Count Down to Rate Cuts (and Hikes)

Central bankers recognize that word choice has the power to move the markets—sometimes wildly, which is why they are intentional and exacting in their communications. For example, they may settle on using a slightly firmer adjective than in their last missive to describe a change in the economic environment or their confidence in achieving a particular objective. The desired result is to nudge market expectations toward an intended direction without triggering a big surprise market reaction when a policy change is eventually made.

Yet, a rate cut can be expected this summer, according to ECB President Lagarde. She was interviewed by Bloomberg in Davos at the World Economic Forum just a day before the start of the quiet period which precedes ECB monetary-policy meetings. When asked if there could be majority support for such a move she replied, "I would say it's likely, too. But I have to be reserved, because we are also saying that we are data dependent, and that there is still a level of uncertainty and some indicators that are not anchored at the level where we would like to see them." Betting on inflation receding faster than the ECB forecasts resulting in an earlier pivot, markets continued to price in the first 25-basis-point (bp) cut at the April meeting, followed by another at every meeting for the rest of 2024. An ongoing risk to this view is upside inflation pressures. There has been a 500% increase in shipping costs from Asia to Europe (based on the Drewry World Container Index cost of moving a container from Shanghai to Rotterdam), driven by the conflict in the Middle East.

What does this mean for European stocks? Historically, the stock market reaction during the 180 days after the first rate cut has been mixed for Europe. The chart below shows the market's path following the start of the last three rate cutting periods in Europe that began in 2001, 2008, and 2011. The economic and earnings environment was different in each of these periods, and this time is no exception. In theory, lower rates should boost demand and market liquidity—but much will depend on the pace and timing of an economic and earnings recovery from Europe's 2023 recession.

While PBoC rate cuts may take place in the coming months, high interest rates have not been what ails China's economy–it's consumer, business, and investor confidence. Attempts to intervene in the stock market last year only saw a temporary reprieve before stocks continued their downward trend. While further measures to revive the economy have been hinted at, the slow drip of policies, which are often reactive, uncoordinated, and targeted rather than prompt and broad, have thus far not been sufficient to spark a turnaround. Consumer confidence remains low due to the hangover from the zero-COVID-19 policies and weakness in consumers' biggest asset: property. Business confidence is also likely low, due to weak demand and regulatory flip-flops.

What could turn economic momentum? A government guarantee of homebuyer deposits at troubled property developers could help boost consumer confidence from its recession-like lows. Measures to reduce government regulations into the operations of business and encourage entrepreneurship could support business confidence. The current focus on supply side stimulus amid excess capacity seems to be fueling a deflationary environment, with China's consumer price index (CPI) below zero for the past three months.

Any rate hikes in Japan could offset some of the excitement over rate cuts by other major central banks in 2024. Any rate hikes over the next year hold the potential to prompt Japanese investors to sell foreign assets and bring them home, a move incentivized by a potentially stronger currency, higher interest rates, and the 28% gain in Japan's NIKKEI 225 Index for 2023. In fact, Japan's Ministry of Finance data showed that Japanese investors turned net sellers of foreign stocks for back-to-back months in November and December after the central bank signaled the coming shift in policy at the October meeting. The size and speed of the reversal of over a decade's worth of investment flows could weigh on non-Japanese investments. The MSCI Japan Index is off to a strong start for this year, compared to the S&P 500.

As with other central banks, the stock market reaction in Canada over the first 180 days following the start of rate cuts is mixed: in three periods stocks were up (1998, 2003, 2020) and in three (2001, 2007, 2015) they were down. Often rate cuts come during periods when economic and earnings growth is weak. Canada's stock market is uniquely tied to natural resources, so a stronger outlook for global manufacturing may be more relevant to Canada's stock market than rate cuts intended to encourage domestic demand alone.