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“Sometimes the questions are complicated, and the answers are simple.”
— Dr. Seuss
While Dr. Seuss may not have spent any time in the investment industry, his quote could certainly be applied to the conversations that investment professionals have on a day-to-day basis. The questions we debate can be challenging, with many different inputs and opinions on how things might unfold. But sometimes if we step back, the ultimate solution can be relatively easy to implement across portfolios.
After months if not years of investors asking when the Fed would cut rates, we finally got our answer. Thanks to my colleague, Joe Dunn, we have all the information we need to understand what the Fed did and what it will be looking at going forward in his recent blog post.
Investors and the Fed in its public comments seem confident that the Fed’s rate-cutting efforts will support a soft landing for the economy as inflation continues to come down toward its target of 2 percent. Still, I believe that the role of a portfolio manager is to think through possibilities that could upend the consensus view, as that could lead to increased volatility across markets. So, with the benefit of more information, let’s build on my post on market volatility from last month.
The Fed Builds Its Case
The view that the economy will achieve a soft landing might become a reality over time. In a post-meeting press conference, Chairman Powell pointed to evidence for why this rate cut is a down payment on making that scenario likely. The market’s expectations for the path forward for interest rates and the Fed’s dot plot also confirm the confidence in that outcome.
Interest rates will follow a slow and steady path if the inflation data continues to trend downward and if the economic data, particularly employment data, continues to support economic expansion.
Are Declining Rates Good for Stocks?
Over the past 15 years, investors have learned that when rates go down, stocks tend to go up. This recency bias is perhaps the biggest driver behind investors’ asking when the Fed will cut rates. On multiple occasions over the past 18 months, we have seen where the market has been trying to lead the Fed to rate cuts. In fact, expectations coming into this year were that the Fed would cut rates six times in 2024.
But let’s consider what happens when we look through a longer lens. The Fed’s cutting cycles haven’t always equated to strong return periods in the market. Looking under the hood, the market seems to understand that.
Source: UBS, Citigroup, Bloomberg. Citigroup Economic Surprise Index is constructed using weighted historical standard deviations of surprises (difference between actual releases and Bloomberg surveys) for different macroeconomic indicators, where the weights depend on the announcement’s effect on the foreign exchange markets. With an index over zero, its economic performance generally beats market expectations. With an index below zero, its economic conditions are generally worse than expected. Surprise index readings climb up as the economy recovers but decline fast as the economy declines. Correlation is a statistical measure that expresses the extent to which two variables are linearly related. Data as of August 2024.
Throughout much of 2024, stocks rallied on weak economic data because they believed it would lead to rate cuts and sold off on strong data as it seemed to indicate the Fed pause would last longer. But as can be seen in the chart above, the market has rallied on stronger economic data because the focus has shifted away from rates moving lower to the reason rates will move lower going forward. That reason will depend on what type of economic backdrop we have.
Fed Rate Cuts and Their Effect on Asset Allocation
If one had a crystal ball that revealed the economy’s future path with 100 percent certainty, then a portfolio could be constructed to maximize returns for that scenario. But we don’t. So, it is important to understand how the path of economic growth has historically impacted different asset classes.
Source: Bloomberg, FactSet, MSCI, Russell, Standard & Poor’s, J.P. Morgan asset management. Soft landing: a scenario where the economy slows just enough to prevent inflation without causing a recession. Hard landing: a scenario where efforts to slow the economy result in a downturn, often leading to a recession. U.S. large-cap: S&P 500. U.S. small-cap: Russell 2000. U.S. value: Russell 1000 Value. U.S. growth: Russell 1000 Growth. International: MSCI ACWI ex USA. 10-year Treasuries: Bloomberg U.S. Treasury Bellwether (10Y). 2-year Treasuries: Bloomberg U.S. Treasury Bellwether (2Y). Bloomberg U.S. Agg: Bloomberg U.S. Aggregate Bond. U.S. HT: Bloomberg U.S. High Yield Corporate Bond Index. Commodities: Bloomberg Commodity Index. USD: DXY Index. Cash: Bloomberg U.S. Treasury Bills (1-3M). Soft landing includes the cutting cycles starting in 1984, 1995, and 1998. Hard landing includes the cutting cycles starting in 1989, 2001, 2007, and 2019. The 2019 hard landing episode began with a soft landing, where the Fed cut rates 75 bps, followed by a hard landing months later due to the onset of the COVID-19 pandemic. International equities, U.S. high-yield, commodities, USD, and cash do not include the 1984 soft landing episode due to a lack of available data. U.S. high-yield, commodities, and cash do not include the 1989 hard landing episode due to a lack of available data. Equity and commodity returns are price returns; fixed income and cash returns are total returns. All returns are shown in U.S. dollars. Past performance is no guarantee of future results. All indices are unmanaged, and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Index total returns assume reinvestment of dividends.
Investors like the potential of a soft-landing scenario because they believe the markets should act well. Historically, all asset classes have had positive returns in a soft-landing scenario. But if the consensus is wrong and we have a recession? Then there is room for disappointment and much different returns for various asset classes historically.
What Should We Be Watching?
