Jerome Powell chooses his words carefully. The US Federal Reserve (Fed) chairman leaves every option on the table. But his message since last week’s rate-setting meeting has been clear.
‘You investors are expecting more interest rate cuts than you’re likely to get in 2024. But, yes, we do anticipate cutting rates three times this year’.
There remains some uncertainty about when that process gets underway, but the consensus now is for a first cut in May. So, now is the right time to think about how markets are likely to behave in the months that follow the pivot. Fortunately, the first half of that job - learning from history - has already been done for us. Hat tip to Duncan Lamont at Schroders, who has trawled through the relevant US data since 1928.
His analysis shows 22 downturns in interest rates in that 96-year period. On average the US stock market has beaten inflation by 11pc in the 12 months following the initial rate cut. That compares with 5pc for government bonds in the same period, 6pc for corporate bonds and 2pc for cash.
It is important to understand why interest rates are being cut
If central banks are easing policy in response to an economic downturn, the subsequent market performance is, perhaps unsurprisingly, less good for shares but a little better for bonds - an 8pc real return for shares and 7pc for both types of bonds. This is the norm. In sixteen of the 22 occurrences, the economy was either in recession at the time of the first cut or entered one within 12 months.
When rates are cut for the more benign reason that the battle with inflation has been won without the need to push the economy into recession - a soft landing - the results favour shares more clearly. A 17pc inflation-adjusted return for equities and just 2pc for government bonds and 4pc for corporates. In all cases the return from cash is just 2-3pc, a warning not to be too cautious at times like this.
Of course, these are averages. If markets were predictable, we’d spend less time thinking about them than we do. There have been six rate-cutting phases since 1928 in which the market fell in the subsequent 12 months - sometimes, as in 1929 and 1973, by a significant margin. But these tend to be periods of major economic dislocation - they include the Wall Street crash, the bursting of the dot.com bubble and the financial crisis.
Rate cuts are, broadly speaking, good news for investors. No surprise there. Falling rates reduce the cost of borrowing for businesses and households, and they make risk-free assets like cash relatively less attractive. Boosting the stock and bond markets makes people feel richer, so it’s an obvious tool for a central banker trying to stimulate the economy.
Within the stock market, which sectors or styles might you expect to do best in a rate-cutting environment? Shares with lots of future growth potential should do better because a lot of their value is accounted for by cash flows that will materialise many years hence. Lower interest rates increase how much these are worth in today’s money which is why the Magnificent Seven tech stocks did so well last year, as investors anticipated lower rates, and so badly in 2022, when the cost of borrowing was rising.
Again, however, the reason for the rate cuts is important. That’s because cheaper ‘value’ shares tend to do well in a cyclical economic upswing. In the absence of a recession, a rate-cutting cycle can favour shares whose value is more in the here and now - industrials, property companies, smaller companies. Many of these underperformed in 2023, and they might be expected to play catch up as and when rates start to fall this year. Housing stocks, in particular, would be a beneficiary of falling mortgage rates.
It’s also worth keeping an eye on how falling rates impact the dollar
If the Fed is ahead of other central banks in cutting rates, the dollar could fall in value. This typically favours emerging markets and goes some way to explaining the recent popularity of the Indian stock market which is trading at an all-time high.
The amount of cash currently sitting on the side lines is another reason to expect history to at least rhyme. A combination of rising interest rates and concerns about the health of banks has led to massive inflows into money market funds. Perhaps US$8trn is sitting in these cash funds. When interest rates start to fall, some of this will chase higher returns in the stock and bond markets. Dividend paying shares will be particularly attractive when this happens.
One possibility is that a recession-free rate cut cycle could light a fire under the stock market in the way that it did in the second half of the 1990s. History never repeats itself exactly but there are some striking similarities between then and now. First, in 1995 the Fed doubled interest rates in 12 months then gave back three rate hikes as inflation returned to 2pc. Then, in 1998, the Fed cut rates to stem the fallout from currency crises in Asia and Russia despite a solid economic backdrop at home.
This time, it’s the flagging Chinese economy that’s put a lid on the oil price and related inflation. So, the Fed may cut rates again despite a strong domestic economy. At the same time, AI offers the same scope for an extended economic expansion as the arrival of the internet did in the 1990s. An equity market melt-up is not a given, but it is a possibility that no-one would want to miss.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
