The reason for the Fed's interest rate cut has been further strengthened this week.
Recently, American macroeconomic data has been weakened in clusters. After the release of weak data such as unemployment rate, PMI, and durable goods orders last week, June CPI released this week weakened again. The market has been boosted by expectations of a Fed interest rate cut. After the Fed started its interest rate cut cycle, real estate stocks, pharmaceutical stocks, and other interest rate-related sectors are expected to be sought after by the market.
Multiple data show that the US economy is cooling down.
US June CPI has cooled down for the third consecutive month, indicating that the worst inflation in the United States in 40 years is steadily dissipating. Data released on Thursday showed that US overall CPI fell 0.1% month-on-month in June, the first decline since the outbreak of the epidemic; Overall CPI year-on-year growth rate fell to 3%, lower than the expected 3.1%.
Core CPI excluding food and energy costs in June rose by 0.1% month-on-month, the smallest increase since August 2021, with the market expecting a 0.2% increase. The indicator rose 3.3% year-on-year, also the lowest increase in more than three years, lower than the market's expected 3.4%. Core CPI is considered to provide a signal that can particularly explain the direction of inflation.
Among them, the most important thing is that the rent and housing costs, which account for more than one-third of overall CPI, have slowed down in June. The largest category of housing prices in the service industry rose by 02%, the smallest increase since August 2021. The owner's equivalent rent rose by 0.3%, also the lowest increase in three years. This may suggest that the long-awaited slowdown in rent increases has finally arrived. Rental costs are usually one of the last dominoes to fall for inflation, which is why economists are encouraged by the small increase in rents in June.
Luke Tilley, chief economist at Wilmington Trust, a wealth management company, said: "This confirms that the possibility of inflation re-accelerating is very small, and it is time for the Fed to cut interest rates."
After the PPI data was released, US Treasury yields rose on Friday. Although it rebounded more than expected, it did not change the expectation that the Fed may cut interest rates at the September meeting. This is mainly because the sub-item data used in PPI to calculate the PCE price index preferred by the Fed did not show a significant increase.
Before the US June CPI suffered a cold, a series of more forward-looking economic data released earlier had already shown that the US economy was cooling down.
Economic indicator: PMI contraction
For example, both the US manufacturing and service sector PMIs have suffered. The US non-manufacturing PMI for June recorded 48.8, hitting a new low since May 2020, lower than the expected 52.5. Due to the sharp contraction of business activities and the reduction of orders, the US service industry experienced the fastest contraction in the past four years in June. The ISM manufacturing index has continuously contracted for three consecutive months. The organization’s survey of service providers shows that due to high borrowing costs, declining corporate investment, and uneven consumer spending, demand is under greater pressure.
Investment indicator: Durable goods orders unexpectedly declined
Secondly, US factory orders in May fell by 0.5% month-on-month, below the expected growth of 0.2%. Among them, after excluding transportation and defense projects, which more directly reflect the business investment, orders also fell month-on-month. The decline in durable goods orders reflects the weakness of durable goods demand and also indicates that future business investment is not optimistic. US durable goods orders are a quite important indicator in the reports on manufacturing shipments, inventories, and new orders, and are regarded as leading indicators of manufacturing prosperity.
Consumption indicator: Weak retail sales
At the same time, consumer spending, accounting for 70% of US GDP, also showed signs of weakness. US retail sales almost did not grow in May, and previous months’ data have been revised downwards, indicating that consumers are facing greater financial pressure. Data shows that retail sales without adjusting for inflation increased by only 0.1% month-on-month, lower than the expected growth of 0.3%, and the monthly retail sales rate for the previous month was revised downwards to -0.2%. Moreover, the only service category in the report-restaurant and bar spending-dropped by 0.4%, the largest drop since January.
Moreover, the largest retailers in the United States have also issued warning signals in the past two weeks. Retail giants such as Walmart, Macy's, and Target have recently withdrawn from summer promotion activities, reflecting the decline in US consumer demand through price-for-quantity exchange. Many consumers have reduced their spending on groceries and are looking for cheaper products and cheaper alternatives.
PepsiCo's financial report released on Thursday showed that sustained inflation in the United States forced many shoppers to cut spending and instead buy cheaper supermarkets' own brands; after a sharp increase in two consecutive years, PepsiCo's sales in North America in the second quarter of this year fell by 4%.
The market's expectation for a Fed interest rate cut is heating up.
The slowdown in US June CPI is greater than expected, further proving that high inflation has dissipated, which means that the market may soon usher in a Fed interest rate cut.
