Strategy : US rate cuts : Rate cuts priced in, earnings cuts less so by Kotak Institutional Equities
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US rate cuts: Rate cuts priced in, earnings cuts less so
The gradual weakening of the US economy, especially in the labor markets, with the consistently soft inflation prints, has sharply increased the probability of the US Fed cutting rates. A cut in US rates may see higher EM and India inflows. However, the recovery trajectory in the export-oriented Indian sectors will depend on the growth trajectory of the US economy.
Moderating core inflation creates the necessary conditions for rate cuts in US
The US economy has seen sufficient progress in core inflation in recent months, while growth parameters have worsened steadily (see Exhibits 1-3). We have greater confidence in impending rate cuts based on the broad-based softening of core inflation, unlike in previous instances over the past 18 months (see Exhibit 4). It will be important to observe if the US Fed’s dot plot moves closer to market expectations in the coming meetings (see Exhibit 5).
Weakening growth provides further impetus for cutting rates
The US economy has seen a steady slowdown, especially in (1) activity levels, (2) consumer confidence and (3) labor markets, in recent months, which was not the case in the previous 18 months when markets were excessively optimistic (see Exhibits 6-8). The US non-farm payroll addition data has seen constant downward revisions in recent months, suggesting a weakening trajectory in labor markets (see Exhibit 9). However, jobless claims, while increasing in recent months, have been broadly under control (see Exhibit 10).
EMs, particularly India, may see an increase in flows
EMs have seen massive underperformance versus DMs over CY2022-24, primarily led by (1) the US’ strong performance, which has deterred interest in EMs and (2) China’s weak performance (see Exhibits 11-12). A cut in US interest rates may result in the revival of flows into EMs during the risk-on phase. However, (1) prevailing geopolitical tensions between the US and China and (2) persistent weakness in the broader Chinese economy (see Exhibit 13) may temper expectations. India may stand out as a beneficiary of this trade, given its relatively stronger macroeconomic position. Valuations will be a headwind.
Recovery in exports may be gradual
The US economy has historically seen muted growth during the initial phases of rate cuts, with a sharp slowdown in (1) personal consumption expenditure and (2) value addition by non-farm businesses (see Exhibits 14-15). We expect the US economy to see a cut in private spending, as growth weakens, which may result in longer-than-expected recovery in Indian exports. However, US markets appear to be fairly nonchalant about the earnings of US corporates, based on consensus expectations (see Exhibits 16-18). Nonetheless, we note that markets are pricing in weak growth in consumer and financials for the US markets in CY2025. As such, we see decent risks of a delayed recovery in US spending across sectors such as financials and retail, which may not be currently factored in the valuations of Indian IT services companies.
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