Declaring Independence From the U.S.

The Federal Reserve looks to emerge as a global outlier on policy interest rates, likely cutting rates later in this cycle than other major central banks. As the Fed delays the start of cuts, other central banks are declaring independence from the U.S.'s Fed with the European Central Bank's (ECB) Lagarde making that clear in the press conference following the April meeting when she explicitly stated, "We are not Fed dependent." The heads of the Bank of Canada (BOC) and the Bank of England (BOE) also expressed similar sentiments last week. And March saw Swiss officials delivering the first interest rate cut of the current cycle by a central bank with one of the world's 10 most-traded currencies and is expected to lower rates again in June.

The odds of a 25-basis-point (bp) rate cut by the Fed in June have come down from a "sure thing" at the start of the year to merely a 15% chance in the eyes of the interest rate futures market. At the same time, the odds remain well over 50% for other major central banks, as you can see in the chart below.

Looking past June, the outlook for the number of rate cuts priced in for all of 2024 has slipped from between six to seven at the beginning of the year to between one and two for the Fed, and between three and four for the ECB, as you can see in the chart below.

The widening divergence between the outlook for rate cuts in 2024 for the Fed and those of other major central banks is strengthening the dollar since higher interest rates on cash can make holding a currency more attractive. This can have multiple implications for stock market investors:

• A stronger dollar could eventually hurt earnings for U.S. companies through making exports less competitive and weighing on the earnings growth of U.S. companies' overseas-sourced profits. Earnings growth of non-U.S. companies on their U.S. sales could benefit.
• A stronger dollar also boosts commodity exporters and acts as a drag on commodity importers because crude and other industrial goods are typically quoted in dollars. The Energy and Materials sectors tend to do well in this environment (see our latest Sector Views).
• Stock market valuations in countries where rates are likely to be cut more aggressively may rise, offsetting the drag on performance from a falling currency for U.S.-based investors. We have been seeing this effect with the price-to-earnings ratio rising for much of this year for the MSCI EAFE Index, contributing to its total return and offsetting the drag from currency impacts.

It appears that the stronger and more resilient U.S. inflation picture is helping to drive the diverging policy outlook that is currently lending support to the U.S. dollar. The consumer price index (CPI) surprised on the upside in the U.S. for the past three months, while being lower and surprising on the downside in Europe, Canada, and Switzerland.

Last week's China first-quarter GDP release illustrated the imbalance between business investment (solid) and consumer spending (weak), as government stimulus efforts remain directed to increasing supply over supporting demand contributing to non-existent inflation.

However, we believe it is misguided to believe that excess manufacturing capacity in China will result in an export of deflation from China to the rest of the world to help to bring down stubborn U.S. inflation.

• First, among developed economies like the U.S., imports from China make up less than 2% of overall household consumption—with most of the current pace of inflation coming from services which are not imported from China. Services contributed 3.2% of the 3.5% headline CPI for the U.S. in March, and 1.8% of 2.4% headline CPI in the eurozone. Using the same periods, goods prices subtracted from overall U.S. CPI and contributed to only 0.3% to eurozone CPI. The modest impact of lower goods prices is unlikely to offset still high services prices.
• Second, import prices are only a small portion of the final price of a good, which is often more influenced by wholesale and retail services performed in the destination country. The San Francisco Fed estimates nearly half of spending on imports stays in the U.S. paying for the local components of these goods. One example indicated $25 of the $100 price of athletic shoes manufactured in China by a U.S. company went to the Asian factory, while the rest of the price represented profits of the U.S. company, transportation costs, wages for workers in U.S. warehouses and retail stores, rental cost for retail space, insurance, etc.
• And third, China's infrastructure spending and manufacturing stimulus could add to global inflation pressures if greater demand boosts commodity prices, like those for base metals which have tend to be up sharply this year.

Moreover, excess capacity in China is nothing new that would prompt a sudden trade shock. Low levels of capacity utilization have been a feature in China for over a decade, rotating among different industries, with current excess in the automobile industry, according to comments by U.S. Treasury Secretary Yellen and EU Commission chief Ursula von der Leyen. So, it is unlikely that China is the solution to the U.S. inflation problem. Counterintuitively, very low export prices may incite higher tariffs. If the export price is low enough that it prompts lawmakers to institute new and bigger tariffs in efforts to protect domestic industry, it can increase prices for consumers. It would follow then that additional U.S. tariffs on Chinese produced goods, such as the recently proposed rise to steel tariffs, may further boost U.S. inflation and serve as a counterpoint to any arguments for deflationary effects from inexpensive imports.
 

Is the dollar's strength merely a temporary boost tied to geopolitics over the Russia-Ukraine and Hamas-Israel conflicts rather than tied to the diverging outlook for rates? History suggests it isn't likely to be a major factor. We composed this list of 28 past geopolitical events that were indicative of conflicts involving Russia or Middle Eastern countries to illustrate the limited impact those events have had on the markets and the dollar.

In general, markets tend to move in anticipation of what may come, rather than merely reacting to what already happened. In contrast to a rising dollar on perceived fears of a conflict escalation, the dollar has typically been down in the month leading up to a geopolitical event (43% of the periods in the above table).

Global stocks, as represented by the MSCI World Index which includes both U.S. and non-U.S. companies, were up nearly 70% of the time immediately after the events occurred, despite being down slightly most of the time in the lead-up to those events. Gold, oil, and the dollar also climbed on average post-event—although the consistency of those gains (50-61% of the time) was not as high as with stocks (68%).

Of the 28 total periods, global stocks were up in the month prior to the event during 15 of them—a little more than a coin flip and slightly less than the two-thirds of the time that a month posted an average gain over the full 55-year period. Perhaps this softer performance in the month prior to an event reflects some concern over heightened geopolitical tensions. Of those same 15 periods, stocks were down five times one month after the event, three of which were during recessions, making geopolitics unlikely to be a key reason that stocks were down. As for the remaining two periods? The ascendancy of Putin as president of Russia in December 1999 preceded the start of the 2000 Dot Com market crash and the capture of Osama Bin Laden in May 2011 aligned with the European Debt Crisis. In our opinion, these two geopolitical events happened coincidentally with major economic events, making them unlikely to have been a key driver of stocks' declines during those periods.

A 55-year-long look at history shows very few times—if any—that a geopolitical event was a major factor in changing market trends. Of course, there is always the potential for a first time.

Michelle Gibley, CFA^®, Director of International Research, and Heather O'Leary, Senior Global Investment Research Analyst, contributed to this report.