[Financial Planning for the 100-Year Life] Asset Allocation During Interest Rate Cuts

In the second half of this year, following the European Central Bank (ECB), the U.S. Federal Reserve (Fed) lowered its benchmark interest rate. Subsequently, the People's Bank of China and the Bank of Korea also cut their benchmark rates. Central banks worldwide are competitively lowering interest rates. The question is how long this rate-cutting phase will last and how asset allocation should be managed during this period.

In 2020, as the economy plunged into a severe recession due to COVID-19, central banks around the world drastically cut interest rates and increased money supply. As a result, bond and stock prices surged, consumption increased, and the economy recovered rapidly. However, the side effect of this rapid economic recovery was a significant rise in inflation. In June 2022, U.S. consumer prices rose 9.1% year-on-year, marking the highest level since November 1981 (9.6%). In July of the same year, South Korea's consumer price inflation also rose to 6.3%, the highest since December 1998 (6.8%).

The primary monetary policy goal of central banks is price stability. To curb inflation, central banks worldwide sharply raised interest rates and implemented quantitative tightening from 2022 through the first half of 2023. For example, the Fed increased the federal funds rate target from 0.00?0.25% in 2022 to 5.25?5.50% by June 2023. Around the same time, the Bank of Korea raised its benchmark rate from 0.5% to 3.5%.

As the lagged effects of rate hikes appeared, inflation dropped to around 2%, but signs of economic slowdown centered on consumption have emerged in various countries. Therefore, central banks are now responding by lowering benchmark interest rates. How long and how much will rates be cut? This depends on future economic growth (employment) and inflation rates. Moreover, the Fed's decisions, as the leader of the global economy and financial markets, are most crucial.

According to the Fed's economic outlook from the September Federal Open Market Committee (FOMC), the benchmark interest rate, which was 4.75?5.00% in September, is projected to be 3.4% in 2025 and 2.9% in 2026. This indicates that the Fed plans to lower rates through 2026. Although the duration and extent of rate cuts will vary depending on each country's economic conditions, central banks' monetary policies are unlikely to deviate significantly from this path.

Interest rate cuts will increase money supply. In particular, the money supply relative to the real economy is expected to increase more. A representative indicator is the "Marshall K." Generally, Marshall K is calculated by dividing a country's broad money supply (M2) by nominal gross domestic product (GDP).

When Marshall K increases, market interest rates tend to fall, and stock indices rise. Analyzing U.S. data since 1990, the correlation coefficient between Marshall K and the 10-year Treasury yield was -0.72, and with the S&P 500 it was +0.86. From 2000 to 2023, a 1% increase in China's Marshall K corresponded to a 1.4% rise in the Shanghai Composite Index. In South Korea, a 1% increase in Marshall K was associated with a 2.6% increase in the KOSPI.

According to the Bank of Korea's financial flow data, in the second quarter, South Korean individuals (households and non-profit organizations) held financial assets worth 5,408 trillion won. Of these, 46.1% were cash and deposits, followed by insurance and pensions at 27.8%. Bonds and stocks accounted for 3.6% and 21.1%, respectively. With central banks worldwide cutting rates, Marshall K is expected to increase. This suggests that the increased money will flow more into financial markets than into the real economy, such as facility investments.

Unless there is a severe economic recession, market interest rates are expected to fall and stock indices to rise. In this environment, the proportion of cash and deposits in our personal financial assets is considered high, while the proportions of bonds and stocks are low. Increasing the share of bonds or stocks during the period when central banks are cutting rates could potentially yield higher returns from financial asset investments.

Kim Young-ik (Adjunct Professor, Graduate School of Economics, Sogang University)