Recalibration of Fed Policy
On September 18th, the Fed announced a 50bps cut to the overnight target interest rate reducing it from 5.25%-5.50% to 4.75%-5.00%.[1] Notably, this is the first rate cut in this cycle and the first step towards reducing the Fed’s restrictive policy stance.
With inflation heading back to target and the labor market softening, the economic data heading into this announcement indicated a cut of either 25 or 50 bps. The market was evenly split between the two outcomes. The announcement of 50bps surprised the market on the margin.
From a historical perspective, 50bps rate cuts are generally reserved for emergencies and yet the labor market and consumer spending data remain sturdy. Chair Powell was expressly asked during his press conference if this large cut constituted an admission that the Fed is late to begin easing rates. As we discussed repeatedly, this is the core question. Has the Fed waited too long to ease rates to prevent a recession or are they “on-time”. Chair Powell’s reply was revealing: “…we don’t think we’re behind…but I think you can take this as a sign of our commitment not to get behind. So, it's a strong move.”[2] On the one hand, those words provide some comfort but remember that this is the same Fed that told us inflation was “transitory” in 2021.
Nevertheless, the importance of this rate cut is more symbolic than anything. Interest rate cuts tend to take months before filtering through the economy, so these cuts do not produce an immediate economic stimulus. Rather, it is a sign that the Fed is focused on the glide path back to neutral rates, which most economists believe is around 3%. The Fed’s economic projections indicate reaching the neutral rate sometime in 2026.[3] As comparison, the market has the Fed Funds rate returning to 3% by June 2025. These widely differing expectations are sure to change as the economic data rolls in. Here we are again, data dependent and continuing to assess whether the Fed has been too restrictive for too long.
While this “wait-and-see” mode seems unsatisfactory, there is now an asymmetry to the direction of interest rates as the idea the Fed may have to raise interest rates seems off the table. As the economic picture decelerates, the direction of interest rates is down with the only question being by how much.
Meanwhile, the S&P 500 and the Dow Industrials just set new record highs. Although lagging, the Nasdaq is well above the lows set in August as technology names stage a recovery. With still relatively sturdy economic fundamentals, stocks are getting a lift as interest rates have declined. After peaking in May at 4.7%, the 10 Year US Treasury bond yield has declined to 3.7%. Bonds have benefited in this environment. The US Aggregated bond index – a key fixed income benchmark – has risen an impressive 8.5% since May.
Q4 Seasonal Rally Ahead?
Where does the market go from here? We have a Fed that is laser focused on the labor market and any other data points that could indicate a weakening economy. We know now that they are not shy about using their “bazooka”, which is what the market used to call a 50bps cut. This suggests that we are back to having a Fed “put”. In other words, if the economic data looks too weak, they will likely cut rates commensurately. Historically, this state of play is constructive for markets.
For investors, this creates an unusual win-win situation. If the economy tanks, the Fed will cut rates to defend it. Stocks may pullback in the short run, but bonds may be big winners. If the economy meanders along – much like the Fed’s projection of 2% GDP through 2027[4] – stocks could be lifted by gradually lower interest rates that serve to support valuations and a less restrictive economic climate that is good for corporate earnings. In this case, bonds will simply provide a nice yield and portfolio stability while stocks may continue rallying to new highs.
In the very short term, we are exiting September, which is historically the worst month for stocks and entering a seasonally favorable fourth quarter. So long as the economic data continues at its current pace and interest rates decline, the conditions exist for a nice run into year end. Notably, the market may still endure bouts of volatility from the upcoming elections or unforeseen circumstances. However, the point remains that there are more reasons to lean risk-on than risk-off.
Do this mean the Market will Broaden?
We have been talking about the “Magnificent 7” and Growth companies’ relative performance to the market for years. We had to delineate between these two different sets of companies because the fundamentals of each and, hence, their performance have been vastly different.
Sources: Bloomberg
The chart above shows clearly why growth stocks have been generally outperforming value stocks. They grow their earnings faster! This has been particularly important during the last two years as recession concerns grew in investors’ minds. Growth companies, like technology companies, are seen to have more secular demand drivers that are less subject to recession whereas Value companies are more cyclical in nature (e.g., banks, energy companies). Stocks outperform when reported results are higher than expected and the reverse when expectations are missed. The chart above reflects the earnings per share expected by the market over the next twelve months. Not surprisingly, Growth companies have higher growth expectations which creates a higher bar to clear. The estimates for Value companies are more subdued, perhaps offering a lower hurdle to clear, particularly if recessionary fears prove unfounded.
Sources: Bloomberg
While valuation – high or low – is not the sole driver of stock performance, it is an important sign of how “popular” a stock is and certainly indicates that owners of the stock believe that future earnings are likely materially higher than consensus. High valuation stocks can be great, but they can also be subject to “Icarus”-like falls from grace if high investor expectations cannot be met. Similarly, low valuation stocks can be excellent sources of overlooked value, but they can also be cheap for a reason due to flawed business models.
Either way, Value stocks have generally been overlooked as economic fears have increased. But, if the Fed “put” is at hand and interest rates are declining we may see more and more investors go bargain hunting. Valuation among Value stocks are climbing indicating that investors believe that next year’s earnings estimates likely need to be increased. A broadening of investor interest to Value stocks would likely be a positive for the market in our view.
Conclusion
We (prematurely?) declared victory over inflation 18 months ago as we saw indisputable signs of disinflation. The Fed just acknowledged our call. While it is nice to have our prediction finally vindicated, it is a bit disconcerting that it took the Fed this long. Last week’s “not emergency” rate cut of 50bps is somewhat satisfying, but does it mean the Fed has been too restrictive for too long? According to economist and Nobel laureate Milton Friedman, the full impact on economic variables such as inflation, employment and GDP from changes in the Fed Funds interest rate has a long and variable lag.[5] It will be difficult to know how many cuts are needed to navigate an economic soft landing. As a result, we are in a period where we need to ask how many more cuts are needed. This is the key question to ask over the coming months. The good news is that the Fed put is back and as the adage says, “Don’t Fight the Fed.”
Disclosures
LIM is an Investment Advisor based in Dallas, Texas and registered with the Securities and Exchange Commission. Registration does not imply a certain level of skills or training. LIM is a company with purpose, dedicated to creative and unique thinking. We focus on portfolio valuation and research, along with superior client experience. We seek to identify investment opportunities by looking at economic factors, security valuation and human behavior. We start with the fundamentals of portfolio management and valuation. Then we build on these fundamentals with unique thinking and creative intelligence gathering to form a viable investment thesis. We believe this approach leads to dynamic global portfolios with increased return and managed risk. LIM utilizes Charles Schwab & Co. Inc. (“Schwab”), a FINRA-registered broker-dealer, member SIPC, as its custodian of assets. LIM is independently owned and operated and not affiliated with Schwab.
Additional disclosures:
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Definitions
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value.
The Nasdaq Composite Index is a market cap-weighted index, representing the value of all stocks listed on the Nasdaq Stock Market. The composition of the Nasdaq Composite is a mix of long-established companies that have been on the exchange since inception, to IPO newcomers, companies that grew from OTC exchanges or switched from other exchanges.
The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.
The Bloomberg US Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar-dominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate pass throughs), asset-backed securities and commercial mortgage-backed securities.
The S&P 500 Equal Weighted Index is the equal-weight version of the S&P 500. The index includes the same constituents as the capitalization weighted S&P 500 index, but each company is allocated the same fixed weight at each quarterly rebalance.
The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 Index total market capitalization.