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Are lower rates enough to drive markets higher?

The PSEi has rallied strongly the past month and a half, rising by 7 percent. The outlook of the domestic economy has also improved as interest rates continue to go down, thanks to the benign inflation environment and the ongoing reduction in banks’ reserve requirement ratio (RRR). As a result, the yield curve is no longer inverted, which used to be one of the major concerns of investors.

The pressure for rates to go up is now much less, thanks to falling oil prices and the likelihood the US Fed will cut rates. Note that after hitting a peak of $66.20/barrel in April, the price of oil has gone down to $57.30/barrel as of this writing. Meanwhile, economists are now anticipating the Fed to cut rates twice by the end of this year. This is a sharp contrast to the consensus view earlier that the Fed would raise rates twice in 2019.

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Despite the strong performance of the PSEi, many investors remain cautious toward the stock market. After all, the outlook of the US economy is now much worse, brought about by President Trump’s imposition of higher tariffs on a number of Chinese imports. He also threatened to expand tariffs on another $300 million worth of Chinese goods. Trump’s actions hurt business sentiment, as reflected in several indicators.

For example, the US Markit Manufacturing Purchasing Managers Index (PMI), which measures the level of activity of purchasing managers in the manufacturing sector, deteriorated sharply to 50.1 as of June 21. Although it still indicates expansion as it remains above the critical 50 level which separates growth from contraction, the number is sharply lower from 55.7 at the start of the year and 52.6 in May.

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After a rally earlier, the price of copper has gone down from $6,415/metric tons as of end April to $5,960/MT currently. Given copper’s numerous applications in cyclical industries, the lower price of copper is viewed as an indicator of global economic weakness.

Finally, the yield on the US 10-year bond has fallen by 48 basis points from its end April level to 2.02 percent which is the lowest for the 10-year bond yield since November 2016. This could be an indicator of investors’ increasingly cautious outlook on the US economy, prompting them to switch to bonds which are considered to be safe haven investments.

Surprisingly, despite the deteriorating outlook of the US economy, the US market still went up in June after falling initially in May. The S&P 500 is now back to an all-time high. The latest rally was triggered by increasing hopes of a rate cut by the US Fed. Earlier in June, Fed Chair Jerome Powell said the Federal Reserve was ready to respond if the Trump administration’s ongoing trade war would hurt the US economy.

Although the Fed did not cut rates during its meeting two weeks ago, eight out of the 17 participants on the Fed’s policy-making board now believe that one or two rate cuts are needed this year to keep the economy strong, up from only six as of March this year.

Aside from the United States, other emerging markets are performing well. For example, the benchmark equity indices of Thailand and Indonesia are both up by more than 7 percent compared to a month and a half ago after suffering from a steep sell-off earlier in May. Even the Shanghai Stock Exchange Composite Index in China is up by 0.8 percent in the same period, despite the fact that the Chinese economy is most vulnerable to the ongoing US-China trade war.

Admittedly, lower rates are highly favorable for equity markets. As they say, “Don’t fight the Fed!” However, nobody knows if lower rates are enough to drive markets higher, even with the growing risk of a recession in the United States. There is reason to be cautious especially since historically, a weaker US market has negatively affected the performance of global markets including the Philippines.

Given the uncertainty on the sustainability of the US market’s strong performance, the best way to control risk is by managing exposure to the stock market. To stay prudent, make sure the amount you have invested is not too much, allowing you to stomach any volatility that could take place assuming that the market fails to go up in a sustainable manner. This should be an amount you can afford to keep invested over a long period of time. Also, make sure to invest only in fundamentally sound stocks that are trading at attractive valuations as those stocks are expected to be more resilient to volatility.

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