Three Key Thoughts:
1.     The Fed Cut Finally Arrives
2.     China: We’re Skeptical on Stimulus
3.     Geopolitics: A Dangerous Mess

The Fed Cut Finally Arrives

The Federal Reserve finally delivered the long-awaited cut in the Federal Funds rate at its September meeting. The one-half percentage point reduction was bigger than most investors had expected. The markets reacted predictably: US stocks were up while the dollar was down, helping international stocks. Among US stocks, market leadership changed significantly. Large cap technology stocks lagged the market while a broad range of other sectors including health care and consumer staples did well.

As we noted last quarter, we expected the market’s obsession with AI to fade and wondered whether optimism about interest rate reductions might replace it. In the short term, that is what happened. However, the most recent economic reports have been more positive and inflation reports steady, giving rise to a concern that growth may be too strong and inflation not yet tamed.

The upcoming election also provides some uncertainty as to the future direction of economic policy. But neither presidential candidate seems interested in fiscal discipline – you could argue it’s a race to see who can increase the deficit fastest – so that rightfully adds to concern about inflation returning. Meanwhile, the US government posted a $1.8 Trillion deficit for the year ended September 30. That level of deficit spending has, in our opinion, offset the impact of Federal Reserve’s higher interest rate policies for the last couple of years, keeping the economy growing.

Having surprised the markets a bit with the one-half percentage point cut, we expect the Fed to go slow from here. We would be surprised if we don’t see a couple more one-quarter point reductions at the two meetings left this year. However, Chairman Powell has made it clear that they will respond to incoming data, so the markets will likely continue to hang on every inflation and employment report for the time being.

China: We’re Skeptical on Stimulus

When the Chinese government lifted its harsh pandemic lockdown policies two years ago, many expected a strong bounce back in the Chinese economy. While there was a bounce, it was short-lived, and several underlying economic problems were exposed. Most notably, real estate developers were financially overextended as they had counted on continued high demand for housing. The declines in home prices not only dented consumer confidence but caused prospective buyers to back away, further pressuring prices. So far, government programs to address the problems have been much too weak.

Adding to these issues, the government took many actions in the interest of “common prosperity” and “national security” that appeared to reverse decades of private sector successes. Collectively, these further hurt consumer and business confidence. Not surprisingly, foreign direct investment also plummeted.

We believe that China now suffers from a lack of confidence in the future. Young people have cut back on marriage, family formation and housing purchases as job prospects have been reduced and the opportunities for financial gain limited. Saving is in, spending is out. Yes, the programs announced a few weeks ago are the most substantive since the Great Recession. But interest rate cuts, easier down payment terms and lower bank reserve regulations aren’t going to create loan demand when consumers and businesses aren’t interested in borrowing. Until confidence in the future is restored, the effects of stimulus programs are likely to be limited.

Geopolitics: A Dangerous Mess

The Middle East has taken over from the Russia/Ukraine war as the world’s biggest trouble spot. Israel’s battle against Iran and its proxies, Hamas and Hezbollah, threatens to expand and pull other nations into a broader war. The US is trying to hold onto its role as leader of the western allies, while Russia, Iran, North Korea and China (most of the time) actively work against them. This epic battle calls for strong leadership, which much of the west lacks, while our adversaries possess it in spades.

For several years now, the US military has been trying to limit its involvement in the Middle East, as it wound down wars in Iraq and Afghanistan and it intended to focus its deterrence efforts on China. However, the threat posed by Iran has never been well-contained and it is now front and center. Combined with the resource drain associated with arming Ukraine, the US military now finds itself resource-constrained in a world with increasing challenges.

Investment Implications

Bolstered by unprecedented deficit spending and higher productivity from technology investments, we expect the economy to keep growing and inflation to slowly decline. This should allow stocks and bonds to fare reasonably well. The greatest risks today are geopolitical and should not be ignored. We continue to believe that well-diversified portfolios with substantial amounts of liquidity are most appropriate for this environment.