With the Federal Reserve poised to make its long-awaited rate cut
this week, our CIO and Chief US Equity Strategist tells us why
investors have pivoted their concerns from high inflation to
slowing growth.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan
Stanley’s CIO and Chief US Equity Strategist. Along with my
colleagues bringing you a variety of perspectives, today I'll
be talking about what to expect as the
Fed likely begins its long-awaited rate
cutting cycle this week.
It's Monday, Sept 16th at 10:30am in New York.
So let’s get after it.
After nearly 12 months of great anticipation, the Fed is
very likely to start its rate cutting cycle
this week. The old adage that it is often easier to travel than
arrive may apply as markets appear to have priced an aggressive
Fed cutting cycle into the middle of next year while
assuming a soft-landing outcome for the economy.
More specifically, the two-year US Treasury yield is now 180
basis points below the Fed Funds Rate which is in line with the
widest spread in 40 years, a level associated with a hard
landing. This is the bond market's way of messaging to the Fed
that they are late in getting started with rate cuts. This
doesn't mean the Fed can't get ahead of it, but they may
need to move faster to keep investors' hopes alive.
As a result, the odds of a 50 basis point cut have increased over
the past week but it’s still well below a certainty. This is
unusual going into an FOMC meeting and is setting markets up for
a greater surprise either way. How the markets react to what the
Fed does this week will have an even greater influence on
investor sentiment than usual, in my view. Ideally, rates
should rise at both the front and back end if the bond market
likes the Fed’s actions because it signals they aren’t as
far behind in trying to orchestrate a soft landing.
Conversely, a fall in rates will be a vote of lower
confidence.
On the other side of the ledger, we have the equity market which
appears to be highly convicted that the Fed has already secured
the soft landing, at least at the index level. Today, the S&P
500 trades at 21x forward earnings, which also assumes a healthy
path of 10 percent earnings growth in 2024 and 15 percent growth
in 2025.
Under the surface, the market has skewed much more
defensively as it worries more about growth and less about
high inflation. I have commented extensively in this podcast
about this shift that started in April and why we have been
persistently recommending defensive quality for months. With
the significant outperformance of defensive sectors since
April, the internals of the equity market may not be betting on a
soft landing and reacceleration in growth as the S&P 500
index suggests.
Keep in mind that the S&P 500 is a defensive,
high-quality index of stocks and so it typically holds
up better than most stocks as growth slows in a late cycle
environment like today. These growth concerns will
likely persist unless the data turn around, irrespective of
what the Fed does this week.
In the 11 Fed rate cutting cycles since 1973, eight were
associated with recessions while only three were not. The
performance over the following year was very mixed with
half negative and half positive with a very wide but equal
skew. Specifically, the average performance over the 12 months
following the start of a Fed rate cutting cycle is 3.5
percent – or about half of the longer-term average returns. The
best 12-month returns were 33 percent, while the worst was a
negative 31 percent.
Bottom line, it’s generally a toss-up at the index level. The
analysis around style and sectors is clearer. Value tends to
outperform growth into the first cut and underperform growth
thereafter. Defensives tend to outperform cyclicals both
before and after the cut. Large caps also tend to outperform
small caps both before and after the first rate cut. These last
two factor dynamics are supportive of our defensive and large cap
bias as Fed cuts often come in a later cycle environment.
It’s also why we are sticking with it.
Thanks for listening. If you enjoy the podcast, leave us a review
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