The Easing Cycle Begins
In the most anticipated Federal Open Market Committee meeting since the COVID-19 pandemic, the U.S. Federal Reserve lowered the federal funds rate by 50 bps on September 18, commencing its cutting cycle. With this easing cycle now underway, speculation on the pace of future cuts and the terminal rate will likely lead to further uncertainty and volatility. This begs the question – what, if anything, can prior cutting cycles teach us about how markets and sectors may perform moving forward?
At the highest level, context is important. While the initial cut size of 50 bps versus 25 bps can imply urgency, other factors are in play, which in turn affect both market returns and potential sector rotation. Is there an appropriate historical analogue to serve as a roadmap for investors going forward? We investigate the five prior rate cut cycles in search of answers.
The 1995 Fed Cut – 25 bps
After a 300 basis point rate hike cycle from January 1994 to early 1995, the Fed cut rates in the summer of 1995 with the reasoning that inflationary pressures had receded. Amid a persistent bull market, the S&P 500 hardly flinched following July’s 25 bps rate cut, and was up 19.5% over the subsequent 12-months. With all sectors broadly higher, Health Care, Staples, and Financials were the primary sector leaders while Technology, Materials, and Utilities lagged.
The 1998 Fed Cut – 25 bps
Following the blow-up and orchestrated rescue of Long-Term Capital Management (LTCM) in mid-September of 1998, the Fed cut rates from 5.50% to 5.25% to help settle financial markets and promote continued economic growth. The S&P 500 subsequently bottomed in early October. Despite its low profit contribution and sky-high valuations, Technology took the reins of sector leadership over the three, six, and twelve months following the Fed’s first cut in 1998. As cyclicality and extreme risk-taking took hold of the market, the defensive Health Care, Staples and Utilities sectors unsurprisingly lagged the broader market.
The 2001 Fed Cut – 50 bps
Following the meteoric rise of the late 90s into the market peak in March of 2000, the stock market and economy deteriorated rapidly. Unemployment rose from a low of 3.8%, while consumer confidence weakened and corporate profits fell. As financial markets reeled from the dot-com bubble unwind, the Fed cut rates by 50 basis points to 6.00%. Naturally, Technology was the hardest hit amongst GICS sectors. The S&P 500 was down about 15% one year later and was grappling with the tragic aftermath of 9/11. The S&P’s drawdown ultimately extended lower until bottoming in October 2002. This is one of the prime instances where a 50 basis cut preceded further downside volatility within financial markets.
The 2007 Fed Cut – 50 bps
The Great Financial Crisis remains one of the most poignant and painful moments in market history. Similar to the dot-com bubble, the Fed cut rates 50 basis points in an attempt to stem the effects of rapidly tightening financial conditions. The S&P 500 ultimately peaked in December of 2007 and fell 56% from levels seen at the first Fed rate cut. Staples, Materials, and Health Care were the sector leaders one year later as defensive positioning took hold. Financials were the undisputed laggards among equity sectors, unsurprising given their position at the center of the financial crisis.
The 2019 Fed Cut – 25 bps
In August 2019, the Fed opted to begin its easing cycle with a 25 basis point cut with the unemployment rate at historically low levels not seen since the late 1960s and inflation below 2%. A year later, the market would find itself five months removed from the COVID-19 market lows, which in turn catalyzed the risk-on, cyclical leadership from the Technology and Discretionary sectors. Energy, Financials, and Industrials were the primary laggards 12-months after the Fed’s initial cut as those sectors grappled with lingering pandemic-driven headwinds.
Where Do We Go Now?
The old saying goes that history doesn't repeat itself, but it often rhymes. While the five prior Fed easing cycles back to the 1990s are not a robust sample size, investors can still glean information from how sectors behaved historically in different macro backdrops.
Three cycles started with a 25 bps cut. The 1995 Fed cut took place during an unrelenting bull market with secularly falling interest rates. The 1998 cut was in the latter stages of the dot-com bubble and partially catalyzed by the LTCM’s blow up. With the backdrop of strong employment but uneven global economic growth, the Fed eased in 2019 before the COVID pandemic took hold. The common thread between these three instances? Each of these saw a higher market in the subsequent twelve months.
But is it right to group this year’s 50 bps cut with prior historical examples? 2001’s rate cut was on the heels of a scathing bear market as investor excess unwound. 2007’s easing preceded the Great Financial Crisis. Perhaps not.
So what’s different this time around? Of the five historical instances reviewed, Technology averages as the best performing sector (even accounting for 2001). While it’s fair to retort that the 1998 example skews the returns, it’s important to remember the sector is drastically different from what it was 25 years ago. Home to most of the Magnificent Seven, Technology is now one of the most significant profit contributors to aggregate sector profits. Health Care provides both defensive characteristics, as well as growth leverage to the nascent GLP-1 and weight loss drug industry. The unemployment rate would likely serve as an important factor in which Discretionary or Staples stocks take the baton of leadership.
Ultimately, the expectations around the pace of future cuts and the terminal rate will be important determinants of market trajectory and sector positioning.
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