The economy matters more than the Fed

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

• The US Federal Reserve started to cut rates in September after making five quarter-point hikes since March 2022. Fixed income markets are now anticipating aggressive further cuts before the end of next year, and global equities are making new highs on the expectation that the Fed will save the day and deliver a soft-landing of the US economy.
• This article puts the recent moves in perspective and explores how equity markets have performed in previous US easing cycles, going back 50 years.
• While developed market equities returned 8% on average in the year following the first Fed rate cut, returns varied substantially depending on how the economy was doing over the period. This is why it would be imprudent to assume that markets will continue marching higher, purely on the basis of expected rate cuts.
• Having said that, some segments of the market have been more predictable than others in previous easing cycles. More specifically, defensive sectors outperformed cyclicals consistently in the subsequent 12 months, regardless of whether the economy was in recession or not. With regards to quality stocks, they outperformed the market during recessions, and performed in line during the soft landings.

After raising interest rates by a cumulative five and a quarter percentage points since March 2022, the US Federal Reserve (Fed) started to ease monetary policy in September, with a 50 basis point (bp) cut. At the time of writing, fed fund futures are pricing in close to two percentage points of additional cuts by the end of next year. Meanwhile, equities are hitting new highs on the hope that those aggressive moves will allow the Fed to deliver a ‘soft’ landing for the US economy.

Equity market performance in previous easing cycles

This article explores how equity markets have performed in previous US easing cycles, going back 50 years, and whether there has been any consistent trading pattern. The analysis covers nine episodes, being when the Fed started to trim rates in July 1974, April 1980, July 1981, August 1984, June 1989, July 1995, January 2001, September 2007 and August 2019. Out of those nine episodes, seven were followed by a recession (or a ‘hard landing’), and two led to a soft landing (1984 and 1995). 

It is worth noting that all of the episodes that led to a recession were preceded by an inverted yield curve, similar to that seen between July 2022 and September 2024, with 10-year US Treasury yields being lower than 2-year ones. In contrast, the two soft landings occurred alongside a normal, uninverted yield curve.

History shows that US equities returned 11% on average (including dividends) in the 12 months following the first rate cut, based on the performance of the S&P 500. However, this average masks widely different outcomes, depending on how the economy was doing over the period. Total returns varied substantially, between -19% in 2008 and +38% in 1981. They averaged +6% during the seven recessions, and +27% during the two soft landings. Please note: past performance is never a guarantee of future performance.

The chart below shows how the MSCI World performed in the 12 months before and after the initial US rate cut. Unsurprisingly, with US equities representing 70% of the index today (and approximately 58% over the past 50 years), the message is very similar. Developed market equities returned 8% on average in the year following the first rate cut. However, those returns varied between -21% in 2008 and +36% in 1985, averaging +2% during recessions and +28% in soft landings.

Developed market equities returned 8% on average in the year following the first Fed rate cut, but within a wide range

MSCI World total returns (including dividends) in the 12 months before, and the 12 months after, the first Fed rate cut in the past 50 years

For comparison purposes, the next chart shows how other equity indices performed in the same six-month and 12-month periods following the first US rate cut.

Equity market performance in the six months and 12 months following the first US rate cut

Based on data since 1974 for a selection of equity indices, and since 1980 for investing styles marked as (*)

Ultimately the economy matters more than how much the Fed will cut 

Given the wide dispersion of equity returns in the months following a rate cut in the past 50 years, it would be imprudent to assume that stocks will continue making new highs, purely on the basis that the Fed will save the day. Historically, it has been rare for the US central bank to deliver a soft landing after a rate-hiking cycle. Recessions have been the norm rather than the exception, especially when the yield curve was inverted. But recessions have also varied substantially in terms of depth and length. 

Ultimately, the economy matters more than the easing cycle when it comes to equity market performance. Our economists expect the global economy to slow below trend over the coming months, but they don’t anticipate a severe slowdown. Instead, global GDP is forecast to grow by 3.2% in real terms in 2024, and by 3.0% in 2025.

That said, the starting point is important too, and it is worth noting that equity markets have performed very strongly in recent months. As shown in the first chart in the article, the MSCI World rose by 20% in the year before the September rate cut, while it was broadly flat in the previous nine rate-cutting cycles. 

As a result, valuations look stretched by historical standards, with the MSCI World now trading on 18.6 times forward earnings, a 24% premium over its 20-year average. In addition, sentiment and positioning are elevated, and therefore represent a headwind for markets.

Having said that, some segments of the markets have been more predictable than others in previous easing cycles

While broad equity indices have performed very differently under previous easing cycles, some internal trading dynamics have been more consistent than others (see graphs).

• Our analysis shows that in eight of the previous nine easing cycles, defensive sectors outperformed cyclicals in the subsequent 12 months, regardless of whether the economy was in recession or not. In developed markets, they outperformed by 6% on average during recessions, and by 4% during soft landings. Defensive sectors’ worst performance was in the year following the 1980 rate cut, when they performed in line with cyclicals after a brief period of underperformance. This makes intuitive sense, as the Fed was cutting rates in response to a slowing economy, and defensive sectors tend to outperform in economic downturns.
• Unsurprisingly, quality stocks outperformed the market during recessions, by 4% on average, based on MSCI World indices, and they performed in line during the soft landings of 1984 and 1995.
• Finally, history also shows that US equities generally outperformed the rest of the world in previous easing cycles in USD terms, by 6% on average during recessions, and by 2% outside of recessions. This can be explained by the market’s more defensive tilt and the fact that the dollar tends to appreciate when the global economy deteriorates. However, we would argue that those characteristics are already reflected in the price today, with US equities trading at a 62% forward price-earnings premium to the rest of the world, based on MSCI indices, versus 35% on average over the past 10 years. 

The results of this analysis are consistent with our preference for defensive and rate sensitive sectors, and our focus on quality stocks trading at a reasonable price.

Previous easing cycles saw defensive sectors outperform their cyclical peers, whether or not this was during a recession

Average relative returns of defensive versus cyclical sectors in developed markets in the 12 months before and after US rate cuts since 1974, and of quality stocks against the rest of the market since 1980