Key Questions: When The Fed Cuts Rates, Should Investors Cut Their Exposure to Stocks?

It’s Complicated, but It’s a Critical Question to Address.

There’s a harsh-sounding axiom in the financial lexicon that says, “Economic expansions don’t die of old age. Rather, they are murdered by the Federal Reserve.”

Jerome Powell, chairman of the Federal Reserve (“the Fed”), has spent the past two-plus years combatting inflation after it surged to levels not seen in four decades in the aftermath of the COVID-19 pandemic. In so doing, he and his colleagues forcefully and speedily raised interest rates with the aim of cooling the economy down and taking inflation down, too. 

Midway through his inflation-fighting campaign, in the fall of 2022, Powell suggested that the Fed should keep raising interest rates, even if it meant that jobs would be lost, unemployment would rise, and a recession would ensue. The Fed, in effect, appeared willing to “murder” the economy into a recession to reduce inflation.¹

Last week, Powell clearly conveyed a meaningful shift: Inflation is on a sustainable path back to the Fed’s target, the once-overheated labor market has “cooled considerably," and because he and the Fed “do not seek or welcome further cooling in the labor market … the time has come for policy to adjust,” Powell said. His goal: Start lowering interest rates to forestall a recession.

If successful, this would mark a historic moment in the 111-year history of the Fed, as it rarely gets this right, and for good reason. After it is initially released, economic data is frequently revised (many times substantially so), meaning that the Fed is not always looking at clean data when making decisions. In addition, when the Fed does act, its impact is felt over time, not immediately.

As of July 2024, the U.S. unemployment rate stood at 4.3%. This is low by historical standards, but it is up nearly 100 basis points (1%) since January 2023. The takeaway: The Fed’s actions from two years ago are being felt. But with inflation seemingly under control and with unemployment on the rise, the Fed will soon start lowering interest rates.

So, What Does This Mean for Equity Investors? It Depends.

Since 1990, there have been six rate-cutting cycles. In four of those episodes, stocks were higher 12 months after the Fed began cutting, with a one-year return ranging between 9% and 22%. But in two of those episodes, stocks were lower, including a decline of 10% one year after the Fed started cutting interest rates in 2001, and a larger 18% decline 12 months following the Fed’s rate cuts in 2007. What explains the difference: whether the economy falls into a recession.

The optimist in me says that the Fed will be successful. It will start cutting in time to avert a recession and a large correction in the equity market will be avoided (though some volatility is likely). The realist in me, however, says that such a scenario cannot be assured and thus we should hope for the best but prepare for a less sanguine outcome.

This means maintaining a balanced risk posture or keeping one’s portfolio in line with its strategic asset allocation targets. We also suggest instituting small tilts to asset classes where valuations are less demanding.

And despite the risk of a serious equity market slide (again, not our base case), we recommend investors revisit their allocations to cash and consider deploying excess liquidity into a more diversified, more productive portfolio composed of high-quality stocks and bonds. For the recent above-average returns evident in money market funds may soon be a thing of the past. (NOTE: Stay tuned for several articles that will be published soon expanding on this important topic.)

When and How Much Will They Cut?

While the Fed was explicit that it will be reducing interest rates soon, Powell was more elusive on the number of rate cuts and when they might occur: “… the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks,” he said.

One possible guide is the difference between the Fed’s current policy range of 5.50%–5.25%, and the yield on the 2-year U.S. Treasury yield, which historically “leads” the federal funds rate and currently approximates 4%. This would imply a drop in short-term interest rates of 1.25–1.50%, or five or six rate cuts. This might serve as a possible base case, but much depends on the health of the labor market and whether inflation remains on the Fed’s glidepath to its 2% target.

In other words, there remain several “known unknowns," something that has perhaps never been more true given the unusual nature of the post-pandemic economy and several unique forces impacting the economy, including immigration, work from home, and profound changes in consumer buying patterns (namely, a preference for experiences over goods).

Aggressive rate cuts by the Fed will likely not materialize, we believe, unless and until a larger rise in unemployment occurs. In addition, because the considerable fiscal budget deficit is not likely to narrow anytime soon, this could keep interest rates elevated as well.

But regardless of the number of times and the amount by which the Fed lowers rates, the larger implication for investors is that rate cuts are coming. Although we don’t advocate making any wholesale changes to one’s portfolio, we believe it is prudent to revisit one’s overall exposure to risk, move excess cash into high-quality bonds, maintain a bias toward high-quality stocks, and incorporate “New Tools” such as certain alternative and real asset strategies to enhance the diversification of a total portfolio.

The time for policy to adjust has come, Powell has told us. And the time to review your portfolio has come, too.