Since the start of 2023, investors have had to deal with interest rates at levels not seen since 2007. However, the last cycle of rate hikes is now behind us and it's time to focus on what cuts of rates means for markets.
The Federal Reserve has signaled that a rate cut could be on the horizon as traders are placing a 100% probability on one during the September FOMC meeting, according to CME FedWatch. Additionally, recent market volatility and soft economic data have given the Fed additional support to begin its rate-cutting cycle.
When determining the impact interest rate cuts have on financial markets, it is important to consider why the Fed is cutting rates. The down cycle is usually caused by a slowdown in the economy, rising unemployment and falling inflation ie. from an impending recession. Recent economic data and the steepness of the yield curve can warn us that a recession is just around the corner. Now, I'm not saying we're going to go into a recession, but what I'm saying is that it's an important factor when considering the potential impact of rate cuts on certain parts of the financial markets.
The S&P 500 Index has posted a strong return of 20% (Source: Zephyr) since the last rate hike (July 26, 2023) through the first six months of 2024. However, stock volatility has increased recently and stocks have fallen as we near the start of a potential rate cut cycle. With all indicators signaling an upcoming rate cut cycle, it's time to review how various asset classes have performed in past rate cut cycles and answer the question, “Should investors be wary of what they want when they want a landing cycle?” I took a look at the last five rate cut cycles to help answer these questions.
In a vacuum, some investment professionals believe that lowering rates is good for the broader equity market during recessionary and non-recessionary periods. However, this is not necessarily the case, especially during the last five rate cut cycles.
As you can see in Figure 1, the S&P 500 performed well in anticipation of the first rate cut. However, equity performance has been mixed over the year following the first cut of the cut cycle. The fate of stock performance hinged on why the Fed was cutting rates and the health of the US economy. The cut cycle that began in 1984 and ended in 1986 was the only cycle of the five that did not coincide with a recession. Not surprisingly, this cycle had the best performance in the year after the first rate cut. Interestingly, the average return of the S&P 500 index after one year was -0.5%.
As you can see from Figures 2 and 3, equity performance for the 12 months following the first rate cut has been mixed. The S&P 500 Index posted positive returns over the 12 months following the cuts of June 1989 (+16.61%) and August 2019 (+11.96%) while posting negative returns following January 2001 (-11.88%) and September 2007 (-11.14%). . It is important to note that those four cycles also coincided with a recession. We have to go back to the rate cut cycle that began in September 1984 to find one that didn't involve a recession. Stocks performed much better in the 12 months following the start of the 1984 cycle, with the S&P 500 posting a return of +18.23% and the Russell 2000 posting a return of +15.69%.
It's also a mixed bag when looking at the performance of the equity sector after the first rate cut (Note: The S&P 500 Equity Sector Indices were created in October 1989). The materials sector was the only sector to produce positive returns over the past three crop cycles.
The story is different for fixed income during rate cut cycles (Figures 4 and 5). It is well documented that fixed income, both government and corporate, experienced some of their worst pullbacks ever during the last rate hike cycle in 2022. However, a rate cut cycle has presented opportunities for investors of total return to the past. When interest rates fall, bond prices rise, so a rate cut cycle can offer attractive total return opportunities for investors. This is exactly what happened during the previous four cutting cycles. In fact, only one of the major fixed income asset classes—high yield—produced negative returns (June 1989 and September 2007). Outside of high yield, every other fixed income asset class produced strong total returns over the 12 months after the first dip. This is not a surprise as high yield bonds are riskier than other asset classes and the respective recessions adversely affected the asset class. Additionally, higher duration asset classes that are more sensitive to interest rate movements fared better. A slow and methodical rate cut cycle can provide opportunities for both total return and income-seeking investors.
When trying to position your client's investment portfolios for a rate cut cycle, it's important to ask yourself, “why is the Fed cutting rates?” rather than just focusing on cuts. Additionally, watch the pace of cuts, if a recession is near or already in place, the Fed is likely to make big cuts, which is likely to spook stocks. Or is the pace of cuts slow and methodical to ease the brakes somewhat and give the economy a little more fuel? Watching the pace of cuts is a good indicator of whether the Fed is concerned that a recession is imminent or a slight tapering is on the horizon. It is important to focus on the health of the economy and corporate earnings while building investment portfolios that are diversified across uncorrelated asset classes in order to withstand a rate cut cycle.
Ryan Nauman is Market Strategist at Zephyr