The data provided further supports the general theme that stock markets tend to perform well after the Federal Reserve starts cutting interest rates, particularly when compared to bonds and cash.

Average Real Returns for US Stocks After Fed Rate Cuts

• Stocks Perform Strongly: In the 12 months after the Fed begins cutting rates, US stocks have delivered an average real return of 11%, outperforming both government bonds (5%) and corporate bonds (6%). Cash, meanwhile, has significantly underperformed, with stocks beating cash by an average of 9%.

• Bonds vs. Stocks: Although stocks outperform bonds overall, bonds (both government and corporate) also show positive returns after rate cuts, with corporate bonds averaging a 6% return and government bonds returning 5%. Bonds tend to offer stability, particularly in recessionary periods, where their returns are more consistent.

• Cash Underperformance: Cash consistently underperforms both stocks and bonds. On average, cash returns 2%, making it a significantly less attractive option than equities or bonds in the period after rate cuts begin.

Interest Rate Cuts in Expansions vs. Recessions

Examining the past 50 years (since 1972), Franklin Templeton analyzed interest rate cutting cycles during expansions and recessions for the US market. Historical patterns show that when rate cuts are implemented during expansions, the markets have generally responded positively. Equities typically experience an upswing in the three-, six-, and 12-month periods following the first cut.

Recessionary Cuts:

In the three months following a rate cut during a recession, all major indices experienced declines. The S&P 500 fell by -4.96%, the Nasdaq dropped significantly by -7.30%, and the Russell 1000 and Russell 2000 saw declines of -3.00% and -2.89%, respectively. This trend indicates an initial negative reaction by equity markets when the first rate cut happens during a recession, likely due to investor concerns about the broader economic downturn.

Expansionary Cuts:

Conversely, when rate cuts occur in an expansionary period, equity indices have shown positive performance. Over a six-month period, gains were notable, with the S&P 500 returning 6.79%, and the Nasdaq up by 8.27%. Both the Russell 1000 and Russell 2000 also saw gains. The one-year period after the first cut in expansions shows strong overall growth, especially in the Nasdaq, which posted a 25.33% return. This highlights that rate cuts during expansions fuel bullish sentiment, as investors believe such cuts will extend economic growth.

In recessions, the immediate aftermath of a rate cut tends to result in equity declines, but longer-term trends can recover. In expansions, the market responds positively almost immediately, reflecting optimism about the sustained economic environment. Let’s look at both of these scenarios in more depth.

Expansionary Interest Rate Cuts

This graph illustrates the hypothetical growth of $100 invested after expansionary rate cuts. It covers the period following the first cut and demonstrates the cumulative growth of major indices.

• Within 30 days, all major indices (S&P 500, Nasdaq, Russell 1000, and Russell 2000) start to show positive returns, indicating an initial investor optimism that expansionary rate cuts will stimulate the economy further.

• After the initial 30 days, the growth rate continues steadily across the board, with all indices showing gradual improvement.

• Nasdaq leads the pack indicating the technology-heavy index tends to outperform in expansionary environments following rate cuts. The Russell 2000 (small-cap stocks) lags slightly behind, while the S&P 500 and Russell 1000 end around similar levels.

Recessionary Interest Rate Cuts

This graph shows the hypothetical growth of $100 after rate cuts in recessionary environments, highlighting increased volatility in the first 150 days compared to cuts made during expansions.

• Immediately following the rate cut, equity performance is volatile, and most indices initially drop. This is consistent with recessionary periods where markets react to economic uncertainty, even with easing monetary policy.

• The S&P 500 and Russell 1000 demonstrate this volatility as both indices struggle to break out of their initial dip.

• After approximately 150 days, the indices start recovering, showing a general upward trend as investor sentiment stabilizes and monetary easing begins to have positive effects on the economy.

• Similar to the expansionary periods, the technology-heavy Nasdaq shows stronger resilience and recovery, even in recessionary environments. Tech stocks likely benefit more from lower interest rates, even when economic fundamentals are weak.

Stock Performance Relative to Recessions

Recessionary Cuts: In 16 of the 22 cycles, the U.S. economy either entered a recession or was already in one when the Fed began cutting rates. While recessions are often perceived as harmful for stocks, the data suggests otherwise. Even when recessions followed rate cuts, stocks tended to perform positively on average. This shows that while recessions may trigger short-term volatility, they haven’t necessarily been catastrophic for equity markets in the longer term.

Non-Recessionary Rate Cuts: Stock returns are even more favorable when a recession is avoided. During expansionary cycles, equity markets tend to rally more robustly as investors perceive rate cuts as a means to extend economic growth. These periods have historically delivered better returns for stock investors compared to those in which recessions followed.

Analysis of Post-Rate-Cut Market Drawdowns

Expansionary Rate Cuts: Typically result in shorter and shallower market downturns. On average, the maximum drawdown in equities was -4.91% during expansionary cycles. These downturns often reached their nadir within one month of the rate cut, indicating a quick market correction before recovery.

