Morgan
Wealth Management

Rethinking the Rate-Cut Playbook

Aug 7, 2024

Investment strategies that worked ahead of past Fed rate cuts may not be as effective this time around. How should you position your portfolio instead?

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • The likelihood of an economic “soft landing,” instead of a recession, changes the calculus of how investors should prepare for Fed rate cuts. 
  • For example, allocating more to longer-duration bonds and small caps, or bidding up cyclical stocks, may be less prudent in this cycle.
  • Investors may consider above-benchmark exposure to fixed income and slightly below benchmark on duration, while favoring active stock-picking or the equal-weight S&P 500. 

Markets are now fully expecting the Federal Reserve to begin lowering interest rates in September and many investors are asking: Will the traditional rate-cut playbook continue working?

 

Historically, when the Federal Reserve has appeared on the verge of bringing down rates, many investors boosted their exposure to longer-duration bonds and certain stock categories like small-cap, cyclical and value-oriented equities, while bidding up economically-sensitive “cyclical” names.

 

Markets followed that script in July after cooling inflation data boosted investors’ confidence that the Fed would soon take action. That catalyzed a market rotation from the so-called Magnificent 7 mega-cap tech stocks, which have dominated large-cap equity indices, to those seen as rate-sensitive, including “cyclicals” and small caps.  

 

This erased most of the S&P 500 Index’s July gains, while the tech-heavy Nasdaq Composite fell nearly 1%. The small-cap Russell 2000 Index, meanwhile, advanced 10%. Disappointing jobs data for July released last week stoked fears that the Fed has waited too long to begin easing, sending the 10-year Treasury yield decisively below 4% and bond prices higher. Equities and Treasury yields continued to decline early this week.  

 

Still, even as the market’s mood darkens over the prospect of economic slowing, Morgan’s Global Investment Committee believes a “soft landing,” in which growth cools, but doesn’t collapse, remains the most likely outcome. As such, we are cautious about the traditional rate-cut playbook, which is typically premised on recession. Here are three key reasons why. 

  1. 1
    Higher Rates May Weigh on Bonds

    The traditional playbook: A recession would typically spur rapid and deep Fed rate cuts. Anticipating steep declines in short-term bond yields, investors often defensively shift money to longer-duration bonds to lock in current higher yields and potentially benefit from a rise in bond prices as rates fall.

     

    Why this cycle is different: This time, however, a soft landing looks more likely than a recession. Such a scenario should require only slow and shallow Fed rate cuts, leaving the so-called terminal rate higher than in past cycles. The U.S. government’s continued heavy borrowing could also put upward pressure on yields. This all suggests that rates may stay higher for longer than many investors expect, limiting the potential for declining bond yields to produce capital gains. 

  2. 2
    Cyclical Stocks Should Stabilize

    The traditional playbook: Often, when a recession appears on the horizon, investors expect plummeting rates to support the prices of economically sensitive, or “cyclical,” equities, even as faltering growth pressures their earnings. This can cause their price-to-earnings multiples to expand.

     

    Why this cycle is different: We don’t expect rates to plummet, nor do we see cyclicals’ earnings sharply declining. Instead, with a post-COVID economy bringing higher growth and productivity, inflation-adjusted rates are likely to normalize to their 80-year average of 1.6%, about double their 20-year average. In a soft landing, cyclicals’ earnings should stabilize, with select opportunities to expand margins through cost cutting.

  3. 3
    Small Caps Remain Vulnerable

    The traditional playbook: Seeing attractive relative valuations, investors have been buying up smaller stocks ahead of expected rate cuts, anticipating that lower borrowing costs may benefit these businesses in particular.

     

    Why this cycle is different: However, as we recently noted, analysts have been lowering their performance forecasts for these stocks lately. What’s more, many smaller companies face profitability challenges, and the expected rate cuts are unlikely to fully resolve those issues. 

How to Invest

In one sense, the recent drop in Treasury rates and action in the equity market do seem rational. Still, we caution investors about over-extrapolating the trends historically associated with the traditional rate-cut playbook, as the relevance of those trades typically assumes a recession.

 

Instead, investors should consider maintaining above-benchmark exposure to fixed income, but staying slightly below benchmark on duration. They should remain cautious of chasing gains in small caps, which are unlikely to endure. Active stock-picking or investments in the equal-weighted S&P 500 may be better alternatives to potentially enjoy the broader market gains that should result from an expected soft landing.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from August 5, 2024, “Rates: Too Far, Too Fast?” Ask your Morgan Financial Advisor for a copy. Listen to the audiocast based on this report.

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Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market.  Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds.  High yield bonds should comprise only a limited portion of a balanced portfolio.

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.

Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets and frontier markets, since these countries may have relatively unstable governments and less established markets and economies.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity.

Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.  Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

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