Does the larger-than-expected cut in policy rates by the Federal Reserve suggest the central bank “knows something we don’t”? That is, that the growth outlook is weaker than believed and a bigger cut was needed to stave off a recession? We do not think so.
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Even though central banks are thought to avoid surprising the markets by signalling ahead of decisions the next likely move, the US Federal Reserve did manage to wrongfoot many with their 50 basis points (bps) cut at their meeting on 18 September. The argument for just a 25 bps reduction was that the inflation data was not entirely benign, growth data not so weak, and the approaching US election warranted prudence.
The Fed evidently concluded otherwise, betting that inflation data would improve and worrying that policy rates at such a restrictive level did risk a bigger slowdown in growth, disrupting the central bank’s objective of a “soft landing”.
The reaction of the markets took two forms. For some, the bigger cut suggested the Fed “knows something we don’t”, that is, that the growth outlook was perhaps weaker than investors believed and hence the larger cut was necessary to stave off a recession. This view might explain why the initial reaction of US equity markets was muted.
Subsequently, a more sober assessment of the current growth outlook lead to the conclusion that growth is currently solid (the Atlanta Fed’s GDPNow forecast stands at 2.9% for third quarter 2024), and financing costs for companies had now fallen by up to 50 bps. The market subsequently rallied. Flash purchasing manager indices for September to be released this week will tell us whether that positive interpretation is warranted.
We are of the view that the US will achieve a soft landing and believe the more optimistic evaluation of the larger cut is the right one. Despite the extreme market volatility over the summer, partly prompted by worries about potentially overoptimistic forecasts for AI-generated profits, earnings expectations remain positive (see Exhibit 1). Our multi-asset team is modestly overweight equities, particularly the tech-heavy US NASDAQ index.
Cutting cycle patterns
To assess how markets might evolve from here, many have looked to what occurred during previous cutting cycles. This time, however, such an analysis may not necessarily be helpful. That is because in four out of the last five cutting cycles since 1984 a recession subsequently ensued. The exception was the period from 1984-86, when the Fed cut rates by 575 bps and US growth slowed but remained positive (averaging 3.6%; see Exhibit 2).
The implications for asset allocation in the recession cases was fairly straight forward: growth is turning negative while interest rates are falling, hence fixed income should outperform equities, and defensive equities should outperform cyclicals. Historically, that is exactly what happened. But we do not anticipate a recession this time, believing the Fed will achieve a soft landing with US growth only slowing to around its long-run trend rate and inflation returning to target.
This suggests that interest rates may not decline by as much as they have done in the past because the Fed will not need to provide as much stimulus to restore growth. Instead of the nearly 600 bps in reductions that occurred in 1984-86, the Fed’s latest “dot plot” forecasts only 225 bps. If anything, there is a risk that longer-term interest rates rise as worries about US debt levels are reflected in a higher risk premium for US government bonds (which is why many of our fixed income portfolio managers see curve ‘steepeners’ as a profitable trade). Equity returns in a soft landing scenario should also be better than when the economy did tip into a recession.
Interestingly, the relative returns between fixed income and equities and between cyclicals and defensive sectors are similar in the recessionary cutting cycle periods and during the soft landing one. In the 12 months following the first cut, during the four “recession” cutting cycles, fixed income outperformed equities on average by over 600 bps (8.5% vs 2.2%). Cyclical equity sectors had negative returns while defensives held up better (see Table 1).
In the 12 months following the start of the soft landing cycle in 1984, the fixed income US Aggregate index returned 24.4%, though this reflected the high starting point for yields as the fed funds rate was nearly 12% before the first cut. Equities did much better, too, returning 18.7%. Defensives again outperformed cyclicals, by nearly four percentage points, though there were notable differences at the sector level. A notable difference was the outperformance of value stocks vs growth, when typically they lag.
Of course past returns only offer a hint of how the future might unfold, but investors should keep in mind the unusual circumstances of the current environment when using history to set their allocations.
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