CICC: Fed rate cut expected to open up domestic rate cut space, focus on liquidity benefiting assets in short-term rate cut trades

According to the information from the Wise Finance app, CICC released a research report stating that the Fed's rate cut is expected to open up room for domestic rate cuts, which will help alleviate the still relatively high financing costs. In terms of sector allocation, in the short term of rate cuts, attention can be focused on assets benefiting from liquidity. Historical experience shows that Hong Kong stocks perform better than A-shares. Sectors such as semiconductors, automobiles (including new energy), media and entertainment, software, and biotechnology may have higher resilience. Conversely, high dividends may underperform in the short term, but this is also a normal phenomenon. However, short-term liquidity-driven movements do not change the overall allocation pattern. The bank believes that unless there is a significant fiscal stimulus to offset private credit contraction, the market will still present a structural trend under a volatile pattern. The key focus is on three directions: overall return decline (stable returns from high dividends and high buybacks, i.e., "cash cows" with ample cash flow), partial leverage (policy support and still vibrant technological growth), partial price increases (natural monopoly sectors, upstream and utilities).

CICC's main points are as follows:

Monetary policy path: Inflation cooling strengthens the probability of a rate cut in September, the third quarter is a key window

In the second quarter, the rise in US bond rates tightened financial conditions, leading to a weakening trend in economic data announced since July, further boosting rate cut expectations. This has become a "mirror image" of the fourth quarter of last year and the first quarter of this year, as well as a constant reminder that the less expected a rate cut, the more likely it will happen, and vice versa. The reason for this is the uniqueness of this cycle. As the financing costs and investment returns of various sectors are very close, not much rate cut is needed to restart the credit cycle and boost demand. This is also why the market's anticipation of a rate cut ahead of time will delay the urgency of the Fed's rate cut. The implied rate cut expectation from CME rate futures currently shows a 90% probability of a rate cut in September. If nothing unexpected happens (such as a sudden supply shock, or excessive rate cuts leading to a loosening of financial conditions and a subsequent improvement in demand), a rate cut will also become a high probability event. Therefore, rate cut trading may gradually open up.

The third quarter is a key window for the Fed's rate cut, but a rate cut does not mean a significant cut, and the opening of rate cuts does not mean that rate cut trading can last long. On one hand, the bank calculates that the third quarter is a period of rapid decline in inflation, providing a window for rate cuts, and inflation will slightly rise in the fourth quarter as the general election enters the sprint phase. On the other hand, the purpose of this rate cut is not economic recession, but to alleviate the restrictive nature of monetary policy and the issue of inverted yield curve, so there is no need for continuous and substantial rate cuts.

"General" rules of past rate cut cycles: Simple "historical averages" are meaningless, more similar to 1995 and 2019

From a general perspective, by summarizing the frequency and average annual performance of various assets one month, three months, and six months before and after the start of six rate cut cycles since the 1990s in a simple average manner. Overall, US bonds, gold, and the Shanghai Composite Index performed better before rate cuts than after, while industrial metals, crude oil, the Hang Seng Index, the Nasdaq, and the US dollar performed better after rate cuts than before; Hong Kong stocks have greater elasticity than A-shares; at the industry level, defensive and growth sectors led before rate cuts and continued to do so after, although cyclical sectors showed some recovery in performance 3-6 months after rate cuts The biggest problem with simply averaging historical experience is that it masks the differences between each time. Interest rate cuts are a result rather than a reason, so when judging the impact on assets, it is more important to start from the economic environment, rather than simply copying historical experiences of interest rate cuts. Most interest rate cuts in history occurred in recession scenarios, while this round is a preemptive interest rate cut, so there are fundamental differences in the impact on assets.

Therefore, a more meaningful approach is to find comparable periods, and the interest rate cuts in the current environment are more comparable to 1995 and 2019. In 1995 and 2019, the economy slowed down before the interest rate cuts but did not enter a recession, achieving a soft landing after a slight interest rate cut. In terms of assets, gold and US Treasury bonds performed better before the interest rate cuts, and after the cuts, the gains narrowed, gradually transitioning from the denominator-driven logic of gold and US Treasury bonds to the numerator-driven logic of US stocks and copper. Domestic assets rebounded slightly at the beginning of the interest rate cuts, but the magnitude was limited, relying more on their own fundamentals. For example, in 2019, even with the Fed's interest rate cuts, due to the L-shaped recovery of domestic fundamentals, the market mostly showed a structural trend of range-bound volatility.

The "unusual" pattern of this cycle: the interest rate cutting cycle is relatively short, and the easing is already halfway through, gradually transitioning from denominator-benefiting assets to numerator-benefiting assets.

