Traditionally, a big Fed rate cut combined with stock prices hovering near all-time highs is an ominous sign for the stock market.
Large rate cuts, like the one approved and predicted by Fed officials last week, typically reflect an economy the Fed is trying to pull out of a recession, and stocks at record highs often mean the market has little room to rise.
This time it’s different.
Some analysts say the market is poised to benefit from a rare best-case scenario.
“The Fed is easing monetary policy and the economy is healthy,” said Jeffrey Schultz, head of economic and market strategy at Clearbridge Investments. “That’s a powerful combination that’s going to deliver (big) market returns.”
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But at least one expert argues that the Fed’s dramatic actions last week underscore concerns that the economy is at risk of slipping into a downturn. Such a sharp drop would likely hit stock prices hard.
What has the Fed done with interest rates?
The Fed cut its key short-term interest rate by half a percentage point last week, the first cut in four years and more than many economists had expected. The Fed also now expects to cut rates by a total of 2.25 percentage points by the end of next year and 2.75 percentage points by the end of 2026, bringing the rate to 2.9% from about 5.4% before the meeting.
There’s no question that markets welcome the Fed’s rate cuts. They lower borrowing costs for businesses and consumers, stimulating economic activity and boosting corporate profits. They also encourage investors to move money out of bonds, which currently offer low yields, and into riskier assets like stocks, which offer the potential for much higher returns.
What happens to the market during a recession?
But since 1984, when central banks cut rates to pull the economy out of or avoid a recession, the S&P 500 has fallen an average of 11.6% in the year after the first rate cut, according to an analysis by Ryan Detrick, chief market strategist at investment firm Carson Group.
In other words, the damage that a weakened economy does to corporate profits more than offsets the benefits of low interest rates.
By contrast, when the Fed lowers rates to return to normal after a series of hikes, the S&P 500 has risen an average of 13.2% over the following 12 months, Detrick’s analysis shows. That’s primarily why Fed officials say they’re cutting rates now.
Why did the Fed start raising interest rates?
Fed officials have raised the key federal funds rate from near zero in 2022 and 2023 to rein in economic activity and rein in inflation, which hit a 40-year high of 9.1% in mid-2022. With inflation now below 3%, near the Fed’s 2% target, officials have said it’s time to cut rates.
Fed Chairman Jerome Powell acknowledged last week that job growth has slowed significantly this year, but added that the economy and labor market remain strong.
“The U.S. economy is doing well,” Powell told reporters. “The economy is growing at a solid pace, inflation is falling, the labor market is (strong), and we want to keep it that way by lowering interest rates before they hurt economic growth.”
The S&P 500 closed slightly lower on Wednesday after the Fed’s historic move as investors worried that the half-point cut underscored the Fed’s concerns about the employment situation and the economy, Detrick said. The only other times the Fed has initiated such a large rate-cutting cycle were right before the recessions of 2001 and 2007-2009, Detrick said.
But Detrick said the Fed likely opted to cut rates this time around simply to make up for lost time after leaving rates unchanged in July. Powell acknowledged that officials could have cut rates in July if a report showing weak job growth had been available then.
The stock market soared to a record high on Thursday after initial jobless claims, a reliable indicator of layoffs, recently fell to a four-month low, signaling the economy remains strong. Some of the gains were erased on Friday, and stocks could be weaker than usual in September and October ahead of the presidential election, Detrick said.
What is the current economic situation?
But the unemployment rate, while it has jumped this year to 4.2% from 3.7%, is still historically low. The economy grew at a strong 3% annual rate from April through June and is expected to grow at a similar rate this quarter. And recent strong gains in U.S. productivity, or output per worker, are likely a sign of more economic growth to come, Detrick says.
Analysts expect corporate earnings to grow a healthy 10.2% this year, according to FactSet.
“The Fed has said interest rates are too high and they’re normalizing them,” Detrick said. “We’re not in a recession.”
How has the pandemic affected the economy?
Clearbridge’s Schultz said the unusual dynamics of the coronavirus pandemic have put the Fed and the economy in a good position: Consumer demand was so strong coming out of the pandemic that the Fed’s rate hikes to tame inflation stoked spending and economic growth without causing a recession.
Schultz also said inflation had slowed relatively quickly as pandemic-related supply chain disruptions and product shortages were resolved, setting the stage for a big, market-friendly rate cut without any major risks of a recession.
Schultz said that during the two times the Fed cut interest rates by a quarter of a percentage point in the 1990s, the central bank merely “tweaked” rates rather than making sharp cuts like it does today.
Is the US stock market overvalued?
By historical standards, the stock market is overvalued: S&P 500 stocks are trading at 20.9 times expected earnings per share over the next 12 months, compared with an average of 19.4 over the past five years and 18 over the past 10 years, according to FactSet.
But Mr. Detrick said high valuations should never stifle a strong market rally, so long as the economy and corporate earnings are strong.During 20 events since 1980 when the Fed began cutting interest rates while the S&P 500 was within 2% of its all-time high, the index rose even more the following year, by an average of 13.9%, according to Mr. Detrick’s analysis.
“High valuations are not a very good (market) timing mechanism,” he said.
It has surged 24% last year and 19.4% so far this year, and Detrick said the benchmark index could rise another 15% by the end of 2025.
What are the biggest risks to the economy?
Some experts disagree. “Many parts of the economy remain very weak, including housing, commercial construction and the industrial sector. Everything is in recession,” David Rosenberg, president of Rosenberg Research and a veteran economist, wrote in a Thursday note.
He continues to see a recession making stocks riskier and bonds more attractive. Just as the Fed should have started raising rates sooner to prevent inflation from surging, it should have started cutting rates sooner, he said.
“The Fed is currently lagging the growth curve as much as it was lagging the inflation curve more than two years ago,” he wrote.