The Wait Is Over

With the US Fed’s 50 bps rate cut, the rate cutting cycle has begun. What should investors expect in the months and years ahead?

On Wednesday, the US Federal Reserve’s Board of Governors announced a rate cut of half a percentage point, or 50 basis points (bps). This came as a welcome move by market participants, including us, given our concerns back in the spring that the Federal Reserve (Fed) should not wait too long to cut rates.

Mixed data throughout the year with higher/lower-than-expected inflation and employment readings had spurred broad debate amongst economists and investors around which numbers to weigh more or less heavily. We had been more concerned about growing signs of weakness in the labor market rather than the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) prints showing inflation was stickier than expected. While we had hoped for a July rate cut, the size of the cut this week reflects the Fed’s intention to make up for its delay.

What Should Investors Expect Going Forward?

Now that the rate cutting cycle has begun, what should investors expect in the months and years ahead? While no two cycles are completely alike, and we have a limited number of past cycles to extrapolate from, we can make several observations about what we are likely to see. In the nine rate cutting cycles since 1981, US Treasuries, on average, outperformed equities and cash during the length of the cycle. The exception was 1998 where they underperformed cash. (What happened in 1998? That rate cutting cycle was triggered by the Russian debt default that started on August 17 of that year, and the subsequent collapse of Long-Term Capital Management, which led to widespread withdrawal of liquidity across global financial markets.)

The positive performance of US Treasuries may seem unintuitive given that Treasury yields typically decline in the months leading up to a rate cut and then move sideways thereafter. However, this positive performance is an average across the rate cutting cycles, and it turns out that equities, while also averaging positive returns, were punished during certain cycles—1981, 2001, and 2007—those cycles where the Fed was not able to avoid a hard landing.

It is especially interesting when conventional wisdom has stocks doing well after interest rate cuts for several reasons. Lower rates make it cheaper for businesses to borrow which is constructive for corporate profits. Lower rates also mean future cash flows are discounted less, leading to higher valuations for stocks all else equal. And lower rates in theory increase the equity risk premium. In practice, however, many other drivers impact stock and bond returns. It appears that the market has reacted differently if it perceives conditions are such that the Fed can successfully engineer a soft landing or there is too much uncertainty over future economic growth which often happens when there is an external crisis.

Where Are We Today?

On one hand, this rate cutting cycle kicks in as a result of slowing economic growth that was intentionally crafted through the post-pandemic rate hikes. By all accounts, it is measured and shows all the signs of a controlled soft landing. This bodes well for both bonds and equities (with equities outperforming bonds if we go by history). On the other, this cycle is starting at a time when the S&P 500 Index is near all-time highs and valuations are stretched in the Technology sector (2001 saw a decline of 12% in equities in the year following the first rate cut!).

We are also less than two months away from a US presidential election, one that has been accompanied by unusual uncertainty. The only other time a rate cutting cycle started in the fall of an election year was September 1984. That was Ronald Reagan’s (Republican) landslide over Walter Mondale (Democratic) while Paul Volcker’s Fed was dealing with the aftermath of the 1970s inflation crisis. Equity markets went on a tear in the second year after that rate cutting cycle started.

Therefore, we have two points for equity markets performing well (while bond markets also do well) and one point against equities. This is one reason why most investment professionals do not advocate for timing around interest rate cycles. Even if we can predict the path of Fed rate cuts perfectly, we still do not have a definite best allocation mix.

One approach, and the one that makes the most sense for long-term investors, in our view, is to diversify across equities and bonds in a way that is consistent with an investor’s cash needs. This is just basic liability-aware diversified asset allocation. Another approach is to allocate across asset classes in a way that hedges against the worst possible outcomes. This of course is another form of diversification, one built around limiting risk exposures, but for long-term investors without specific future cash needs, this may be a strong option. Related to both approaches, adding commodities, real assets, private assets, and other alternatives could serve as additional diversifying levers.

The Bottom Line

While investing for macro regimes isn’t easy, there are proven ways we can thoughtfully approach building macro-resilient portfolios. The most likely scenario in our view, however, is still a soft landing, which means that balanced portfolios should generally do well.