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WeekWatch - Did the Fed buckle under pressure?
Stock Take
After months of lobbying by the US president demanding that the Federal Reserve cut interest rates, there are signs he may get his way. In a speech on Friday Jerome Powell, chair of the US central bank, hinted strongly at a September rate cut. This would be the first rate change since January of this year.
After a lacklustre week, US financial markets rallied following the news. The Dow Jones Industrial index rose by more than 800 points (+1.9%). This was its first record high of the year. The broader based S&P 500 gained 1.5%, its best performance since May. Share prices in Europe and the UK also closed higher. Bond prices rose (and yields, which move in the opposite direction, fell) and the prices of oil and gold also climbed. In contrast, the prospect of lower interest rates on dollar deposits saw the dollar weaken.
When bad news is good for investors
Why are US interest rates expected to fall? The committee deciding on interest rate changes at the Federal Reserve (Fed), led by Jerome Powell, has two responsibilities. The first is to achieve maximum employment. The second is to keep inflation steady and low, with a target of 2%. If both work as intended, interest rates remain in a ‘goldilocks’ zone, not too high and not too low.
Although investors welcomed the possibility of a September interest rate cut, Powell’s reasoning was cautious. He identified potential risks in the economy that could affect both parts of his mandate. These include in particular the domestic jobs market and US employment.
Recent data shows a marked slowdown in job creation. The number of new applications for jobless benefits has been rising, while the level of those collecting unemployment benefits is at a near-four year high. As a result, many analysts think it likely the Fed will cut rates at its next meeting in September. Powell’s comments have reinforced this viewpoint.
Meanwhile the inflation picture has also worsened. In July, core inflation, which strips out the more volatile food and energy prices, rose to an annual rate of 3.1%. This was above market expectations. The latest release of the Fed’s preferred inflation indicator, focusing on personal consumption expenditures, was 2.6%. Both these readings are above the Fed’s 2% target.
Inflationary pressures also look set to increase. There are signs that rising costs from higher tariffs on imports will increasingly be passed onto US consumers this year. This signals a change from earlier this year when companies absorbed the additional costs, sacrificing profitability. The US government’s crackdown on illegal immigration is also expected to affect the supply of labour.
Choosing the least bad option?
It seems strange that the Fed is signalling a possible interest rate cut even as the inflationary backdrop worsens. Yet this highlights a difficult with the Fed’s dual mandate – full employment and steady inflation. It is also trying to deliver on both, but with only one tool, interest rates. At times, such as now, one or the other has to be prioritised.
Why did Powell focus on employment at the expense of inflation? He highlighted an “unusual situation” in the labour market. The outlook here could deteriorate quickly, which could be reflected in much higher layoffs and higher unemployment.
Smaller companies up while tech firms lag
Lower interest rates are usually positive for the economy and stock markets. This is because borrowing costs for companies and consumers come down and they spend more.
On Friday, more than 400 companies in the S&P 500 rallied in response to the prospects of lower interest rates. The strongest rises were in areas and sectors regarded as prime beneficiaries of lower rates, such as the smaller company Russell 2000. Smaller companies often have higher levels of borrowings than larger ones. They are also more reliant on borrowings to grow and so will gain from a lower debt burden. The financials sector, which includes banks, is also a beneficiary.
Among the S&P 500, real estate (property), energy and materials (commodities) led sector returns. In contrast, the only two sectors that lagged were tech and communication services. Both these sectors have already performed strongly and are highly valued.
The US dollar retreats
In contrast to the performance in stock markets, the US dollar weakened on the prospect of lower interest rates. This caused bond yields to fall - and prices to rise. The risks of a weaker currency are that imports become more expensive, fuelling inflation. More positively, exports become more attractive, supporting businesses and possibly the balance of trade.
A month is a long time in markets
There are risks associated with lowering rates. Before Powell’s speech Greg Venizelos, fixed income strategist at SJP, noted that future effects of tariffs“…will be more disruptive than perhaps the markets think. Both inflationary and negative for growth.” He also warned of “a certain exuberance, if not complacency, in markets”.
The Fed will announce its latest decision on interest rates on September 17. Market data now shows a 75% chance it will decide on a cut. Yet there are reasons why the Fed may not decide on an interest rate cut, even if investors expect one. These include; further stubborn inflation readings, often described as ‘sticky’; a strong jobs report suggesting the economy is doing well without the stimulative effects of further rate cuts or a geopolitical shock that could cause oil prices to jump. Any of these could cause the Fed to pause and led to a reversal of some of the moves recently seen in markets.
Wealth Check
Nobody likes talking about death, and many of us aren’t that keen to talk about money either. So, it’s not surprising that we often put our estate planning, and inheritance tax (IHT) in particular, on a back burner.
However, while we may not enjoy talking about death or taxes, one thing’s for certain - nobody wants to pay any more tax than they have to.
To help, here are a few ways to mitigate your IHT bill and leave more to those you love.
Start giving money now
Each tax year, you can give away up to £3,000 tax free, which is called your annual gifting exemption. If you didn’t use your £3,000 gifting exemption in the previous tax year, you can combine two years’ worth and give away £6,000.
You can also make any number of small gifts up to £250 per person, which is called your small gifts exemption (provided you haven’t made other gifts to the same person). These exemptions apply each tax year.
In addition, you can gift your son or daughter £5,000 if they’re getting married, £2,500 to a grandchild or great-grandchild and £1,000 to anybody else.
However, if you die before seven years have passed and a gift is above your available IHT exemption, it will become chargeable to IHT and tax may be payable. One little bit of good news however, is that the rate of tax which applies to the gift over the available allowance tapers off after three years, ranging from 40% to 0%. This is called taper relief. Essentially, if you’re considering making a larger gift, get generous sooner rather than later, if you want to avoid the IHT seven-year rule.
Make gifts from spare income
If you’re a higher earner, you may wish to make regular gifts from your disposable income. In tax-terms this is known as the ‘normal expenditure out of income exemption’. If you’ve got more income than you need to live on, you can gift money on a more regular basis.
For this to help mitigate your eventual IHT bill, you’ll need to demonstrate to HMRC that you can afford these payments and still enjoy a comfortable standard of living.
Always keep a record of these gifts and let your loved ones know where it is or give them a copy. This can help if the payments are investigated by HMRC, either before or after you die.
Sort out life assurance – and write it in trust
One IHT-friendly option is to take out a life-assurance policy where the sum assured covers your predicted IHT bill. That way, your family can use these funds to cover the tax bill.
For this to work, however, you need to write the policy in trust. That way, the payout falls outside your estate for IHT purposes. The premiums you pay into the policy are considered as a lifetime gift and may be covered under the ‘expenditure out of normal income’ rule, or your annual gifting exemption.
The levels and bases of taxation, and reliefs from taxation, can change at any time. The value of any tax relief generally depends on individual circumstances.
In The Picture
More expensive debt is a headache for the current government, as it will need to find more cash to pay it down.
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The information contained is correct as at the date of the article. The information contained does not constitute investment advice and is not intended to state, indicate or imply that current or past results are indicative of future results or expectations. Where the opinions of third parties are offered, these may not necessarily reflect those of St. James's Place.
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