The latest inflation data may help convince Fed policy makers that inflation is returning to its target of 2%. Earlier this year, the brief rise in the inflation rate caused Fed officials to lower their expectations for interest rate cuts. Their response is that they need to see a few months of data proving that inflation is cooling before they have enough confidence to lower the key rate from its 23-year high.
Powell reiterated on Wednesday that recent price readings show 'further moderate progress,' and 'more good data' will increase the central bank's confidence in inflation returning to its 2% target. He said that for inflation that has fallen back, 'I do have a degree of confidence,' the data is fairly clear on this issue, but not yet ready to say there is enough confidence.
Powell said there is no need to wait for inflation to fall to 2% before cutting interest rates. Because waiting too long could lead to inflation falling too low, which is not what the Fed wants to see. He said that if more inflation data shows that inflation is stabilizing and falling to 2%, or if he sees unexpected weakness in the labor market, he may consider cutting interest rates. But he has no specific inflation numbers in mind about interest rate cuts.
This means that if the entire summer inflation rate remains low, the Fed will begin lowering the benchmark interest rate this quarter. Following the latest data showing a cooling of inflation, the market's expectation for Fed rate cuts this year has increased. Currently, according to the CME Fed Watch tool, the market expects a probability of more than 95% that the Fed will cut interest rates by 25 basis points in September. Generally, it is expected that interest rates will be cut twice this year, and pricing for the third rate cut is increasing.
Wall Street banks have also adjusted their forecasts based on the latest inflation data, with first cuts generally expected to occur in September. JPMorgan and Macquarie have respectively brought forward their first interest rate cut forecasts from November and December to September. Citigroup, Goldman Sachs, UBS and others expect the Fed to begin cutting interest rates by September. Morgan Stanley insists that the Fed will cut interest rates for the first time in September, followed by a rate cut at 'every meeting before mid-2025.'
Richard Flynn, managing director of GTJA, said the June CPI report is a boost for the Fed and investors who want to see the final rate cut. This is the latest in a series of data releases that continue to lay the foundation for Fed rate cuts this year, as early as September. We expect this economic optimism to benefit the market.
Neil Dutta, head of Renaissance Macro Economics Research, even said that 'dovishness has what it needs' and may even lower interest rates at the July meeting.
Overall, the cooling of inflation opens the door to Fed rate cuts in September, and the Fed is likely to signal the first rate cut in September—the most likely time is the interest rate meeting at the end of this month or the Jackson Hole Global Central Bank meeting next month. Rubeela Farooqi, chief US economist at High Frequency Economics, said the Fed will change its tone at this month's meeting. Further slowing of prices, plus weak labor market conditions, support the message conveyed by the FOMC meeting this month to open the door to the earliest rate cut in September.
Fed rate cuts are coming, how will they impact Hong Kong and US stock market layout?
Recently, the expectation of rate cuts has supported the reasons for investors to remain bullish on US stocks. Many analysts believe that the timing and degree of Fed rate cuts may provide a buffer for US stocks as earnings season and US political risks test them. Besides strong earnings and the hot topic of AI, the market's bet on rate cuts this year has been one of several factors pushing the S&P 500 index up about 17% so far. The market's bet on rate cuts this year has fluctuated greatly, for example, investors currently expect the first rate cut in September, compared to only about 50% a month ago.
The start of rate cuts will indicate that 'the Fed supports the market,' said Yung-Yu Ma, chief investment officer of BMO Wealth Management. He expected the Fed to cut interest rates about six times next year. He said: 'We think this is absolutely positive for the market and the economy.'
According to Truist's research, as long as the economy avoids a recession, the US stock market usually rises six to 12 months after the Fed's first rate cut. Keith Lerner, co-chief investment officer of Truist Advisory Services, wrote in his recent mid-year outlook report that US economic growth is currently cooling off from the stimulus frenzy after the pandemic but is not weak. He is still optimistic about the US stock market, but he expects 'volatility' after a strong first half.
Tianfeng Securities also said that under the benchmark assumption that the next few quarters of the US economy may slow down, US stocks may come under pressure in the medium term, but market risk appetite remains high in the short term, and the probability of significant adjustment of US stocks is low within the validation period of economic recovery.
At the same time, if interest rate cuts begin in September, the space of domestic monetary policy will open up, and rate cuts and reserve ratio cuts are worth looking forward to in the fourth quarter. Anxin International pointed out that the encouraging inflation data released by the United States last night, combined with the rotation of funds to lagging Hong Kong stocks with the warming of rate cut expectations, provides funds with the opportunity for rotation.