Broadly speaking, the consensus for a soft landing continues to be supported by economic data. But we should pay attention to some of the upcoming economic reports to try to gain insight into whether the Fed has fallen behind the curve.
Some of it is obvious. In an economy 70 percent driven by the consumer, jobs data is front and center. If people have jobs, they have money. And if they have money, they spend it. While recent earnings reports have shown some weakness in the lower-end consumer, in general, the consumer remains healthy. But the jobs created data has shown a cooling in the employment market over the last couple of months. Going forward, the health of the employment market can certainly be gleaned from the monthly employment data, released for the most part on the first Friday of the month. The Jobs Opening and Labor Turnover report, more commonly referred to as the JOLTs report, is also released monthly and is another look at the health of the jobs market. Finally, the initial jobless claims report is released weekly on Thursday mornings. All these releases are quite popular and can be scrutinized for information regularly.
Unprompted, Chairman Powell also brought up a report that doesn’t always get the full attention of investors: the Beige Book. The Beige Book is released eight times a year and summarizes economic activity across 12 Fed districts.
Data as of September 4, 2024.
Recent reports show an economy muddling along, with the most recent data pointing in negative territory but not yet indicative of a recession. But if the Fed is paying attention to the data, then investors would be well served to do so, too. The next Beige Book report comes out on October 23.
Navigate Uncertainty Through Diversification
The questions facing the market are certainly complicated. But maybe the answers are indeed simple. No one knows with certainty what the path forward is for the economy. Positioning portfolios for a soft landing that turns into a recession will cause unintended risk. But constructing portfolios for a hard landing will cause underperformance if the economy continues to grow in the intermediate to long term.
Consider balancing portfolios across equity and fixed income asset classes. Within equities, we believe representation across market caps, styles, and geographies is appropriate in a well-constructed, balanced portfolio as value, small-cap, and international equities have historically had very different return profiles depending on why the Fed cut rates. The same holds for the fixed income side of the portfolio, as balance across durations and credit qualities seems appropriate. Declining rate environments have historically been a good backdrop for fixed income investors no matter the ultimate reason the Fed cuts rates. Over time, when Fed funds rates have declined, high-quality bonds have outperformed cash. On both sides of a balanced portfolio, we must be cognizant of the risk inherent in each asset class and right-size those positions for the current opportunity set based on what we have learned from the past. (Note that diversification does not assure a profit or protect against losses in declining markets, and diversification cannot guarantee that any objective will be achieved.)
So, while Dr. Seuss wasn’t a market strategist, this quote from Oh, the Places You’ll Go seems an appropriate one for how to think about your portfolios currently. “So be sure when you step, step with care and great tact. And remember that life's a great balancing act.”
Russell 2000 is a market-capitalization weighted index, with dividends reinvested, that consists of the 2,000 smallest companies within the Russell 3000 Index. It is often used to track the performance of U.S. small market capitalization stocks.
Russell 1000 Value is a market-capitalization weighted index, with dividends reinvested, of those firms in the Russell 1000 with lower price-to-book ratios and lower forecasted growth values. It is often used to track the performance of U.S. large market capitalization stocks that are classified by Russell as having value characteristics.
Russell 1000 Growth is a market-capitalization weighted index, with dividends reinvested, of those firms in the Russell 1000 Index with higher price-to-book ratios and higher forecasted growth values. It is often used to track the performance of U.S. large market capitalization stocks that are classified by Russell as having growth characteristics.
MSCI ACWI ex USA is a free float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets excluding the U.S. market. It is often used to track the performance of international (non-U.S.) large and mid-market capitalization stocks.
Bloomberg U.S. Aggregate Bond covers the U.S. investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
The U.S. Dollar Index (DXY Index) is a measure of the value of the U.S. dollar relative to a basket of foreign currencies. The basket of currencies consists of the Euro, Swiss Franc, Japanese Yen, Canadian Dollar, British Pound, and Swedish Krona.
Bloomberg U.S. Treasury Bellwether (10Y) and Bloomberg U.S. Treasury Bellwether (2Y): Bellwether indices track on-the-run U.S. Treasury issuance for the 2-year and 10-year issues. Bellwethers can also refer to the specific instrument against which the spread of a bond is quoted.
Bloomberg 1-3 Month U.S. Treasury Bill Index is designed to measure the performance of public obligations of the U.S. Treasury that have a remaining maturity of greater than or equal to 1 month and less than 3 months. The Index includes all publicly issued U.S. Treasury Bills that have a remaining maturity of less than 3 months and at least 1 month, and are rated investment-grade. In addition, the securities must be denominated in U.S. dollars and must have a fixed rate. The index is market capitalization weighted, with securities held in the Federal Reserve System Open Market Account deducted from the total amount outstanding.
Bloomberg Commodity Index (BCOM) is composed of futures contracts and reflects the returns on a fully collateralized investment in the BCOM. This combines the returns of the BCOM with the returns on cash collateral invested in 13-week (3-month) U.S. Treasury bills.
Bloomberg U.S. High Yield Corporate Bond Index includes all fixed income securities having a maximum quality rating from Moody’s Investors Service of Ba1, a minimum amount outstanding of $100 million, and at least one year to maturity.
