What does a Fed rate cut mean for investors?

• The Fed’s September rate cut ends the central bank's prolonged ‘pause’ period and marks an important inflection point for financial markets, and for investors.
• Our relatively cautious macroeconomic outlook and the potential for seasonal and election-related volatility, combined with relatively rich equity valuations, argues for quality in the core of equity portfolios.
• Investors with a tactical focus may consider buffered products to protect against downside risk in the short term, although we believe any pullback in equity valuations could create an opportunity to reallocate to quality stocks with reasonable valuations.
• Given our view of a slower-than-consensus pace for Fed cuts, we believe the 3-to-7 year ‘belly’ of the yield curve is the most attractive part of the fixed income market to own at current valuations.

The Federal Reserve cut policy rates by 50 basis points at its September meeting, bringing the fed funds rate to a range of 4.75%-5.0% and ending the central bank’s 14-month pause period. The widely expected decision officially kicks off the easing cycle and marks an inflection point for capital markets.

With inflation moving towards the Fed’s 2% target by 2026 as laid out in Fed’s Statement of Economic projection, we see the Committee’s focus going forward likely being more evenly distributed between labor markets and inflation; as a result, the pace of policy rate easing will be determined as much by employment and growth data as it is by inflation. Chair Powell points out that “the risks to achieving its employment and inflation goals are roughly in balance”.

Equity and bond markets have historically done well during cutting cycles, though equity market performance has significantly lagged in rate cut cycles that end in recession.¹ While recession is not our base case, some of the metrics that the National Bureau of Economic Research uses to determine the health of the economy are already beginning to moderate. As growth continues to slow closer to ‘stall speed,’ the economy becomes more vulnerable to an exogenous shock which could have negative implications on equity market performance. Furthermore, we anticipate higher volatility tied to the U.S. election and historically poor seasonals in equity market returns for September and October.²

Figure 1: Asset class performance following previous Fed cuts

This relatively cautious macro outlook, alongside relatively rich equity valuations, argues for quality in the core of the portfolio and allocating to some buffer products to navigate risk in equity markets in the short term. However, we believe that over the medium term any pullback in equity valuations will create an opportunity to allocate to high quality companies with reasonable valuations, such as large-cap value, an area of the market that has underperformed year-to-date, but shows signs of improving earnings in the year ahead.

We favor strategies that select for names with high profitability and low earnings variability or financial leverage. We also like strategies that seek to minimize the impact of volatility, either through selecting low-beta constituents or through providing downside protection via ‘buffers’ or put spreads. Such strategies may outperform as economic uncertainty and event risk could lead to severe volatility in the months ahead. Finally, we also like active strategies that can nimbly reallocate as the market prices in different outcomes.

Though July and early August saw elevated flows into small caps, we think this is a moment to consider reallocating from mega-cap to large-cap, rather than from large- to mid or small.³ Based on Fed forecasts for rates in their September Summary of Economic Projections (SEP), rates will remain close to 3% for the next two years, while economic growth will slow from current levels. While high beta small caps can post sharp rallies on rapid shifting narratives, we do not believe that the earnings backdrop or rates at current levels can support sustained small cap performance.⁴

Fixed income markets have historically outperformed cash during rate cutting cycles (Figure 2). Inflation is beginning to move towards the Fed’s target of 2% and the central bank has made clear that they do not seek or welcome any further weakening in labor markets. As Fed Chair Jay Powell points out, the current level of restrictive policy rates gives the FOMC ample room to cut rates if there are any exogenous shocks in the coming months. We believe that intermediate duration bonds can once again serve the important role of being a diversifier in an investor’s portfolio.

The front end of the market will be driven by monetary policy while the long end by fiscal policy. Given the start of the rate cutting cycle is here, we believe fixed income should play a larger role in portfolios but are cautious on the long end of the curve as we think mounting deficits, heavy issuance and normalizing term premium — meaning the compensation investors will require to take on interest rate risk in long-term Treasuries — will keep longer rates more elevated.

Instead, we believe investors could lock in intermediate duration yield in fixed income while they are still available. In our view, the 3- to 7- year ‘belly’ of the yield curve is the most attractive part of the market to own at current valuations.  

We think that investors could be better served by focusing on income generating assets in the belly of the curve. Given strong corporate fundamentals, we think that high yield bonds as well as structured credit are an important way to add income in portfolios, especially during a period when equity market valuations look fully priced.