The global rate-cutting cycle is underway.

Earlier this summer, the European Central Bank cut interest rates for the first time in nearly five years, bringing them down to 3.75%. Following suit, the Bank of England made a tight decision in August to cut rates to 5%, marking its first rate cut since the coronavirus pandemic. This cut comes amid stronger economic growth, persistent inflation (with service inflation still robust at 5.2% year-on-year), and wage pressures that may take years to ease, especially considering the potential for further inflation from recent government pay proposals.

A notable exception to the rate cutting trend is the Bank of Japan, which recently surprised markets by raising interest rates to 0.25%—the second hike this year—signalling the end of a 40-year battle against deflation.

What about the world’s most dominant economy? The US Federal Reserve is the one major central bank yet to act, with expectations set for a 0.25% rate cut in September. The ‘goldilocks’ macroeconomic environment has been disrupted in the US by a series of lower data points, including a significantly weaker manufacturing activity indicator.

However, it was the disappointing July jobs report - considered the core engine of the US economy - that prompted the market to sharply re-price interest rate cuts. The market now anticipates the Fed will cut at every meeting this year and almost 2% in cuts over the next 12 months due to fears of a US growth slowdown.

This shift in expectations led to sharp market reactions in risk assets such as equities in early August, causing a surge in the market’s ‘fear gauge’—the VIX volatility index. The VIX spiked to levels not seen outside major market meltdowns, driven by a combination of increased concerns over a US growth slowdown, issues related to artificial intelligence, the unwinding of carry trades and ongoing geopolitical risks, all amid heavily concentrated big tech equity positions.

The restrictive monetary policy (ie high interest rates) in many economies is exerting significant pressure on businesses. For instance, bankruptcies in the US have surged, with total filings up over 30% year-on-year over the last 12 months. Major central banks are therefore cautiously cutting interest rates, while being mindful of the risk of reigniting inflation. Consequently, central banks will remain data-dependent in the medium term, focusing on growth, inflation and the labour market to guide their next moves. Predicting the cutting cycles of central banks remains a challenging task, and one that markets often misjudge.

This dynamic leaves risk assets at a crossroads. Currently, markets appear to be shifting their focus from inflation back to growth. The global economy is showing signs of cooling, as evidenced by global manufacturing PMI indicators being in contractionary territory. Despite this, earnings and sales expectations, along with forward net margins for the US, Europe and Japan, are all moving higher, suggesting above-trend growth.

If a recession materialises and central banks lag in their rate-cutting cycle, risk assets will fall sharply. For now, macroeconomic data favors a soft landing. If central banks can cut rates in an orderly manner, risk assets may grind higher, although the risk-reward balance is not overly attractive.

July and August will be remembered as one of the most significant periods in recent years in terms of political events and market volatility. This period saw an assassination attempt on a US presidential candidate, the replacement of another US presidential nominee, the Nikkei 225 suffering its biggest single decline for nearly four decades, an enormous +10% Japanese yen trade-weighted index rally, recession fears and markets pricing in large rate cuts by the Federal Reserve.

As we move into the final stretch of the year, there is much for investors to contend with, from the global growth outlook to potentially escalating geopolitical risks. Politics will remain at the forefront of investors’ minds, particularly as the outcome of the US election remains uncertain. Undoubtedly, there will be further volatility, but with volatility comes opportunity.

Gareth Gettinby is investment manager at Aegon Asset Management