Transcript
Amada Agati:
Let’s rewind the tape! Because it’s déjà vu all over again in the October edition of Adding Alpha. The Fed is back in rate cutting mode after another extended pause, and it feels a lot like the same dynamics heading into Fall 2024. So let’s explore if investors should expect similar outcomes.
Ever since Fed Chair Powell’s Jackson Hole speech in August, investors have been anticipating a rate cut from the Fed and sure enough, we got 25 basis points in September.
In a nod to last year’s setup ahead of the FOMC meeting, there was pretty solid consensus that a rate cut would happen, but investor sentiment was divided into multiple camps - one that expected a 25-basis point rate cut, one that expected 50 basis points, and one that expected no cut at all!
A little bit of a “should I stay or should I go now” kind of vibe.
With another rate cut in the books, as well as confirmation of the Fed’s data-dependent plans to continue cutting into early 2026, we expect another 25 basis points in October, December, and early in 2026. Another ~100 basis points in total, all else equal, should get Fed funds to what economists refer to as the neutral rate, where policy is considered neither too tight nor too loose. Goldilocks!
Here’s where the déjà vu really kicks in; just like last year financial conditions have been easing all year anticipating a Fed rate cut. Now they’re at the easiest level since the Fed began hiking in 2022!
Additionally, the Fed’s $6.5 trillion balance sheet and permanent repo facility should continue to provide a strong liquidity backstop for global financial markets. Same story, different year.
What’s different about the storyline this year compared to last is that we expect less of a market reaction this time around. Sure, looser policy and financial conditions are tailwinds, but we think a lot of this policy action may have been pulled forward and priced into current valuation levels.
Indeed, U.S. large-, mid- and small-cap P/E ratios are all back up to 12-month highs. Just like this time last year. Operating leverage and earnings growth will be the keys to the next leg of the equity market rally.
In fixed income markets, clearly long-term rates didn’t get the message that it’s FALL. Instead, the 10-year Treasury yield has risen by 5 basis points in the weeks following the FOMC meeting. Last year, when the Fed started cutting, long-term rates started rising. By early January, it was an almost perfect inverse correlation of +/-100 basis points. That same dynamic is beginning to form yet again. A reflection of potentially better economic growth prospects…or more worries over deficits and debt levels?!? Déjà vu all over again as it’s likely some combination of both.
The path forward still looks supportive/favorable for the market rally to continue, though likely at a slower pace, than what we’ve experienced in the last two years. Through 9/30, the S&P 500 was up +22% and hit a YTD high in 2024, while it’s up +14% this year and hovering near a YTD high too. Talk about déjà vu.
The purple haze of policy uncertainty will continue to be an important driver. With the path for earnings growth looking like an acceleration into 2026, it will be interesting to see how/when/if the business cycle synchs back up. We hope to get more insight into that as, believe it or not, third quarter earnings season will ramp up in just a few short weeks.
