Boulder: (720) 274-1656 Denver: (303) 357-4741

KEY TAKEAWAYS

  • Stocks have benefited recently from increasing hopes of a Fed rate cut, although investors probably won’t get one this week.
  • Stocks’ historical performance after initial Fed rate cuts has been mostly positive, but it has been greatly dependent on the business cycle.
  • We prefer to see the market stand on its own and take more direction from generally solid fundamentals of economic growth and corporate profits.

Click here to download a PDF of this report.

A potential rate cut may give stocks a lift. Stocks have benefited recently from increasing hopes of a Federal Reserve (Fed) rate cut, pulling the S&P 500 Index back to within 2% of its record high set on April 30, as of June 14. On June 4 Fed Chair Jay Powell signaled a possible cut by saying “we will act as appropriate to sustain the expansion,” and since then, as of Friday, June 14, 2019, the S&P 500 is up 5.4%. The central bank’s verbal pivot, partly an acknowledgement that they must be ready to offset trade tensions, has pushed the odds of a rate cut in July from roughly 60% to 86%, based on the fed fund futures market. So what might a cut mean for stocks?

WILL THE FED CUT?

It’s been a while since we’ve talked about rate cuts. After last cutting rates in 2008, the Fed started hiking rates in 2015 and has raised them a total of nine times since then. Now, amid the longest economic expansion ever recorded in U.S. history, the bond market is aggressively pricing in not one but two rate cuts this year.

Although the bond market may be overdoing it by pricing in two cuts this year, the latest growth and inflation data, along with U.S.-China trade tensions, provide cover for the Fed to lower rates this summer. In particular, the May jobs report was soft, inflation is below the Fed’s target and falling, and headlines suggest that a trade breakthrough at the G-20 in Japan at the end of June has become increasingly difficult to achieve.

Bottom line, we don’t believe that current economic conditions justify a Fed rate cut this week, but we will probably get a signal from Powell that a cut is likely coming in July (we now see a July cut as more likely than not). Fed policy is too tight for a prolonged trade war, while the bond market is forcing the Fed’s hand to an extent, amid slowing growth and depressed interest rates globally.

WHAT MIGHT A CUT MEAN FOR STOCKS?

As we wrote in last week’s Weekly Economic Commentary, if the Fed cuts rates in June or July, we would view it as a course correction and not a precursor to an imminent recession. However, the last two starts to easing cycles (a cut in rates after a series of hikes) in January 2001 and September 2007 immediately preceded recessions. Those business cycles were about to end (tech bubble and financial crisis), and Fed policy was clearly too tight heading into those recessions. Where we are in the business cycle matters a lot.

Looking further back in history, however, reveals a more encouraging picture that is consistent with a mid-cycle pause. As you can see in Figure 1, after the five initial rate cuts before 2001 (1984, 1987, 1989, 1995, and 1998), the S&P 500 rose an average of 11.1% and 15.8% over the subsequent 6 and 12 months, respectively. We think these cases provide better comparisons to today’s environment.

Even including the poor stock market performance after the 2001 and 2007 cycles, the average S&P 500 gains over subsequent 6 and 12 months were a respectable 4.5% and 5.8%.

Wall Street’s favorite analogy for this environment might be the 1995 “insurance cut,” when the Fed cut rates by 25 basis points (0.25%) twice that year. At that point, the expansion was four years old, growth was solid, and the stock market was doing well. After the Fed’s first cut in July 1995, the expansion lasted almost six years longer. One could draw a parallel between the Mexican peso crisis in 1994 and today’s trade tensions, although the relatively stronger economy and early-stage internet boom are among the key differences to consider.

The rate cut in 1998 offers another promising analogy to today’s Fed environment. The U.S. economy was late in the cycle in a very long expansion then—as we probably are now (though hopefully not quite as late)—and the economic cycle and bull market lasted a couple of more years after the 1998 initial cut. We had crises then too, notably the collapse of hedge fund Long Term Capital Management, and problems internationally, in particular the Asian currency and Russian debt crises. But again, the lack of euphoria—dot-com or otherwise—offers a stark contrast.

We could also make a reasonable comparison to the waves of quantitative easing in the years following the financial crisis and the pausing of the Fed’s rate hike campaign in 2016. Stocks responded positively to more stimulus then as they have so far in this cycle.

CONCLUSION

Slower growth, tariffs, ongoing trade tensions, low inflation, and bond market positioning have given the Fed cover for a rate cut. Taking some of the upward pressure off the U.S. dollar provides additional incentive. We don’t think the Fed will cut rates this week, but a July cut is a strong possibility. We expect stocks to applaud an eventual cut and break out to new highs later this year. Trade disputes could throw a wrench in that plan, but we continue to believe that additional economic pain experienced by both the United States and China will bring the two sides together to strike some sort of a deal this summer. We think it will be the same story with Europe and Japan if we get auto tariffs.

Stocks’ historical performance after initial Fed rate cuts has been mostly positive, but it has been greatly dependent on the business cycle.

Our belief that this cycle has more left in it supports comparisons to the initial rate cuts in the mid- and late-1990s rather than the cuts in 2001 and 2007.

We prefer to see the market stand on its own and take more direction from the fundamentals of economic growth and corporate profits. We think fundamentals generally look good here, which we discuss in detail in our Midyear Outlook 2019 slated for release one week from today. Until we get clarity on trade, we’ll gladly take the help.

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in the presentation may not develop as predicted.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.

All indexes are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.

This Research material was prepared by LPL Financial, LLC.

Securities and advisory services offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC). Insurance products are offered through LPL or its licensed affiliates. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL is not an affiliate of and makes no representation with respect to such entity.

If your advisor is located at a bank or credit union, please note that the bank/credit union is not registered as a broker-dealer or investment advisor.

Registered representatives of LPL may also be employees of the bank/credit union. These products and services are being offered through LPL or its affiliates, which are separate entities from, and not affiliates of, the bank/credit union. Securities and insurance offered through LPL or its affiliates are:

Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by Any Government Agency | Not a Bank/Credit Union Deposit

Tracking #1-863987