Recessionary Rate Cuts: Tend to result in significant and prolonged equity declines. The average maximum drawdown was -19.44%, often extending into bear market territory (a decline of 20% or more). The bottom of these drawdowns was typically not reached for several months, reflecting ongoing market uncertainty and economic weakness.

• The 1982 and 2007 rate cuts, both associated with recessions and market inversions, saw drawdowns of -119.67% and -23.91%, respectively, underlining severe market reactions to deepening economic distress.

• Conversely, the 1989 and 1995 rate cuts, which occurred during non-recessionary periods, experienced minimal drawdowns of -1.93% and -0.54%, respectively, demonstrating the resilience of markets when the economic backdrop is more stable.

Post-1990, Equities Declined after First Cut, then Growth Stocks Rallied

In the first 3 months following a rate cut, equity markets showed relatively flat or negative performance across most indices. This reflects caution in the immediate aftermath of rate cuts, especially in the post-1990 environment, where Fed policy shifts may not have had an instant impact on the broader economy.

Despite weak short-term results, most equity indices exhibited solid gains after six months and one year:

• Growth stocks significantly outperformed. The Russell 1000 Growth index posted an impressive 15% gain over the one-year period after the first rate cut, highlighting the strong performance of large-cap growth stocks during these cycles.

• The Nasdaq also performed exceptionally well, rising by nearly 16% after one year. This confirms that tech-heavy indices benefited the most in the post-rate-cut periods.

Both large-cap and small-cap value stocks lagged during these cycles. The Russell 1000 Value index and the S&P 500 Value index showed much weaker performance compared to their growth counterparts. In fact, over a one-year period, the S&P 500 Value even registered a small negative return, underlining how value stocks tended to underperform in the aftermath of rate cuts.

The stark difference between growth and value stocks' performance highlights the preference investors had for companies with higher growth potential, particularly in sectors like technology, during the post-1990 rate-cutting cycles. This pattern suggests that rate cuts, especially in modern monetary environments, stimulate riskier, growth-oriented sectors more than defensive or value-based sectors.

Fast vs. Slow Interest rate cutting Cycles

A fast cycle involves 5 or more rate cuts in a year, while a slow cycle sees fewer than 5 cuts. "Non-cycles" consist of just one rate cut. The impact on the stock market, as seen through the S&P 500, varies significantly depending on the speed of these interest rate cuts.

Post-WWII data shows that slow cutting cycles have been more beneficial for equities, particularly in the first year after the initial cut, compared to fast cycles. Fast cuts generally indicate the Fed is reacting to a recession or financial crisis, leading to higher volatility and greater stock market drawdowns.

The table below analyzed by Charles Schwabb highlights the differences.

1. Slow Interest rate cut Cycles:

1. Typically associated with smaller drawdowns.

2. Over 6 months, slow cycles average a drawdown of -5.5%, and over 12 months, the average deepens slightly to -7.4%.

3. These cycles provide more stability for the stock market, with less severe market pullbacks compared to fast cycles.

2. Fast Interest rate cut Cycles:

1. Fast cycles demonstrate far more volatility and larger market declines.

2. Average drawdowns within 6 months are -10.9%, and they worsen to -20.7% within 12 months.

3. This emphasizes that aggressive rate cuts, typically implemented to combat economic crises, lead to more pronounced market corrections.

3. Non-Cycles:

1. Non-cycles have drawdown characteristics similar to slow cycles, with a 6-month drawdown of -8.1% and a 12-month drawdown of -13.8%.

2. These represent isolated cuts, less followed by additional easing.

In fast cycles, the S&P 500 experienced drawdowns almost three times larger than during slow cycles, especially within the first year following the initial rate cut. Data shown in the table reinforces that slow easing cycles have historically been more favorable for the stock market, while fast cycles lead to much deeper and prolonged declines, potentially signaling more significant underlying economic stress.

Sector Performance: Cyclicals vs. Defensives

In slow cutting cycles, cyclical sectors - such as Energy, Industrials, and Financials—tend to outperform defensive sectors like Utilities and Consumer Staples, with smaller drawdowns due to their lower sensitivity to economic cycles. This is partially due to the inverse correlation between traditional dividend-oriented sectors and longer-term Treasury yields, which spiked earlier this year but have since retreated. In fast easing cycles, defensive stocks experience less volatility, often driven by their inverse correlation with Treasury yields.

The chart compares the performance of cyclical sectors (e.g., Energy, Industrials, Technology) against defensive sectors (e.g., Utilities, Consumer Staples) across different cutting cycles.

1. Pre-Cut Sector Behavior:

1. In the year before the first rate cut, cyclical sectors (blue and black lines) start to underperform, particularly during fast easing cycles (orange line).

2. Defensive sectors tend to maintain more stable performance, indicating their role as safe havens when economic uncertainty looms.

2. Post-Cut Sector Behavior:

1. After the Fed initiates rate cuts, slow easing cycles (blue line) lead to a better recovery for cyclical sectors compared to fast cycles.

