Gold News

When the Fed Cuts Rates in a Boom

Here's what the market did every time...

FIRST a mea culpa, writes Frank Holmes at US Global Investors.

As you know, the market collapsed in the fourth quarter of 2018, sinking some 20% between the end of September and December. Expressed another way, it fell four standard deviations below the mean over 60 trading days – a huge move.

When the market has fallen by that much, it's historically been a good time to get contrarian because a reversion to the mean hasn't been too far behind. Mean reversion, as I explain in 'Managing Expectations', is the idea that prices tend to move back to their historic averages eventually.

The reason I'm telling you this now is that I didn't take my own advice. I believed, as others did, that more pain was ahead. Prices bottomed, but instead of buying, I took money off the table. And watched the market bounce strongly. By the time it became clear that this aging bull market wasn't slowing down, it was too late. The opportunity had come and gone.

We all have a choice on how we deal with setbacks. When asked once about the single most important lesson he's learned over the course of his long career, the billionaire hedge fund manager Ray Dalio pointed to his bad bet in the 1980s. He believed the US was headed for a depression, and when one never came, he fell so deeply into debt that he had to borrow $4,000 from his father to make ends meet. The experience "was one of the best things that ever happened to me because it gave me the humility I needed," he wrote in his bestseller Principles: Life and Work.

I never stop learning, even after four decades spent in global markets. That's as true now as it was when I first started as a young analyst in Toronto. And I'm pleased to say that, after thoroughly reviewing our models, our investment team and I have great confidence going forward.

The market is now at record highs, and unemployment is way down. Even so, a US rate cut is expected as early as this month. During his congressional testimony last week, Federal Reserve Chairman Jerome Powell raised concerns over slower global growth and trade tensions, which in turn have contributed to weaker demand and manufacturing activity. The most recent Global Manufacturing Purchasing Manager's Index (PMI) showed that, at 49.4, factories contracted for the second straight month in June. We haven't seen back-to-back sub-50.0 PMI readings since the second half of 2012.

There's also a one-in-three chance we could see a full-blown recession sometime next year. That's according to the New York Fed's recession probability index, which flashed a 12-year high of 32.9% last month. Since 1960, every time the index has surpassed 30%, the economy has tanked within the next 12 months.

Despite the risks, the US economy is still expanding – an unusual, though not unheard-of, time for the Fed to consider cutting rates.

So let's assume for a moment that the Fed does take action this year. What effect would that have on the stock market as well as manufacturing activity?

That's precisely what analysts at market research firm Fundstrat looked into recently, and what they found is that 100% of the time, the market increased in the next three, six, nine and 12 months. The median gain over nine months, in fact, was nearly 18%.

Hypothetically, if the same thing were to happen today, that would put the S&P 500 Index at around 3,500 by next April.

Once again, for those in the back: In every case going back to 1971, when the Fed began a new easing cycle while the economy was expanding, stocks went up three months, six months, nine months and 12 months later. No exceptions.

That wasn't the case with manufacturing activity. According to our own research, the ISM Manufacturing Index, which measures the US sector, rose only a third of the time three months following a rate cut in good times. Six and nine months out, the index was up half the time. Twelve months out, it was higher about 66% of the time.

Those are decent odds, but a rate cut now would be much more favorable for stocks, statistically speaking.

To get manufacturing up to full capacity, I think there needs to be a resolution to the US-China trade war. That was also the assessment of Renaissance Marco. In a note dated July 2, Neil Dutta, head of economics, observed that the word "tariff" featured prominently in purchasing managers' June commentaries, suggesting trade issues were partly to blame for ISM weakness. If tariffs are indeed a driver of slower manufacturing growth, "it would imply the ISM has room to pick up from here. After all, we've seen some relief over the weekend (China) and earlier in June (Mexico)," Dutta wrote.

If rate cuts are favorable for stocks, they can act as rocket fuel for the price of gold. As I've explained many times before, the yellow metal has thrived in low-rate, weak-US Dollar environments.

Last week UBS reiterated the relationship between gold and interest rates, writing: "Low to negative rates suggest falling cost of holding gold at a time when elevated trade and geopolitical uncertainty strengthen the case for diversification." Strategists Joni Teves, Roque Montero and Bhanu Baweja see gold hitting $1450 an ounce by the end of this year and rising "modestly" to $1500 in 2020.

TD Securities expects gold to average $1400 for the rest of the year, followed by a lift toward $1500 "in the final months of 2020," driven by low to negative rates. One of President Donald Trump's picks for the Federal Reserve Board of Governors, Judy Shelton, is also constructive for gold, as she is in favor of lowering rates and supports a return to the gold standard.

Finally, analysts at Alpine Macro see the beginnings of gold's "third great bull market of the post-war period." A rate cut by the Fed could set in motion a multi-year bear market in the Dollar, analysts write, which is very supportive of gold. With the recent technical break above $1400, "new all-time highs for gold should be seen in the coming years," the research firm writes.

Frank Holmes is chief executive officer and chief investment officer of US Global Investors Inc., a registered investment adviser managing approximately $4.8 billion in 13 no-load mutual funds and for other advisory clients. A Toronto native, he bought a controlling interest in US Global Investors in 1989, after an accomplished career in Canada's capital markets. His specialized knowledge gives him expertise in resource-based industries and money management.

See the full archive of Frank Holmes.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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