GTJA also stated that Hong Kong stocks have undergone a significant rebound against the backdrop of significantly improved domestic and foreign investor sentiment, and sustainability and upward potential in subsequent periods still require more solid fundamental data to match. During the verification period of economic recovery, they still maintain a cautious and optimistic attitude. Guotai Junan believes that with the uncertainty of economic policy decreasing and the trend of overseas interest rate cuts determined, Hong Kong stocks will shake upwards.
Secondly, under this background of expectations, the rate cut related sectors will be sought after by the market. Firstly, the more sensitive real estate sector is expected to welcome bullish news. Secondly, pharmaceutical stocks that are more sensitive to interest costs are also expected to benefit from rate cut speculation. In addition, small cap stocks in the US, which have seen extremely narrow gains this year, are expected to catch up.
Real estate stocks.
The lower-than-expected inflation report brought positive signals to the real estate market, causing investors to reassess the outlook for the sector and driving up the related stocks' performance. Real estate company shares rose significantly on Thursday, up 2.7%, the best single-day performance since 2024, and reaching their highest level since March. Among them, US real estate giant D.R. Horton (DHI.US) rose more than 7%. Investors rushed to buy home builders, digital and commercial real estate stocks, making real estate the best-performing sector in the S&P 500 index, with trading volume about 30% higher than the 30-day average.
With the cooling of inflation and the potential for lower interest rates, the real estate industry may see more investment opportunities, including a rebound in real estate investment trusts (REITs). Rich Hill, head of real estate strategy and research at Cohen & Steers, said: "The outlook for the sector appears to have turned around, and considering the latest inflation data and interest rate outlook, we believe this provides a convincing backdrop for listed REITs, especially with a steady fundamental growth. If inflation continues to cool and interest rates continue to fall, the rebound that began in October 2023 may continue, pushing up lower returns by more than 20%."
Mainland real estate stocks were also strong all day Friday after US CPI data was released: as of the close, Longfor Group (00813) was up 14.29% at HKD 0.8; Seazen (01030) was up 9.35% to HKD 1.52; Longhu Group (00960) was up 8.39% to HKD 11.52; and Agile Group (03383) was up 7.84% to HKD 0.55.
Pharmaceutical stocks.
What's more critical is that after the interest rate cut, as funding costs decline, pharmaceutical companies will increase investment in capital spending, and overseas market businesses will tend to improve. On Thursday, more than 91% of Nasdaq biotechnology index components rose. Among the top ten heavyweights, Moderna (MRNA.US) rose 4.58%, and Amgen (AMGN.US), Gilead Sciences (GILD.US), and others rose more than 1%.
Hong Kong's pharmaceutical sector continued to rise on Friday: as of the close, Kangnuo-B (02162) was up 5.85% at HKD 34.4; Innocare (09969) was up 5.2% to HKD 5.06; Akeso (09926) was up 4.96% to HKD 40.2; and Genscript Bio (01548) was up 4.38% to HKD 10. Pacific Securities pointed out that as the Fed's interest rate hike cycle comes to an end, gradually easing liquidity is expected to bring about a rebound in investment and financing, and overseas demand will improve before domestic demand.
US small cap stocks.
Lower rates may also help expand the stock market's gains. A few large-cap companies, such as Nvidia (NVDA.US), have led the rally in the first half of the year. Bank of America's global research strategist said only 24% of S&P 500 components outperformed the market index in the first half of the year, the third worst six-month performance since 1986.
Joint chief investment strategist at John Hancock Investment Management, Matt Miskin, said lower rates could help those market areas affected by soaring tech stocks and higher interest rates. This includes small cap companies, which are often more sensitive to interest rates as they are more dependent on financing. The Russell 2000 index, which is dominated by small cap stocks, has risen by just under 2% so far this year. "In many cases, small-cap companies need capital to survive, and the rise in capital costs poses a real challenge to their business. Lower capital costs will certainly help these companies," he said.
Risk
Of course, rate cuts are not always a positive signal and often occur when the Fed is forced to relax its monetary policy quickly due to economic deterioration. A study released last month by Wells Fargo Investment Research found that the S&P 500 index fell an average of 20% in the 250 days after its first rate cut in an easing cycle. The company's strategist wrote that if the Fed cuts rates due to declining inflation, the stock market may perform well over the next 6 to 18 months. However, they wrote: "If the Fed is forced to cut rates substantially in response to macroeconomic or market turmoil, we expect stocks to be affected."