2. Over the first year following a rate cut, slow easing cycles result in a 4.3% gain for cyclical sectors, while fast easing cycles show a decline of -2.9%.

3. This underscores how cyclical sectors benefit more when the Fed takes a gradual approach to easing rather than aggressive rate cuts.

Is the US in a Recession?

As of now, the U.S. economy does not seem to be in recession, though signs of a potential slowdown are present. In the second quarter of 2024, U.S. real gross domestic product (GDP) grew by a robust 2.8%, indicating continued economic expansion. Additionally, the Federal Reserve’s June 2024 Summary of Economic Projections suggests positive GDP growth will persist throughout 2024 and 2025. The Fed has shown a willingness to ease policy, with progress made towards reducing inflation to its 2% target. This easing, while slowing the economy, has not halted expansion.

The Fed is contemplating rate cuts not because of a faltering economy but because inflation is finally moderating, and monetary policy doesn’t need to be as restrictive. This unique environment opens up the possibility of a “soft landing”, where the Fed manages to lower inflation without triggering a recession.

Given these conditions, and barring an unexpected external shock, any rate cuts made this year would likely be categorized as expansionary. As a result, we consider it plausible that the ongoing bull market will continue, although heightened volatility is a possibility.

Our historical analysis above supports this outlook. Following past expansionary rate cuts, equities have shown consistent gains over six- and twelve-month periods. The analysis demonstrates that U.S. large-cap stocks and small-cap stocks tend to perform positively in the months following rate cuts.

• 6 months after a rate cut during an expansion, the S&P 500 has historically risen by 6.79% and the Russell 1000 by 7.00%.

• Over a 12-month period, the gains become more pronounced, with the Nasdaq showing the largest average return of 25.33%.

US Fed Interest Rate Cut Expectation in 2024

Weaker than expected U.S. job growth for August and July is adding pressure on Federal Reserve policymakers to begin cutting interest rates. The Labor Department’s latest report showed nonfarm payrolls increased by only 142,000 in August, down from an already lowered 89,000 in July, both numbers falling short of economists' expectations. With a 3 month average of just 116,000 jobs added per month, this is significantly below the 200,000 jobs typically seen as necessary to meet population growth demands.

• Futures traders are now pricing a 35% to 55% chance of a larger-than-expected 50 basis point cut. However, most analysts had previously expected a more conservative 25 basis point cut.

• Some economists however are arguing that while the labor market is clearly slowing, a 25 basis point cut would be more appropriate to avoid signaling panic about the economy's health. Counterintuitively, a 50 basis point cut would send a message that the economy is in trouble, which may not accurately reflect the current situation.

Impact of Interest Rate Cut on Indian Markets

A US Federal Reserve rate cut can have significant implications for the Indian markets, affecting various sectors and asset classes. Here’s a detailed analysis of the potential impact:

1. Increased Foreign Investment

• Effect: As US interest rates decrease, the yield on US Treasury securities becomes less attractive. This could prompt US-based investors to seek higher returns in emerging markets like India.

• Impact: India, with its relatively higher growth prospects and potential for returns, could see an inflow of foreign capital into both equities and debt markets. This influx of foreign institutional investors (FIIs) and foreign portfolio investors (FPIs) could drive up demand for Indian stocks and bonds, leading to an increase in asset prices.

2. Benefiting Sectors – Especially IT

With a Fed rate cut, borrowing costs for US corporations may decrease, encouraging them to invest more in technology upgrades and services. Indian IT companies, which have significant exposure to the US market, could see a boost in their order books, driving growth in this sector. Increased corporate spending in the US could lead to more business for Indian IT firms, which may reflect positively on their stock prices.

3. Impact on the Indian Rupee:

• Effect: As foreign investors pour capital into Indian markets, they would need to convert their foreign currency into Indian Rupees (INR), thereby increasing demand for the INR.

• Impact: This increase in demand for the rupee could lead to an appreciation of the Indian currency against the US dollar. A stronger rupee may reduce the import costs for India, though it could also make Indian exports relatively more expensive, affecting sectors that rely heavily on exports.

4. Bond Market Rally:

• Effect: Lower interest rates globally make existing bonds with higher interest rates more attractive, potentially leading to a rally in the bond markets.

• Impact: With US rates falling, Indian government and corporate bonds could become more appealing to both domestic and foreign investors. As demand for Indian bonds rises, their prices could increase, and yields might decline. This could reduce borrowing costs for the Indian government and corporations, facilitating increased capital investments and stimulating broader economic growth.

This historical trend implies that adding to equity positions in the wake of an expansionary rate cut may be a beneficial strategy for investors, as markets have generally shown upward momentum in similar situations, despite possible volatility. However, even if the economy were to enter a mild recession, historical trends indicate that both stocks and bonds could still deliver positive returns in the long run.

Read this article to understand Interest Rate Cut Expectations In 2024 For India, US & the World