The Fed rate cut is imminent. What investment opportunities are there in the Hong Kong and US stock markets?

This week, the reasons for the Fed's rate cut have been further strengthened.

Recently, U.S. macroeconomic data has been weakening in clusters. Following the weakening of data such as the unemployment rate, PMI, and durable goods orders announced last week, the June CPI released this week weakened again, boosting market expectations for a Fed rate cut. After the Fed began its rate cut cycle, sectors related to rate cuts such as real estate stocks and pharmaceutical stocks are expected to be sought after by the market.

Multiple Data Shows U.S. Economy Cooling Down

The U.S. CPI in June has cooled down for the third consecutive month, indicating that the most severe inflation in the U.S. in 40 years is steadily receding. Data released on Thursday showed that the overall CPI in the U.S. fell by 0.1% month-on-month in June, the first decline since the outbreak of the pandemic; the overall CPI year-on-year growth rate fell to 3%, below the expected 3.1%.

The core CPI in June, which excludes food and energy costs, rose by 0.1% month-on-month, the smallest increase since August 2021, with market expectations of a 0.2% increase. This indicator rose by 3.3% year-on-year, also the lowest increase in over three years, below the market expectation of 3.4%. The core CPI is considered to provide a particularly telling signal of where inflation may be heading.

Of particular importance, the rate of increase in rents and housing costs, which account for more than one-third of the overall CPI, slowed down in June. The largest category in the service sector, housing prices, rose by 0.2%, the smallest increase since August 2021. Owner's equivalent rent rose by 0.3%, also the lowest increase in three years. This may indicate that the long-awaited slowdown in rent increases is finally here. Rental costs are usually one of the last dominoes to fall in inflation declines, which is why economists are encouraged by the small increase in rent in June.

Luke Tilley, Chief Economist at wealth management company Wilmington Trust, said: "This confirms that the possibility of inflation re-accelerating is very small, and it is time for the Fed to cut rates."

Meanwhile, after the PPI data was released, U.S. bond yields rose on Friday. Despite a rebound exceeding expectations, it did not change the overall expectation for a Fed rate cut at the September meeting. This is mainly because the sub-item data used to calculate the Fed's preferred inflation gauge (PCE price index) in the PPI did not show a significant increase Moreover, before the unexpected cooling of the U.S. June CPI, a series of more forward-looking economic data had already indicated that the U.S. economy was slowing down.

Economic Indicator: PMI Contracts

For example, both the U.S. manufacturing and services PMI experienced a significant decline. The U.S. non-manufacturing PMI in June recorded 48.8, a new low since May 2020, falling short of the expected 52.5. Due to a sharp contraction in business activities and a decrease in orders, the U.S. service sector saw the fastest contraction in four years in June. The ISM manufacturing index contracted for the third consecutive month, with the organization's survey of service providers showing that demand is under greater pressure due to high borrowing costs, cooling business investments, and uneven consumer spending.

Investment Indicator: Durable Goods Orders Unexpectedly Decline

Secondly, U.S. factory orders in May fell by 0.5% month-on-month, compared to an expected growth of 0.2%. Specifically, orders excluding transportation and defense projects, which more directly reflect the state of U.S. business investment in manufacturing, also saw a month-on-month decline. The decline in durable goods orders reflects weak demand for durable goods and indicates a lack of optimism for future business investment. U.S. durable goods orders are a significant component in reports on manufacturing shipments, inventories, and new orders, and are considered a leading indicator of manufacturing activity.

Consumer Indicator: Weak Retail Sales

At the same time, consumer spending, which accounts for 70% of the U.S. GDP, also shows signs of weakness. U.S. retail sales barely grew in May, and data from the previous months were revised downward, indicating greater financial pressure on consumers. The data shows that retail sales, not adjusted for inflation, only grew by 0.1% month-on-month, lower than the expected 0.3% growth, with the previous month's retail sales rate revised downward to -0.2%. The only service category in the report, spending at restaurants and bars, declined by 0.4%, the largest drop since January.

In addition, several of the largest retailers in the U.S. have issued warning signals in the past two weeks. Retail giants such as Walmart, Macy's, and Target have successively withdrawn from summer promotions, reflecting a decline in U.S. consumer demand in exchange for price concessions. Many consumers have cut back on spending on groceries, opting for cheaper goods and more affordable alternatives.

PepsiCo's financial report released on Thursday showed that sustained inflation in the U.S. has forced many shoppers to cut expenses and switch to cheaper supermarket private labels; after significant price increases for two consecutive years, PepsiCo's sales in North America in the second quarter of this year decreased by 4%.

