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Written by: Gabriela Santos and Mary Park Durham
“The time has come” was a memorable phrase from Chair Powell’s speech at the Jackson Hole Symposium last week. After a few false dawns this year, Federal Reserve rate cuts are imminent, with the discussion now shifting to how quickly rates will come down. How should investors be positioned ahead of the first cut? Historically, asset class performance has varied depending on why rates are moving lower: risk assets typically perform well during “soft landings” and suffer during “hard landings.” In both scenarios, cash has consistently underperformed core fixed income, highlighting the growing opportunity cost of not being fully invested, especially in that asset class. The time has more than come for investors to consider whether portfolios are appropriately positioned for the rate cutting cycle ahead, especially given portfolio imbalances that may have developed over the past few years.
Over the past month, it has become clear that inflation is no longer the only risk on the Fed’s radar. Confidence in the disinflation progress has increased, with PCE inflation now under 3%. However, concerns about downside labor market risks have grown following the softer-than-expected July jobs data. The Fed seems intent on keeping the “soft landing” on track by cutting rates proactively, not reactively. A first rate cut at the September 18th FOMC meeting seems all but certain. The discussion has now shifted to the size and frequency of these cuts, as well as the ultimate destination. If the labor market continues to normalize, rather than collapse, rate cuts should be seen as “normalizing” rather than “easing.”
However, investors should recognize this still means current short-term rates are as good as they are going to get: 3-month Treasury yields are likely coming down from 5.4% today to around 3.5% over the next 18 months. However, if the economy loses more momentum, rates could decline more rapidly and settle at an even lower level. One of the biggest risks for investors in a falling rate environment is reinvestment risk. For fixed income, investors have not missed their opportunity to capture attractive yields, with core bond yields still at 4.4%, but the window is rapidly closing. As witnessed this summer, what’s here today can quickly be gone tomorrow: 2-year yields dropped 85bps in less than two months.
So, where should investors allocate capital? History can be a useful guide, but not all rate cutting cycles are created equal:
- “Soft landings”: Risk assets, like large-cap equities and high yield bonds, have done well when rate cutting cycles have coincided with a soft landing. Critically, large-cap stocks have performed almost twice as well as small-caps, suggesting investors should focus on quality under either economic scenario. Interestingly, U.S. Growth and Value equity returns were similar, suggesting investors should rebalance portfolios from previous winners. Lastly, core bonds have had positive performance and have outperformed cash by 4%pts on average.
- “Hard landings”: When rate cuts coincide with recessions, risk assets have suffered. Within equities, international equities have suffered the most, followed by the Value style and small-caps, while U.S. large-cap and the Growth style have tended to fare better. In fixed income, quality has shined, as high yield bonds have seen negative returns while core bonds have provided very solid returns (helping to diversify portfolios). Long duration has outperformed short duration by a significant margin during hard landings.
Looking at “soft” versus “hard landings” is key when thinking about risk levels and duration. Additionally, investors may want to correct portfolio imbalances that may have developed since the last rate cutting cycle. This is especially true and time-sensitive for core fixed income. The time has come for investors to capitalize on attractive entry points while they are still available.
Asset class performance has varied depending on why rate cuts have occurred
1984-present, avg. returns 12 months after first Fed cut, monthly, grouped by soft or hard landing
Source: Bloomberg, FactSet, MSCI, Russell, Standard & Poor's, J.P. Morgan Asset Management. Soft landing: scenario where the economy slows down just enough to prevent inflation without causing a recession. Hard landing: scenario where efforts to slow down the economy result in a downturn, often leading to a recession. U.S. large cap: S&P 500, U.S. small cap: Russell 2000, U.S. Value: Russell 1000 Value, U.S. Growth: Russell 1000 Growth, International: MSCI AC World ex-U.S., 10Y Treasuries: Bloomberg U.S. Treasury Bellweather (10Y), 2Y Treasuries: Bloomberg U.S. Treasury Bellweather (2Y), Bloomberg U.S. Agg: Bloomberg U.S. Aggregate, U.S. HY: Bloomberg U.S. High Yield - Corporate, Commodities: Bloomberg Commodity Index, USD: DXY Index, Cash: Bloomberg U.S. Treasury - Bills (1-3M). Soft landing includes the cutting cycles starting in 1984, 1995, and 1998. Hard landing includes the cutting cycles starting in 1989, 2001, 2007, and 2019. The 2019 hard landing episode began with a soft landing, where the Fed cut 75bps, followed by a hard landing months later due to the onset of the COVID-19 pandemic. International equities, U.S. high yield, commodities, USD, and cash do not include the 1984 soft landing episode due to a lack of available data. U.S. high yield, commodities, and cash do not include the 1989 hard landing episode due to a lack of available data. Equity and commodity returns are price returns, fixed income and cash returns are total returns. All returns shown are in USD.