by Joe Herrle, CFA
Vice President, Alternative Assets
“What to Expect When You’re Expecting” is a book for many first-time parents. My wife and I are preparing for our third child’s arrival in October, a process that has been a mix of excitement and logistical planning. While this is not our first rodeo, the passage of time has certainly brought a fresh set of challenges. Much like the anticipation of a new family member, the financial markets eagerly await interest rate cuts. While we’ve experienced a few in recent memory, the reason for them was an outlier – the COVID-19 pandemic and associated lockdowns. It’s been quite a while since the Fed lowered rates in a more normalized economic environment, so it’s worth revisiting history to see what we might expect this time.
To begin with, many of the economic distortions brought about by the financial responses to the pandemic have run their course. The significant idiosyncratic shock and the largest-ever financial stimulus that followed caused distortions in the economy. These distortions rendered the usual signals for gauging economic health – jobless claims, manufacturing activity and the inverted yield curve – somewhat ineffective. Like physics, when you approach a black hole, the laws of physics begin to break down; when interest rates are near zero and over $5 trillion is injected into the economy, traditional indicators can’t be relied on.
Now that the stimulus-response excesses have run their course and supply chains and labor markets have normalized, we can trust the signals the economy sends us. The data shows a gradual slowdown and that interest rates are still restrictive. Combine this with a steadily decreasing inflation rate, and you get an environment where rate cuts are on the table.
What you would infer from financial news is that rate cuts are always a good thing. In a vacuum, they are: lower rates boost economic activity. However, what is more important is the reason for the cut. A rate cut is usually because we are in, or very near, a recession. Therefore, the S&P 500 tends to decline right around the first cut and annualizes on average 6.6% gains in the following year, below its 7.7% annual average since 1970.
But, the current economy is not what you would consider average when rate cuts are on the table. Simply put, we do not foresee a recession in the near term. Instead, we are headed for the rare, but not impossible, soft landing. Why? Because unemployment remains very low, household balance sheets are in good shape, and corporate earnings continue to grow.
Source: Macrobond, Bloomberg
The difference in equity market performance is striking when comparing a hard landing to a soft landing. On average, a soft landing produces annual returns that are 21% greater than the average hard landing in the year following a rate cut. The soft landing playbook calls for a positive outlook on stocks. Although the economy is gradually slowing, and we may be more defensively positioned within equities, we will remain constructive on equities overall. Until economic indicators materially weaken, we will stick with our soft landing game plan.
Takeaways For the Week:
After quickly declining over 8% starting in mid-July, the S&P 500 has rebounded and is within 2% of making an all-time high in response to positive jobs, inflation and consumer data
With positive economic data this week, the probability of multiple rate cuts in September has declined substantially. Still, markets are pricing in at least one 0.25% rate cut at the next meeting