Market Expectations for Fed Rate Cuts Rise

The greater-than-expected slowdown in June CPI further proves that high inflation has subsided, indicating that the market may soon see a rate cut from the Federal Reserve The latest inflation data may help convince Federal Reserve policymakers that inflation is returning to the 2% target. Earlier this year, a brief rise in the inflation rate led Fed officials to lower their expectations for rate cuts. Their response was that they needed to see several months of data showing a cooling of inflation before they could have enough confidence to lower the key rate from its 23-year high.

Powell reiterated on Wednesday that recent price readings show "further modest progress," and "more good data" will enhance the central bank's confidence in inflation returning to the 2% target. He said that for inflation that has already fallen, "I do have a certain degree of confidence," the data on this issue is quite clear, but he is not yet ready to say there is enough confidence.

Powell stated that it is not necessary to wait for the inflation rate to fall to 2% before starting to cut rates. Because if you wait too long, inflation may fall too low, which is not what the Fed wants to see. He said that if more inflation data shows that inflation is stabilizing and falling to 2%, or if unexpectedly weak job market conditions are seen, a rate cut may be considered. However, he does not have a specific inflation figure in mind for rate cuts.

This means that if inflation remains low throughout the summer, the Fed will start cutting benchmark rates this quarter. Market expectations for Fed rate cuts this year have increased following the latest data showing a cooling of inflation. Currently, according to the CME FedWatch Tool, the market expects a probability of over 95% for the Fed to cut rates by 25 basis points in September for the first time, with a general expectation of two rate cuts this year, and pricing for a third rate cut is increasing.

Wall Street banks have also adjusted their forecasts based on the latest inflation data - generally predicting the first cut in September. JPMorgan Chase and Morgan Stanley have brought forward their forecasts for the first rate cut from November and December to September. Citigroup, Goldman Sachs, and UBS all expect the Fed to start cutting rates as early as September. Morgan Stanley insists that the Fed will cut rates for the first time in September and then "at every meeting before mid-2025."

Richard Flynn, Managing Director of J.P. Morgan Wealth Management, said that the CPI report for June is a bonus for both the Fed and investors eager to see the final rate cut. This is the latest in a series of data releases that continue to lay the groundwork for the Fed to cut rates this year, possibly as early as September. We expect this economic optimism to benefit the market.

Neil Dutta, Head of Economic Research at Renaissance Macro, even said, "The doves have what they need," and could even cut rates at the July meeting Overall, the cooling of inflation opens the door for the Federal Reserve to cut interest rates in September, and the Fed is likely to signal its first rate cut in September - most likely at the end of this month's rate meeting or at next month's Jackson Hole global central bank meeting. Rubeela Farooqi, Chief US Economist at High Frequency Economics, said the Fed will change its tone at this month's meeting. Further price slowdown, coupled with weak labor market conditions, support the message change at the Fed's FOMC meeting this month, opening the door for an early rate cut at the September meeting.

With the Fed's rate cut imminent, how will it affect the layout of Hong Kong and US stocks?

The recent rise in rate cut expectations has supported investors' bullish views on US stocks. Many analysts believe that as earnings season and US political risks test the US stock market, the clarity of the timing and extent of the Fed's rate cuts may provide a cushion for US stocks. This year, in addition to strong earnings and the hype around artificial intelligence, market bets on rate cuts have also been one of the factors driving the S&P 500 Index up by about 17% so far. Market expectations for rate cuts this year have fluctuated significantly, for example, investors currently expect the first rate cut in September, compared to about 50% just a month ago.

Yung-Yu Ma, Chief Investment Officer at BMO Wealth Management, said that starting rate cuts will show that the "Fed supports the market." He expects the Fed to cut rates about six times next year. He said, "We believe this is absolutely a positive factor for the market and the economy."

Research from Truist shows that as long as the economy avoids a recession, the US stock market typically rises in the 6-12 months after the first rate cut by the Fed. Keith Lerner, Co-Chief Investment Officer at Truist Advisory Services, wrote in a recent mid-year outlook report that US economic growth is currently cooling off from the post-pandemic stimulus frenzy, but is not weak. He remains optimistic about the US stock market, but expects some "volatility" after a strong performance in the first half of the year.

Guotai Junan Securities also stated that under the benchmark assumption of a slowdown in the US economy in the coming quarters, US stocks may come under pressure in the medium term, but short-term market risk appetite remains high, and the probability of a significant adjustment in US stocks is relatively low.

At the same time, if rate cuts begin in September, the space for domestic monetary policy will open up, and rate cuts and reserve requirement cuts in the fourth quarter are worth looking forward to. Guotai Junan International pointed out that the encouraging inflation data released by the US last night, coupled with the "sector rotation" phenomenon in US stocks last night, with the rise in rate cut expectations, funds may also rotate to lagging Hong Kong stocks Tianfeng Securities also stated that against the backdrop of a significant improvement in domestic and foreign sentiment, Hong Kong stocks have ushered in a significant rebound. The sustainability and upward potential of the rally will depend on more solid fundamental data to complement it. During the period of economic recovery verification, a cautious and optimistic attitude is still maintained. Guotai Junan believes that with the decrease in economic policy uncertainty and the confirmed trend of overseas interest rate cuts, Hong Kong stocks will fluctuate upwards.

