With the Federal Reserve expected to begin a rate-cutting cycle next month, concerns are emerging about how equity markets will respond amid recent volatility.
After a turbulent month for financial markets, investors are anticipating the Fed’s initial interest-rate cut in September, followed by a possible second cut in December.
As the S&P 500 Index nears record levels, there is uncertainty over whether investors will view the rate cut as a positive signal for extending economic expansion or if it might spark bearish sentiments.
According to Chris Galipeau, senior market strategist at Franklin Templeton Institute, the timing of the first Fed rate cut is important, but so too is the reason for the cut.
Having undertaken an analysis of economic cycles over the past 50 years, Galipeau and his colleague, senior analyst Lukasz Kalwak, explained that, historically, when the Fed cuts rates during an economic expansion, both equity and Treasury markets perform well.
“When the Fed has cut rates due to recession or fears of recession, there are different results than cuts that have occurred in an expansion, even if growth was slowing,” the pair said in a recent market note.
“When the first rate cut coincided with an expansion, investors have usually become more bullish. Equities rose on average over the ensuing three-, six- and 12 months. When associated with recessions, the first cut had an initial bearish effect. Equities fell in the three-month period, but then rallied,” they elaborated.
At present, the pair said the US economy appears to be in expansion noting that, barring any external shocks, a rate cut in September would likely be classified as expansionary.
Commenting on the findings of the research, Galipeau said: “Rate-cutting cycles since 1990 reveal that nearly all equity market sectors have delivered positive returns one year after an expansionary rate cut, with large caps, growth stocks, and Nasdaq leading the charge.”
Reflecting on current conditions, he said Franklin Templeton anticipates the continuation of the bull market, “though with increased volatility”.
“Our analysis of historical cycles shows that, more often than not, the equity market has trended higher in the six months following the first rate cut, regardless of whether the economy was in expansion or recession. Historically, US large- and small-cap stocks have risen on average over six and 12 months after the first rate cuts,” he added.
Looking at other asset classes, Galipeau added that typically, bond prices and returns are highly sensitive to Fed easing cycles, given that bond prices move inversely to rates.
“It is therefore unsurprising that, in all easing cycles (expansion or recession) since 1972, US Treasuries have performed positively, as measured by the Bloomberg US Treasury Total Return Index (Unhedged),” he said.
“The relative performance of treasuries and equities showed significant differences based on economic conditions. In recessionary rate-cut cycles, US treasuries tended to outperform the S&P 500 Index, especially in the shorter periods of three, six, and nine months after the first cut. In expansionary rate-cut cycles, treasuries performed positively but tended to lag behind the gains of the S&P 500 Index in each period.”
A Reuters poll of top economists has shown that most expect the Fed to cut rates by 0.25 percentage points at each of its remaining meetings in 2024.
