The Cutting Cycle is About to Start

At the moment, the path seems clear: we are about to begin another cycle of interest rate cuts. People often ask themselves, "Isn’t lower yield bullish because the cost of money goes down, which stimulates the economy? And with lower rates, shouldn’t equities perform better since future cash flows will be discounted at a lower rate, thereby increasing their present value and driving valuations up?"

While this logic seems sound, it doesn’t always hold true. The Federal Reserve typically cuts rates when it observes signs that the economy is slowing. The strong data that previously justified tight monetary policy is no longer present. Prices aren’t rising as fast, and in some sectors, they are even declining. This might seem positive, but the Fed's goal is not to lower prices—it is to ensure they rise steadily at around 2%. While inflation appears under control, the risk has now shifted to the employment side of the economy.

So, as the rate-cutting cycle is about to start, the main question is: by how much? A 25-basis-point cut is the most likely scenario. A 50-basis-point cut, however, might raise concerns about the real state of the economy, signaling that it’s not as stable as it seems, and that the adjustment is necessary to stave off potential employment problems. A larger cut may also imply that the Fed should have acted sooner, raising alarms and possibly admitting to an earlier misstep. The Fed prefers to undercut rather than overcut in this cycle. If something breaks they always can act faster. The same applies to rate hikes; they prefer to overhike rather to underhike (from a policy error perspective). For me, a 50-basis-point cut would be a worrying signal, while a 25-basis-point cut seems more probable.

There are different perspectives on this. Some argue that the cutting cycle will be shorter than expected because, although the economy is slowing, it’s not in serious trouble. Rick Rieder, CIO of Global Fixed Income at BlackRock, recently stated: “While we’re quite certain the Fed will commence with its rate cuts at next week’s meeting, there are several significant unknowns that cloud the extent and speed of rate cuts.”

On the other hand, Jeremy Schwartz, CIO at WisdomTree, said: “The Fed is too complacent, and a 50-basis-point cut should remain on the table. Most interpreted today's inflation report as locking in a 25-basis-point cut from the Fed, but our Senior Economist Jeremy Siegel still believes the Fed should be much more aggressive in bringing down rates. We have a measure of inflation that substitutes real-time housing data for the BLS shelter measure (a lagging metric)—this shows inflation is now half of the official numbers released this morning!”

They argue that the Fed’s shelter data is lagging and that real-time inflation data suggests inflation is well below the Fed’s target. This raises concerns that the Fed may be behind in adjusting its policy.

Now that the cutting cycle is a certainty, regardless of the timing, let's examine the impact of rate cuts on the S&P 500. First, we identified periods of rate hikes, holds, and cuts. We classified a holding cycle as a period where rates fluctuated by less than 25 basis points over six months. Any larger movement was categorized as either a hiking or cutting cycle.

According to our analysis, there have been 15 cutting cycles since 1957, and here are the average returns.

The average returns during cutting cycles look promising, but it’s important to note that the data goes back to 1950, a time when the Fed didn’t target interest rates as it does today. In fact, the Fed didn’t start targeting rates until the 1980s. Nonetheless, the data is valuable.

One factor often associated with cutting cycles is recessions, which tend to result in poor stock performance. This could be considered a form of recency bias among investors—and for good reason. Over the last 24 years, every cutting cycle has ended in a recession, on average within five months of the first cut, and stock performance during these periods has been notably weak, as shown in the following chart.

The key question, then, is whether a recession is imminent. Expectations of a U.S. recession within the next 12 months are low among major firms like JPMorgan (35%) and Goldman Sachs (20%). Many analysts have shifted their forecasts from recession to a soft-landing scenario, with widespread agreement. Ironically, this consensus might be problematic. In 2023, almost everyone anticipated an impending recession, but it never materialized. Recessions often strike when no one is expecting them; if forecasting recessions were easy, they wouldn’t happen in the first place.

Sectors Performance Through Cutting Cycles.

Now, let’s review U.S. sector performance during cutting cycles, examining data over the year following the start of a cutting cycle. Unfortunately, I was only able to find sector-specific data since September 1989. Based on our cutting cycle model, this gives us only five cutting cycles for analysis—too few to draw strong conclusions.

Rather than focus solely on the best-performing sectors at year-end, I calculated a weighted average to identify which sectors showed the most consistent returns over 6-month, 9-month, and 12-month periods.

The best-performing sectors, according to the data, are Healthcare, Consumer Staples, and Technology. Meanwhile, Utilities, Consumer Discretionary, and Energy performed the worst. It’s important to note that this data has three potential biases:

1. Three of the last five cutting cycles ended in a recession.

2. Two of these cycles occurred before the tech bubble in 1999, which boosted technology performance.

3. Real Estate data is only available since 2001, so it includes only two cutting cycles.

Now, we now that inside average can happen anything and historical average is kind different from the data. So here we have a chart of every sector for the last 5 cutting cycles.

So, rate cuts should be good for stocks, as long as they aren't driven by necessity or don’t end in a recession, like the cycles we saw in 2001 or 2007. 2020 could be excluded because we’ll never know what would have happened if COVID hadn’t hit. Cutting cycles should support equity valuations and help underperforming stocks start to improve, particularly those with more debt and weaker balance sheets, as the cost of borrowing decreases. These stocks are typically in the mid/small-cap range.

Here is a table with the cutting cycle data, showing that after 1 year, the S&P 500 was higher 60% of the time, with an average performance of 8.62%, as we have seen.

Let’s see how equities react in this cycle, which is set to begin next Wednesday.