Furthermore, under this expected backdrop, sectors related to interest rate cuts will be sought after by the market. Firstly, the real estate sector, which is quite sensitive, is expected to benefit from positive developments. Secondly, pharmaceutical stocks that are sensitive to interest rates are also expected to benefit from speculation on interest rate cuts. In addition, against the backdrop of the extremely narrow rise in the US stock market this year, US small-cap stocks are expected to catch up.

Real Estate Stocks

A lower-than-expected inflation report has brought positive signals to the real estate market, prompting investors to reassess the prospects of the real estate sector and driving strong performances of related stocks. On Thursday, shares of real estate companies saw significant gains, with an increase of 2.7%, marking the best single-day performance since 2024 and reaching the highest point since March. Among them, US real estate giant D.R. Horton (DHI.US) surged over 7%. Investors flocked to residential builders, digital, and commercial real estate stocks, making real estate the best-performing sector in the S&P 500 index, with trading volume about 30% higher than the 30-day average.

With cooling inflation and potential interest rate declines, the real estate industry may see more investment opportunities, including a rebound in Real Estate Investment Trusts (REITs). Rich Hill, Director of Real Estate Strategy and Research at Cohen & Steers, stated: "The outlook for this sector seems to have turned a corner, given the latest inflation data and interest rate outlook. We believe this provides a convincing backdrop for listed REITs, especially with solid fundamental growth. If inflation continues to cool and interest rates continue to decline, the rebound that began in October 2023 may continue, driving returns up by over 20% from the low point."

Chinese real estate stocks also showed strength throughout Friday after the release of US CPI data: by the close, Shimao Group (00813) rose by 14.29% to HKD 0.8; New World Development (01030) rose by 9.35% to HKD 1.52; Longfor Group (00960) rose by 8.39% to HKD 11.52; and Country Garden Services (03383) rose by 7.84% to HKD 0.55.

Pharmaceutical Stocks

Moreover, with the direction of interest rate cuts turning loose, the cost of capital will decrease, leading pharmaceutical companies to increase investment and improve overseas market operations. On Thursday, over 91% of the components of the Nasdaq Biotechnology Index closed higher Among the top ten heavily weighted stocks, Moderna (MRNA.US) rose by 4.58%, while Amgen (AMGN.US), Gilead Sciences (GILD.US), and others rose by over 1%.

In the Hong Kong stock market, the pharmaceutical sector continued to rise on Friday: by the closing bell, CanSino Biologics-B (02162) rose by 5.85% to HKD 34.4; Sino Biopharmaceutical (09969) rose by 5.2% to HKD 5.06; Kangmei Pharmaceutical (09926) rose by 4.96% to HKD 40.2; and GenScript Biotech (01548) rose by 4.38% to HKD 10. Pacific Securities pointed out that as the Fed's interest rate hike cycle ends, gradual easing of liquidity is expected to bring about a revival in investment and financing, with overseas demand improving before domestic demand.

U.S. Small Cap Stocks

Lower interest rates may also help expand the stock market's upward trend. A few large-cap companies like Nvidia (NVDA.US) led the first half of the year's rally in the U.S. stock market. Global research strategists at Bank of America said that only 24% of S&P 500 index components outperformed the index in the first half of the year, marking the third worst performance since 1986.

Matt Miskin, Co-Chief Investment Strategist at investment management firm John Hancock, stated that lower interest rates may help market sectors that have been affected by the surge in large-cap tech stocks due to higher rates. This includes small-cap companies, which are often more sensitive to interest rates as they rely more heavily on financing. The Russell 2000 index, which is mainly composed of small-cap stocks, has only risen by nearly 2% so far this year. He said, "In many cases, small-cap companies need capital to survive, and the rise in the cost of capital poses a real challenge to their business. Lower capital costs will certainly help these companies."

Risks

Of course, rate cuts are not always a smooth signal and often occur when the Fed is forced to quickly loosen monetary policy due to economic deterioration. A study released last month by the Investment Research Institute of Fuguo Bank found that the S&P 500 index averaged a 20% decline in the 250 days following the first rate cut in an easing cycle. The company's strategists wrote that if the Fed cuts rates due to a decrease in inflation, the stock market may perform well in the next 6 to 18 months. However, they wrote, "If the Fed is forced to cut rates significantly to address macroeconomic or market turmoil, we expect the stock market performance to be affected."