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How do Equity Markets React to Fed Rate Cuts?

Updated: Aug 1, 2019

With the Fed cutting rates for the first time in 11 years, we felt it was an opportune time to share with clients how equity markets have historically reacted to an initial Fed rate cut. As a refresher, Fed Chairman Jerome Powell cut the Fed Funds rate for the first time since the global financial crisis, moving the target 25 bps to between 2.0% and 2.25% from between 2.25% and 2.5%. Although we enjoy speculating on whether rate cuts are the right move at this point and the potential implications of unprecedented monetary policy, today we’d like to simply explore “How do equity markets react when the Fed begins cutting interest rates?”


Without considering any additional qualifiers, history tells us that equity markets react positively to initial Fed rate cuts. According to our friends over at Ned Davis Research, in 18 of the previous 23 initial rate cutting periods, the Dow has risen by 16% on average in the following year[1]. This makes intuitive sense; companies have lower borrowing costs, there is greater liquidity sloshing around in the financial markets, and given the relatively unattractive lower rates, equity multiples often expand. Equities look pretty good in a rate cutting scenario!


The astute reader may want to take that question a step further and assess the impact of initial rate cuts during different economic scenarios. We are, after all, in the midst of the longest bull market in history and that should have an impact on the efficacy of initial rate cuts, right? The question then becomes “How does the equity market react to initial Fed Rate cuts in different economic environments?”. The team at NDR put the below chart together to show that in periods where the economy avoided a recession 12 months after the initial cut, markets rose by 24% on average[2]. In scenarios where the market did fall into a recession during the subsequent 12-month period, markets still rose by 11%[2]. So, are initial Fed rate cuts always a bullish indicator? Not necessarily - we need to dig a bit deeper…



Let's focus our attention on initial rate cuts when a recessionary period occurs within the subsequent 12-month period. The below chart illustrates that in these periods, the timing of the cut is a critical factor. Historically speaking, when the initial cut occurs at the end or the beginning of the recessionary period, it has proven to be an effective strategy in sparking confidence in the markets over the subsequent 12-months. However, when the Fed has cut and failed to stave off a recession, equity markets were down by around 6% over the following 12 months[3]. This makes sense, right? Markets are reflecting a lack of confidence in the Fed's ability to avert a slowdown, as well as concerns regarding future economic growth.



So, what does all of this mean for our portfolios? Our CIO, Chris Cabral, has pointed out on several occasions that we take a weight of the evidence approach, leveraging independent sources and empirical evidence to make asset allocation decisions. We believe this allows us to remain unemotional and consider several angles before acting. At the moment, our Economic indicators tell us that a recession is not likely in the near term. The Fed has just cut rates; history implies that equity markets may move higher as a result. While that may be a bullish indicator, our other indicators tell us that valuations are elevated relative to history, and investor sentiment is optimistic. This implies equity markets may have limited upside potential and may be vulnerable to negative surprises. While we cannot predict with certainty how the equity markets will react to what the Fed has just done (anyone who believes they can please email me!), we can tell you that our indicators are currently sending mixed signals. As a result, we believe a neutral stance in equities is appropriate.


Sources:

[1] Ned Davis Research “DJIA Around First Fed Rate Cut”

[2] Ed Clissold “Dissecting market reactions to initial rate cuts”

[3] Ned Davis Research “DJIA Around First Fed Rate Cut: in Relation to Recession”


Disclosures:

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

The information contained above is for illustrative purposes only.

New World Advisors, LLC (“New World”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where New World and its representatives are properly licensed or exempt from licensure.

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