After the cheers for the imminent Federal Reserve rate cut last Friday, the U.S. stock market quickly returned to calm on Monday. Amid the fading recession fears at the beginning of the month and the start of the easing cycle, investors will pay more attention to the changes in future economic data to weigh whether the "soft landing" narrative can ultimately be achieved. Historically, this will also be a key factor in determining the future trend of the U.S. stock market.
The rate cut is not a bull market charge
After the Federal Reserve meeting minutes suggested considering a rate cut in September, Powell's latest speech at the Jackson Hole Global Central Bank Annual Meeting made the timing of the policy turning point imminent. Interest rate futures pricing shows that the Federal Reserve will cut rates by 25 basis points in September.
However, the shift in monetary policy is often not directly related to a new bull market. The S&P 500 index has risen by 18% this year, and the overall valuation is at a historical high. Market participants need to see continuous evidence that economic growth remains resilient while inflation cools, thus achieving a soft landing.
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Alessio de Longis, Senior Portfolio Manager and Head of Investments at Invesco Solutions, said: "The market certainly wants to hear the news of the start of the rate cut cycle. However, the current problem for the Federal Reserve is, how worried are they about the economy? This should have a different view on the impact of the rate cut cycle."
Richmond Fed Chairman Barkin recently published an article stating that the "low hiring, low firing" approach currently adopted by U.S. companies in employment decisions is unlikely to continue. He said that if the economy is weak, companies may take the risk of layoffs. In recent weeks, the Federal Reserve's concerns about the job market have intensified, and Federal Reserve Chairman Powell has said that the core reason for the need to cut interest rates is to prevent further declines in the U.S. unemployment rate. "Either demand will continue, and companies will start hiring again, or you will start to see layoffs," Barkin said.
History has shown that when rate cuts are made in the context of resilient growth, rather than in the face of a sharp economic slowdown, the performance of the U.S. stock market tends to be much better. In 2001 and 2007, after the Federal Reserve cut interest rates, the recession led to a significant adjustment in the U.S. stock market. Evercore ISI strategists said that since 1970, the S&P 500 index has risen by an average of 18% one year after the first rate cut in a non-recession period. During economic recessions, the index has risen by an average of 2% one year after the first cut.
UBS wrote in a report to First Financial Journalists, "As the labor market cools down faster than expected and inflation continues to slow down, the inclination of Federal Reserve officials to cut interest rates is in line with our view that the Federal Reserve is expected to start cutting interest rates in September and cut rates once at the meetings in November and December." The institution found that interest rate cuts by the Federal Reserve in non-recession periods are often beneficial to the stock market, so it continues to be optimistic about high-quality growth stocks.
Potential risks and challengesBefore the next interest rate decision meeting, the Federal Reserve will receive at least three significant reports, namely the Personal Consumption Expenditure Price Index (PCE) on August 30th, the non-farm report on September 6th, and the Consumer Price Index (CPI) on September 11th.
After last month's non-farm report triggered recession fears, further signs of economic weakness may once again disrupt the stock market and shift rate cut expectations back towards 50 basis points. Quincy Krosby, Chief Global Strategist at wealth management firm LPL Financial, said, "The market wants to usher in a rate-cutting cycle because inflation is declining. However, the issue remains whether we will see further deterioration in the labor market."
On the other hand, the market is about to enter a seasonally weak phase. According to data from the Center for Financial Research and Analysis (CFRA), September is historically the weakest month for stock performance, with the S&P 500 index averaging a decline of 0.78% since World War II. If negative news arrives, the rise in stock valuations may also reduce investors' willingness to hold stocks. According to data from LSEG Datastream, as the S&P 500 index approaches its historical high, its forward price-to-earnings ratio has rebounded to 21 times, higher than the 19.6 times in early August, while the index's long-term average is 15.7 times.
The upcoming election race, which is about to enter its final stretch, may also bring disturbances. The latest polls show that the support rates of the U.S. Vice President, Democratic presidential candidate Harris, and the former President, Republican presidential candidate Trump, are neck and neck, and the differences in their policy positions may bring changes in risk appetite as the election approaches.
Andre Bakhos, Managing Director of research firm Ingenium Analytics LLC, said, "The long-term trend of the stock market is as solid as a rock, and any weakness is an opportunity to increase risk exposure. In the short term, we will see volatility and unstable trends, because no one really knows what will happen with the Fed's rate cut before the election."
It is worth noting that the latest analysis from Goldman Sachs' prime brokerage department shows that hedge funds have been retreating during the recent rebound. Fund managers have generally reduced their exposure to the stock market and are selling at the fastest pace since March 2022, "Although the market has rebounded, the total leverage and net leverage in August so far have both decreased, indicating that risk appetite has not recovered after the unwinding of the yen carry trade."
Bruno Schneller, Managing Partner at asset management firm Erlen Capital Management, explained, "Although the overall market is optimistic... hedge funds seem to be skeptical about the sustainability of the rebound and remain vigilant about potential headwinds." He believes that hedge funds are now seemingly hedging against downside risks until the economic and market situation becomes clearer. They may be concerned that the market's optimism is premature, or that economic conditions may deteriorate before these rate cut measures take effect, potentially leading to another recession.
Andrew Beer, Managing Director at Dynamic Beta Investments in New York, also tends to think that many hedge funds may be waiting for uncertainties to clear before investing, with some institutions worried about losing the good gains achieved in the first half of the year. "From a risk-reward perspective, many hedge funds are now focusing on global changes. There are many reasons to be cautious, such as the geopolitical backdrop being quite worrying. Economic takeoff may hit the windshield very soon," he said.
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