With the Federal Reserve poised to make its long-awaited rate cut this week, our CIO and Chief US Equity Strategist tells us why investors have pivoted their concerns from high inflation to slowing growth.
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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about what to expect as the Fed likely begins its long-awaited rate cutting cycle this week.
It's Monday, Sept 16th at 10:30am in New York.
So let’s get after it.
After nearly 12 months of great anticipation, the Fed is very likely to start its rate cutting cycle this week. The old adage that it is often easier to travel than arrive may apply as markets appear to have priced an aggressive Fed cutting cycle into the middle of next year while assuming a soft-landing outcome for the economy.
More specifically, the two-year US Treasury yield is now 180 basis points below the Fed Funds Rate which is in line with the widest spread in 40 years, a level associated with a hard landing. This is the bond market's way of messaging to the Fed that they are late in getting started with rate cuts. This doesn't mean the Fed can't get ahead of it, but they may need to move faster to keep investors' hopes alive.
As a result, the odds of a 50 basis point cut have increased over the past week but it’s still well below a certainty. This is unusual going into an FOMC meeting and is setting markets up for a greater surprise either way. How the markets react to what the Fed does this week will have an even greater influence on investor sentiment than usual, in my view. Ideally, rates should rise at both the front and back end if the bond market likes the Fed’s actions because it signals they aren’t as far behind in trying to orchestrate a soft landing. Conversely, a fall in rates will be a vote of lower confidence.
On the other side of the ledger, we have the equity market which appears to be highly convicted that the Fed has already secured the soft landing, at least at the index level. Today, the S&P 500 trades at 21x forward earnings, which also assumes a healthy path of 10 percent earnings growth in 2024 and 15 percent growth in 2025.
Under the surface, the market has skewed much more defensively as it worries more about growth and less about high inflation. I have commented extensively in this podcast about this shift that started in April and why we have been persistently recommending defensive quality for months. With the significant outperformance of defensive sectors since April, the internals of the equity market may not be betting on a soft landing and reacceleration in growth as the S&P 500 index suggests.
Keep in mind that the S&P 500 is a defensive, high-quality index of stocks and so it typically holds up better than most stocks as growth slows in a late cycle environment like today. These growth concerns will likely persist unless the data turn around, irrespective of what the Fed does this week.
In the 11 Fed rate cutting cycles since 1973, eight were associated with recessions while only three were not. The performance over the following year was very mixed with half negative and half positive with a very wide but equal skew. Specifically, the average performance over the 12 months following the start of a Fed rate cutting cycle is 3.5 percent – or about half of the longer-term average returns. The best 12-month returns were 33 percent, while the worst was a negative 31 percent.
Bottom line, it’s generally a toss-up at the index level. The analysis around style and sectors is clearer. Value tends to outperform growth into the first cut and underperform growth thereafter. Defensives tend to outperform cyclicals both before and after the cut. Large caps also tend to outperform small caps both before and after the first rate cut. These last two factor dynamics are supportive of our defensive and large cap bias as Fed cuts often come in a later cycle environment. It’s also why we are sticking with it.
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