This round of interest rate cutting cycle is more similar to 2019, summarized by the following three characteristics:

1) Limited interest rate cuts under an economic soft landing. Due to the decent economic fundamentals, after the interest rate cuts, the decline in interest rates will ease overall financial conditions, potentially activating private sector investment and consumer demand, so there is no need for continuous large interest rate cuts. The bank's calculations show that this round of easing monetary policy and resolving the issue of inverted yield curve only requires a 100 basis point interest rate cut. This also means that the expectation of a significant interest rate cut by the domestic central bank after external pressures ease still needs to be observed.

2) Interest rate cut trades have "jumped the gun". The current market's expectations for the number of interest rate cuts are still higher than the guidance given by the Fed's dot plot and the amount needed for monetary policy to return to neutral. The bank's calculations include more gold and less US Treasury bonds.

3) High concentration of trades, faster rotation. Reviewing the trades since the beginning of the year, such as the early rise of Bitcoin and Nasdaq, followed by Japanese stocks, gold, copper, and Hong Kong stocks, which then switched back to US tech stocks. The result of fund clustering is that some trades are more concentrated, making it easier to see short-term declines caused by "rotation", such as the shift from leading US tech stocks to small-cap stocks after the CPI announcement, and the style shift in the Chinese market from gold and metals to banks and real estate.

Therefore, combining the characteristics of this relatively short interest rate cutting cycle, the market jumping the gun, and the high concentration of trades mentioned above, for this round of interest rate cut trades, the bank suggests taking a half step ahead appropriately. 1) In the early stages, assets that benefit more from the denominator logic (such as US Treasury bonds, gold, small-cap growth stocks, and some growth stocks in the Hong Kong market) may have greater elasticity, but may gradually end after the interest rate cuts are realized, especially if there is no fundamental support, they cannot sustain for long. 2) In the later stages, the focus should gradually shift to assets that can improve the fundamentals due to interest rate cuts (such as US stocks in the later cycle, leading tech stocks, copper, or sectors benefiting from domestic interest rate cuts). Specifically, Overseas Assets: Transition from Loose Trading to Inflation Trading, with a large initial denominator elasticity, but gradually shifting to numerator benefiting assets after interest rate cuts. In terms of rhythm, the initial main theme is loose trading, but it is necessary to "moderate" and "retreat" when appropriate, switching to inflation trading after interest rate cuts are realized. Benefiting from loose interest rate cut trading can still be participated in, such as US Treasury bonds, gold, etc., but as assets have surged, the loose phase is already halfway through. The time of interest rate cut realization may also mark the end of interest rate cut trading, gradually transitioning to assets benefiting from inflation again, such as bulk commodities like copper and oil, and cyclical sectors in the US stock market.

In terms of assets, focus on assets that benefit both the numerator and denominator from interest rate cuts, and be cautious with assets that only benefit the denominator. Generally, after interest rate cuts, the sequence will follow leading technology stocks (profitable numerator) → small-cap growth stocks (liquidity denominator) → cyclical finance (numerator repair after interest rate cut). However, considering the "surge" and "rotation" situations and the fact that there won't be many interest rate cuts in this round, assets that only benefit from improved liquidity on the denominator side due to interest rate cuts but lack other benefiting logics need to "retreat," such as US Treasury bonds, gold, and small-cap stocks lacking profit support. On the contrary, assets that solve both numerator and denominator issues from interest rate cuts will perform better. After interest rate cuts, assets benefiting from the demand lift brought by the decline in financing costs, thereby improving the profitability on the numerator side, will have relatively higher allocation value. For example, leading technology stocks compared to small-cap stocks lacking profit support, cyclical sectors like finance and real estate, and copper compared to gold.

Chinese Assets: Initial growth stocks may benefit, but relying solely on external environment has limitations, and it is still recommended to focus on structural opportunities in the future. On one hand, the Fed's interest rate cuts will still provide some support in terms of liquidity. The bank estimates that if the 10-year US Treasury bond falls to 3.8-4% (corresponding to 4-5 interest rate cuts in the next year), with risk appetite and profits remaining unchanged, the Hang Seng Index is expected to approach 18,500-19,000 points. If risk appetite further recovers to the early 2023 level, the market is expected to reach around 20,500-21,000 points, with a similar logic for the Shanghai Composite Index.

On the other hand, fundamentals are still the main influencing factor for the performance of the domestic market. In the fourth quarter of last year, the 10-year US Treasury bond yield fell by about 0.7 percentage points to 3.9% from 4.6%, but the domestic market still declined. Looking ahead, whether the market upside space can open up still depends on the repair of domestic fundamentals and policy catalysts. On the positive side, the Fed's interest rate cuts are expected to open up room for domestic interest rate cuts, helping to alleviate the still relatively high financing costs.

Risk Warning: Unexpected deviation in the Fed's interest rate cut path, financial risks or sudden economic recession pressure, unexpected supply-side inflation pressure