Cutting For The Right Reasons

We’d rather be impelled than compelled to do something. We suspect Fed Chairman Jay Powell shares this sentiment, particularly when pondering changes to interest rates. After the Fed’s most recent meeting, investors welcomed the message that the central bank wanted to ease monetary policy. However, several days later, a weaker-than-expected employment report shifted the narrative to the Fed needing to cut rates quickly, with some market participants calling for an inter-meeting rate cut. While the shift in sentiment was swift, the market’s response was consistent with past behavior.

Since 1981, there have been nine rate cut cycles. Four times, the Fed loosened monetary policy enough to stave off a material slowdown. On average, both equities and fixed income rallied in response of the cuts. However, in five of these cycles, the Fed was forced into the decision to head off a recession. The cuts were faster and deeper, helping bonds to rally, but not enough to prevent equities from swooning.

Source: Morningstar

In June, we suggested that even a soft landing might bring more volatility than investors expect. Data will likely oscillate between too hot and too cold. When combined with the seasonally volatile period between August and October, and the chaotic presidential election, we believe investors should gird themselves for potentiall swings in sentiment like we witnessed in late July/early August. Nevertheless, we believe that the economy’s intermediate- and long-term trajectory is  pointing higher, allowing the Fed to change policy from a position of strength rather than panic.

One of the data points that investors latched onto in early August was the unemployment rate, which ticked up to 4.3%. The rise triggered the so-called Sahm Rule, which states that when the unemployment rate rises by 0.5% in a year, the economy is in the initial phase of a recession. However, even Claudia Sahm, the rule’s creator, noted that no single rule fully reflects the economy, especially in the context of the extraordinary events emanating from the pandemic and its subsequent recovery. While we believe that careful monitoring of the trajectory of unemployment is warranted, we remind readers that other popular indicators, such as the inverted yield curve and leading economic indicators, have proven unreliable in recent years.

Source: Claudia Sahm and Bureau of Labor Statistics

Investors must not consider employment data in isolation. Indeed, other metrics remain sanguine. The government reported 2.8% annualized GDP growth for the second quarter, exceeding expectations, while retail spending continues to grow and the unemployment rate remains near historic lows. In our view, the Fed doesn’t need to cut, yet.

However, with rates still in restrictive territory, policymakers have the flexibility to ease and should take advantage of it. The Fed is close to achieving its dual mandate: inflation is at 2.6% and the employment situation is well balanced. With the policy rate sitting at 2x the rate of inflation, we see little risk that the Fed’s first cuts overly stimulate the economy. Instead, it would serve as a symbolic move, signaling to borrowers and lenders that inflation is on the right track.

While economic volatility may lead to higher variability across portfolios, we believe the outlook remains attractive for most asset classes. We would not be surprised to see a longer-term rotation out of the Magnificent Seven to lower valuation alternatives like “the other 493”, SMID cap, and international equities as the economy normalizes. Bonds offer historically competitive yields and the likelihood to act as ballast in the portfolio if the economy deteriorates faster than expectations. In our view, diversified portfolios offer an impelling balance of risk and reward as the Fed makes it next move.