Chart in Focus: What does the rate cut mean for equities and bonds?

As the Federal Reserve (Fed) recalibrates rates to balance price stability and economic growth over time, markets naturally react. While investors have been eager for the arrival of rate cuts to juice their portfolio returns, the context of the cuts matters. The economic backdrop sets the stage for what plays out in the markets from the Fed’s opening act and performance is not guaranteed. 

Most often, cuts are initiated when growth has stalled. However, on the dawn of a new easing era, economic growth appears solid — the victory over inflation is the catalyst for rate cuts. Current worries about increasing recession risk are valid, but with GDP growing at 3% in the US, and with Q3 GDP tracking strong, we believe immediate concerns are overblown.

As a result, history can offer examples of rate cuts facilitating a soft landing. Such periods, such as 1995, were characterized by “mid-cycle adjustments” to policy rates, not weak growth and “late-cycle panic.” Should history rhyme, conviction of a soft-landing achievement should encourage believers to be cautious about big cycle bets or being too defensive; many more cuts are priced than is usual in a mid-cycle adjustment — driven by the rapid disinflation.

Figure 1

Investment implications 

• Equities are historically a major beneficiary following rate cuts in a “no recession” environment (Figure 1), but the sector has already rallied on Fed expectations and some of this may be priced in. While market concentration has been dominated by mega-cap tech, should US corporate earnings remain healthy, rate cuts could be an additional boost for areas of the market that have suffered from “higher-for-longer” rates such as small caps and value.
• In rate-cutting regimes, high-quality fixed income historically tends to have upside regardless of economic environment, an important risk mitigator for allocators. Investors may seek an opportunity to lock in still-elevated yields via high yield prior to further cuts, but in a recessionary environment, the sector tends to act more closely with equities with increased drawdown potential. 
• Commodities tend to react uniquely relative to loosening monetary policy and the economic environment. Sectors like oil have a degree of “codependence” with the economy, with price moves directly affecting the economy and demand shifts from the latter impacting prices. Since the current cuts are coming at a time of good global growth, allocations may fare well if the soft landing plays out, particularly given their ability to hedge against a return of inflation volatility and geopolitical risk.

What we are watching

• Market pricing is critical — in our view, equities are not pricing a recessionary scenario at all, so some of the above may have already played out. Bonds, on the other hand, with >200 basis points of cuts priced in, may be considering a weaker outcome.
• Fed cutting in an election year tends to be an overall larger driver of returns versus the election itself; we are monitoring sectors that are most sensitive to a falling interest-rate environment and undercapitalized to benefit from Fed tailwinds. Meanwhile the US election outcome may lead to idiosyncratic opportunities influenced by policy proposals.
• Economic data, particularly that are indicating consumer and corporate earnings resilience. Perseverance of the steady-state environment is supportive for the “soft-landing” scenario and the associated historical market points of reference.