What happens to stocks when the Fed starts reducing…

How do stocks perform when the Fed cuts rates?

Conventional wisdom says that stocks tend to do well after interest rate cuts. The Fed is cutting interest rates to stimulate the economy by reducing borrowing for businesses and consumers, which tends to be constructive for stocks. It’s certainly true sometimes. But strategists say investors looking for a playbook for an easing cycle should take a more nuanced view. This is especially true in today’s unusual environment, which is still recovering from pandemic-era distortions and is dominated by cutting-edge tech stocks. “Every cycle is different,” says Jeff Buchbinder, chief equity strategist at LPL Financial.

The last four major rate cut cycles show why it is difficult to draw general conclusions. Market performance can vary dramatically in the year after a new easing cycle begins. The Morningstar U.S. stock market index rose more than 21 percent in the 12 months since the start of the Fed’s easing cycle in 1995 as the economy made a rare soft landing. But yields fell by more than 10 percent when the Fed began cutting rates in 2001, when the dot-com bubble burst.

“A lot of investors think there’s some kind of Fed rate cut playbook,” says Denise Chisholm, director of quantitative market strategy at Fidelity. “But it doesn’t really exist.”

“Why” Fed Matters

Underlying the wildly different years are different market fundamentals and Fed attitudes. The market will react differently if it perceives the central bank as confident and in control – projecting a soft landing for the economy – than if it perceives the bank as being reactionary, cutting rates amid the threat of recession.

To understand what the year ahead might look like, “you have to think about why the Fed is cutting rates,” says Lara Castleton, head of U.S. portfolio construction and strategy at Janus Henderson Investors.

A limited history manual is added to the challenge. There aren’t many cases going back to the 1960s, Chisholm says, “so you don’t have a lot of hard data to evaluate.”

About half the time, Chisholm explains, the Fed started easing policy because it sensed the economy was heading for a recession. In the other cases, it cut rates to recalibrate monetary policy (what some call a “maintenance easing”) rather than in response to an economic threat.

Watch your earnings grow

Rate changes don’t tell the whole story. Chisholm says earnings are a more reliable predictor of future stock market returns. When earnings growth is positive and accelerating and rates are coming down, “that’s a positive for the market over the next 12 months,” she says. According to her analysis, when that happens, the stock market, as measured by the S&P 500, returns an average of 14% over that time, compared with a benchmark average of 11% when rates fall and just 7% when they rise earnings go down with rates. . After the second-quarter earnings season, companies in the Morningstar US Market Index posted annualized earnings growth of more than 10% on average.

Chisholm says a wider gap between the target federal funds rate and the inflation rate is another good indicator of strong market returns. Tight rates combined with lower inflation signal that the Fed has more room to cut rates if necessary, which tends to be constructive for stocks. Currently, there is an unusually wide gap between the federal funds rate and the inflation rate.

Prepare for market volatility

As always, no one has a crystal ball for the markets. Even amid encouraging data, stocks move on sentiment.

“As the Fed begins its tapering cycle, markets will still be concerned,” says Buchbinder. “The economy is slowing and the Fed is cutting … you have slow growth and contained inflation.” Amid two better-than-expected jobs reports, investors are grappling with whether the central bank waited too long to cut rates and opened the door to a recession.

Buchbinder adds that much of the upside from the coming rate-cutting cycle has already been fed into the stock market, which has gained more than 24% over the past 12 months. “The market has already benefited from (imminent rate cuts) and so further gains could be limited,” he says. But on the other hand, a true soft landing for the economy could present even more upside for stocks.

It will not be immediately clear which scenario will play out. Buchbinder expects to be litigated on the market in the next few months. “That’s why you have volatility around these inflection points and policy changes,” he says. “They just increase the uncertainty.”

Investors can prepare for both outcomes

Castleton suggests that equity investors position themselves for both scenarios on the margins of their core holdings. While a soft landing is still the base case for many analysts and economists, the slowdown in labor market data over the past two months has sent an undeniable bearish signal. “It’s impossible to tell whether the Fed is late, whether we’re going to have a hard landing or a soft landing,” she says.

She suggests investors look to defensive stocks and REITs, which are sensitive to falling rates, as a buffer for portfolios in the event of a major economic slowdown. Chisholm also sees opportunities in rate-sensitive sectors such as financials and real estate, which she says have not fully assessed the impact of Fed tapering as they typically do. “These sectors have performed quite poorly over the past year,” she says.

Both Castleton and Chisholm suggest investors consider smaller-cap stocks that have struggled in recent years but could break out during a soft landing. If the economy is still strong, “small caps are one of the areas that will definitely outperform, even if they come with more volatility,” Castleton explains.

Chisholm adds that valuations are also on the side of investors, as megacap tech companies have become more expensive this year.