Market Update 8/28/24: Stock and Bond Markets Feast on Fed Easing

By Jack Ablin, Chief Investment Officer. Subscribe for weekly market updates.

Key Judgments:

• Economic backdrop determines how stocks react to rate cuts
• Bonds offer valuable diversification during easing cycles against any backdrop
• Current growth and unemployment data suggest recession is avoidable

The Federal Reserve is expected to cut interest rates in September and possibly again in December, and markets are anticipating multiple cuts over the next twelve months. Fed Chairman Jerome Powell asserted at last week’s Jackson Hole Economic Symposium that “the time has come” for rate cuts, citing his confidence in inflation returning to the two per cent target and concerns about the labor market. Fed easing is a double-edged sword for equity investors. Lower rates raise equity market valuations by propping up market multiples while lower financing costs bolster corporate profit margins. However, Fed easing programs often presage economic slowdowns and recessions. In fact, nearly half of the easing programs dating back to the 1980s were associated with recessions. While we’re not anticipating a recession from today’s perspective, we will be on alert for signs of economic weakening.

Economic Backdrop Determines How Stocks React to Rate Cuts

The stock market’s reaction to rate cuts depends on the economic backdrop. Expansions have coincided with subsequent bull markets, while recessions have fostered market setbacks. According to Franklin Templeton’s easing cycle data back to 1972, in the three months after the first rate cut the S&P 500 gained nearly seven per cent on average during expansions and fell about five per cent in recessions. In the first six months, the returns are more promising: in recessions, equities initially pulled back before reversing course and rallying, with the S&P 500 advancing nearly 10 per cent in expansions, while gaining about one per cent in recessions. Since 1990, large caps, growth stocks, and the NASDAQ have led advances after expansionary rate cuts.

Bonds Offer Valuable Diversification During Easing Cycles Against any Backdrop

Treasury bonds have historically performed well following rate cuts, providing diversification benefits to multi-asset portfolios. The 10-year Treasury yield has trended lower in each of the last 11 easing cycles, although rates have risen incrementally in the interim in four of the cycles. The outlier was 1981, when the 10-year yield rose 2.3 per cent to 15.8 per cent on the back of Volcker’s 4.5 per cent rate cut from 20 per cent to 15.5 per cent. Nonetheless, bonds have represented a valuable diversifier during easing periods, whether in expansionary periods or recessions. 

Bottom Line

Rate-cutting cycles have historically been favorable for both equity and bond holders. That said, this is the most anticipated rate-cutting cycle in memory. We are encouraged that lower rates will soon arrive against a favorable economic backdrop, with the US economy expanding at more than two per cent and the unemployment rate, while at 4.3%, is in the 15th percentile of its historical range – suggesting that the economy is strong enough to avoid recession.