for the Fed, as they have been at pains to emphasise over the last year. As we went through to Friday, there seemed to be a growing belief that the US economy was beginning to slow; in fact, there was an increasing chorus of voices starting to suggest that the chances of a hard landing were growing with bond yields dropping in the run-up to the release. So, news that the US had added a whopping 277,000 jobs, exceeding all 77 forecasts by economists surveyed, caused an immediate reversal in treasury yields as fixed-income investors instantly revised their views on the direction of economic travel and rate expectations.
However, as well as the Non-Farm Payroll (NFP) release from the Bureau of Labour Statistics, the government also released the Household Survey, a poll of a smaller sample of households about their inhabitants’ work status, which showed that the unemployment rate rose to 4%, and employment fell by 456,000. Who to believe? There was a similar divergence late last year, which soon unwound at the start of 2024 in favour of the NFP, so I am inclined to run with the former as the best guide for the health of the American jobs market and, ergo, the US economy.
To my mind, the question that is going to decide the direction of travel for US equities this year, and the one that investors are struggling the most with, is whether we actually need rate cuts for stock markets to continue rising.
The market reaction to the robust jobs data on Friday was a clear reflection of investor indecision. Initially, there was a significant sell-off as the data decreased the likelihood of rate cuts. However, this was followed by a rebound as investors realized that a robust US economy could potentially boost consumer spending and corporate profits, thereby benefiting the market.
I am sure corporate profits will become more important than rate cuts over the year, and this bull market can keep powering higher with three caveats. First, we don’t get a resurgence in inflation that causes an actual change in course, as an upward move in rates wouldn’t be good for markets. And the second is that the ‘Fed Put’ remains in place, which means they are willing to cut – even if they don’t do so – if economic growth slows. And then, finally, earnings and profit growth continue to surprise the upside.
Not too much to ask, is it?
The Q1 earnings season is now behind us, with the earnings growth rate of 6.7% smashing the estimate of 1.7% and most company managements’ forward guidance positive; the omens are good on the earnings front. Looking at analysts’ consensus earnings-per-share estimates for 2024, 2025, and 2026, all three rose as the earnings reporting season progressed, with the latter two rising to new record highs. The actual earnings-per-share estimates as of the May 30 week are:
2024 ($244.68)
2025 ($279.67)
2026 ($314.81)
With analysts notorious for undershooting, you can expect those numbers to be beaten. The research house Yardeni currently estimates $270 (2024), $300 (2025) and $325 (2026), or an increase of 11.1% next year and 8.3% in 2026. If you slapped a P/E Ratio of 20 times on those numbers, which is reasonable if inflation stays moderated, then we expect the S&P 500 to be at 6000 in 2025 and 6500 in 2026. I would take that.
Let’s delve into the intriguing realm of potential future market trends. It’s an arbitrary, hypothetical stab at the future, and who knows what will actually play out. It is possible that AI will enhance productivity, and the digital revolution will accelerate earnings like never before – the Cathie Woods ARK view. Set against that are legions of bears worried about inflation, recession, trade wars, tech bubbles, geo-political tensions and even conventional political worries such as Trump in the Whitehouse again. Still, I don’t know of any bull market that hasn’t had to climb a wall of worry.
Political Change in Emerging Markets
Speaking of political change, before we get to the UK and the US, there is already a lot happening in the world of Emerging Markets, with Mexico, India and South African election results now in. South Africa is leaving single-party control for the first time in 30 years, and investors seem initially wary of what that will mean as the African National Congress Party may need to share power with more extreme parties.
Mexico has given the thumbs down to the free hand voters have given to Sheinbaum with her massive majority. In India, initial polls proved wildly inaccurate as what seemed to be an enormous win for Modi’s BJP party ended up seeing his majority cut and him needing a deal with the NDA to ensure his third term in office. The Indian stock market swung wildly during the week after euphoria for a big win, but it turned to panic as the actual results trickled in. But as has been the case for some time now, investors in India soon rediscovered their bullish disposition, with the market finishing the week close to all-time highs.
Let’s see what next week brings…
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