Special Report written by LGT Crestone Head of Public Markets Todd Hoare.
Late this week, the US Federal Reserve (Fed) lowered official interest rates by 50 basis points (bps), to 4.75–5.00%. The median projection by the Federal Open Market Committee (FOMC) is for an additional 100bps of cuts in 2025 on top of a further 50bps of cuts through to the end of this year (i.e., 200bps in total, which is slightly above the 250bps the market had pencilled in). In this Special report, we look at how the equity market has reacted at the start of previous rate-cutting cycles, and what it means this time round.
The market is now braced for an additional seven to eight cuts by the end of 2025.
The Fed first began exiting the COVID era of ultra-loose monetary policy in March 2022, raising official interest rates 11 times, at one of the fastest paces on record. Rates had been held at 5.25-5.50% for over 12 months, allowing restrictive monetary policy to work its way through the US (and global economy). In turn, this helped bring the Fed’s preferred measure of core inflation back to 2.6%, its lowest level since March 2021.
Economic growth indicators continue to decline and have set off increased cross-asset volatility (albeit September data, despite still surprising negatively, have not missed by as much as the prior month). Equity market price action continues to favour the likelihood of a soft-landing for the US economy, while other markets, such as commodities and rates, have reacted more to incremental growth fears.
With the Fed now equally (if not more) focused on the other side of its dual mandate – employment – the market is now braced for an additional seven to eight cuts by the end of 2025 (~3%). Without wanting to oversimplify the task ahead, much of the debate will centre upon whether the world’s largest economy succumbs to a recession over the next six months. Again, simplistically, out of the last 12 easing episodes, eight were accompanied by a recession and four by a soft landing.
Historically, the initial equity market reaction to the start of rate cuts has tended to be rather muted, but subsequent performance has diverged significantly.
Historically, the initial equity market reaction to the start of rate cuts has tended to be rather muted, but subsequent performance has diverged significantly, depending on which growth outcome prevailed. Longer term, equity performance following the start of a Fed easing cycle has been largely contingent on the growth outcome. A soft or no-landing scenario has seen equities deliver very strong returns, while recessions have usually seen equities show absolute weakness for a number of months after the cuts began.
One key difference this time around is that the S&P 500 Index is already up 28% in the last 12 months. This is much more than the 4% gains made by the index in the run up to the last 12 Fed easing cycles, on average. This could suggest that, even in a soft-landing scenario, S&P 500 returns could be relatively muted this time, given the elevated starting point. Notwithstanding this, 1989 and 1995 saw very similar returns in the lead up to the first rate cut, 25.3% and 27.7% respectively, and both episodes were still able to generate very strong 12-month forward returns.
By factor, both growth and value have shown a tendency to deliver positive returns in the 12 months following a Fed rate cut. However, again this hinges on whether a recession was forthcoming or not. Relative performance across mid-cap and small-cap equities has been variable, irrespective of whether a recession occurred. Mid-caps outperformed large caps in 1998 (no recession) and 2001 (recession) but underperformed in other instances. Small-cap returns have tended to be volatile, and the 2019 rate-cutting cycle suffered from COVID distortions. During the GFC and DotCom bubble, small caps were able to materially outperform large caps, although prior cycles showed no tendency for outperformance.
This time around, however, analysts believe that falling rates will be a critical support for smaller-sized companies. 49% of Russell 2000 (small caps) debt is floating versus only 20% of the S&P 500 debt. Small cap remains abnormally cheap (on a price/earnings and price/book basis) and in the case of the US, they appear to be discounting much higher credit spreads and weaker growth already.
At a sector level, pharmaceuticals, health care, consumer staples, software, and consumer discretionary have tended to exhibit positive one-year forward outperformance versus the market. Banks and insurance have tended to underperform.
This time around, analysts believe falling rates will be a critical support for smaller-sized companies.
Across other assets, commodities have tended to exhibit very muted one-year forward returns. Outside of 1995, the Bloomberg Commodity Index has generated a one-year forward return after the first cut of ~3% to -19%. Investment grade and high yield bonds have shown a strong tendency to deliver positive absolute returns. The US dollar has shown a tendency to weaken half the time after the first rate cut.
This document has been prepared by LGT Crestone Wealth Management Limited (ABN 50 005 311 937, AFS Licence No. 231127) (LGT Crestone Wealth Management). The information contained in this document is of a general nature and is provided for information purposes only. It is not intended to constitute advice, nor to influence a person in making a decision in relation to any financial product. To the extent that advice is provided in this document, it is general advice only and has been prepared without taking into account your objectives, financial situation or needs (your Personal Circumstances). Before acting on any such general advice, we recommend that you obtain professional advice and consider the appropriateness of the advice having regard to your Personal Circumstances. If the advice relates to the acquisition, or possible acquisition of a financial product, you should obtain and consider a Product Disclosure Statement (PDS) or other disclosure document relating to the financial product before making any decision about whether to acquire it.
Although the information and opinions contained in this document are based on sources we believe to be reliable, to the extent permitted by law, LGT Crestone Wealth Management and its associated entities do not warrant, represent or guarantee, expressly or impliedly, that the information contained in this document is accurate, complete, reliable or current. The information is subject to change without notice and we are under no obligation to update it. Past performance is not a reliable indicator of future performance. If you intend to rely on the information, you should independently verify and assess the accuracy and completeness and obtain professional advice regarding its suitability for your Personal Circumstances.
LGT Crestone Wealth Management, its associated entities, and any of its or their officers, employees and agents (LGT Crestone Group) may receive commissions and distribution fees relating to any financial products referred to in this document. The LGT Crestone Group may also hold, or have held, interests in any such financial products and may at any time make purchases or sales in them as principal or agent. The LGT Crestone Group may have, or may have had in the past, a relationship with the issuers of financial products referred to in this document. To the extent possible, the LGT Crestone Group accepts no liability for any loss or damage relating to any use or reliance on the information in this document.
Credit ratings contained in this report may be issued by credit rating agencies that are only authorised to provide credit ratings to persons classified as ‘wholesale clients’ under the Corporations Act 2001 (Cth) (Corporations Act). Accordingly, credit ratings in this report are not intended to be used or relied upon by persons who are classified as ‘retail clients’ under the Corporations Act. A credit rating expresses the opinion of the relevant credit rating agency on the relative ability of an entity to meet its financial commitments, in particular its debt obligations, and the likelihood of loss in the event of a default by that entity. There are various limitations associated with the use of credit ratings, for example, they do not directly address any risk other than credit risk, are based on information which may be unaudited, incomplete or misleading and are inherently forward-looking and include assumptions and predictions about future events. Credit ratings should not be considered statements of fact nor recommendations to buy, hold, or sell any financial product or make any other investment decisions.
This document has been authorised for distribution in Australia only. It is intended for the use of LGT Crestone Wealth Management clients and may not be distributed or reproduced without consent. © LGT Crestone Wealth Management Limited 2024.
