It's Time … For a Fed Pivot

The Federal Reserve has 12 districts around the country, but only one mission: to keep investors guessing. It's that time of the cycle to switch from pause mode to cutting mode, with consensus gelling around a 25 basis points cut at the September Federal Open Market Committee (FOMC) meeting in mid-September, while there are adherents to the 50 basis points view. Much of our ink has been spilled on the history of Fed cycles and their impact on markets; but until this report, we've focused on the hiking and pause segments of historical cycles. Now it's time for us to ease into the next phase.

As we get into this topic, a shoutout is warranted to our great friends at Ned Davis Research for their enviable historical database on the subject; as is often the case, making our job in this case just a little easier (and more robust). An important starting point in assessing rate cuts' impact on stocks necessitates the distinction between "fast" and "slow" cutting cycles. Fast easing cycles were ones during which the Fed cut rates at least five times per year, while slow easing cycles had less than five cuts. "Non-cycles" were cases of only one rate cut, not followed by more.

The chart below covers the post-WWII period of Fed cutting cycles; dividing them into fast, slow and non-cycles. It covers the one-year period leading into the initial rate cut in each cycle, as well as the one- and two-years following the initial cut. As shown—and as further detailed in the imbedded table—there has been a distinct difference in the path of the stock market (via the S&P 500) in the aftermath of different types of cutting cycles. Slow cutting cycles have been much more rewarding for equities (especially within the first year after the initial rate cut) than either fast or non-cycles. This should be intuitive: if the Fed is cutting aggressively, it's likely because they're combatting a recession or financial crisis (or the combination thereof). It's why our mantra of late has been "be careful what you wish for" if you're hoping for an aggressive (fast-moving) Fed this time.

We put some individual and finer points on this analysis in the table below, which is color-coded in keeping with the NDR chart above. We homed in on the differential in maximum drawdowns for the S&P 500 depending on the type of cutting cycle. As shown at the bottom of the table, within the first six months following the initial rate cut, the average maximum drawdown was about twice as large during fast cycles relative to slow cycles. The spread was even wider within the first year following the initial rate cut; with the average maximum drawdown 2.8 times larger in fast cycles relative to slow cycles.

Sector trends are also of note in terms of the history of fast vs. slow cutting cycles. As shown below, slow cutting cycles have been to the decided benefit of cyclical sectors (Energy, Materials, Industrials, Consumer Discretionary, Financials, Technology and Communication Services) relative to defensive sectors (Consumer Staples, Health Care, Utilities and Telecom Services). [As an aside, there is no longer a Telecom Services sector within the S&P 500. S&P did their GICS restructuring in 2018, during which many Telecom Services stocks were merged into the then-new Communication Services sector. NDR's historical analysis is apples-to-apples, hence the inclusion of Telecom Services.]

Sector leadership is about more than just the speed of the rate cutting cycle; but also about trends in longer-term Treasury yields. Traditional dividend-oriented sectors, like Utilities and Consumer Staples, are generally inversely correlated with Treasury yields—helping to explain those sectors' underperformance when the 10-year Treasury yield surged from 3.9% in January, to 4.7% in April, but also their stronger performance so far in the third quarter, given the roundtrip in yields since the April peak. In fact, the strongest breadth improvement since the overall market pullback into early August has been among the most interest-sensitive sectors: REITs, Utilities and Financials all have at least 90% of their stocks trading above their 50-day and 200-day moving averages. For the latest on our Sector Views, see Monthly Stock Sector Outlook (2024) | Charles Schwab.

Fed Chair Powell's speech at the annual Jackson Hole summit underscored a shift in emphasis from inflation to the labor market. It's not as if inflation no longer matters, but members of the Fed have recognized that disinflationary pressures are still quite strong, combined with the fact that the labor picture has continued to soften. As such, risk management has changed in the eyes of the Fed.

As shown in the chart below, it's quite common to see the year-over-year trend in both the headline and core Personal Consumption Expenditures (PCE) Price Indexes ease into the first cut of the cycle. Perhaps unsurprisingly, in the recession cases (shown via the blue and red lines), inflation tended to fall rather sharply after the Fed started cutting. Absent a recession (shown via the green and yellow lines), inflation tended to continue to ease and then reaccelerated a touch nearly six months after the start of the cutting cycle.

As is the case with rate cuts, inflation's decline is also a case of "be careful what you wish for." While the large increase in price levels over the past few years has been difficult for consumers, wishing for a swift decline in inflation or price levels would likely be consistent with a recession (and more significant weakness in the labor market).

Shifting focus to the Fed's labor market mandate, there is a clear difference in payrolls' trends when it comes to recessionary vs. non-recessionary cutting cycles. As shown in the chart below, in cycles when a recession followed within a year after the first rate cut, payrolls tended to peak (on average) a handful of months before the first cut—then declined further throughout the following year. In non-recessionary cycles, payrolls tended to keep rising.

Applying those trends to the current cycle, the upside is that in this cycle the economy has added jobs for 43 consecutive months. The downside is that the slowing trend has been, to use Chair Powell's own word, unmistakable. That warrants—with each jobs report moving forward—a continued, close look at some of the cracks that have been widening under the surface.

Wrapping this report up on one more market point, we'll highlight a great study NDR did when it comes to large- vs. small-cap performance after the start of a cutting cycle. As shown in the chart below, when a recession followed in the year after the first cut, small caps (proxied by the Russell 2000) outperformed large caps (proxied by the Russell 1000) significantly over the following year. Perhaps against conventional wisdom, non-recessionary cutting cycles were not consistent with strong relative performance for small caps. On average, the Russell 2000 went on to underperform the Russell 1000 in the year following the first rate cut. That might seem odd, but small caps tend to outperform as the economy is rebounding aggressively after a recession has ended—a dynamic that doesn't exist in a soft-landing scenario.

That is among the reasons we believe that if investors are inclined to move down the cap spectrum, it should be done with a focus on quality. Over the past year, the profitable members in the Russell 2000 are (on average) outperforming the non-profitable members by a significant degree. We don't think that's a coincidence, given the slow rebound in small-cap earnings expectations and continued softening in the broader economy.

The Fed has been transparent in its telegraphing of the start of rate cuts at this month's FOMC meeting. The beneficial impact of rate cuts tends to be both amplified and nearer-term when the cutting cycle is not accompanied by a recession; with slow cutting cycles more rewarding to equities than fast cutting cycles. It's been said that the Fed often takes the elevator up (when hiking rates) and the escalator down (when cutting rates). Clearly, this cycle was turned on its head during the Fed's hiking campaign, when they decidedly took the elevator up. Equity investors should hope the Fed is eyeing the escalator on the way down.