As market participants brace for a highly anticipated US interest rate cut later this month, investors worldwide are wondering how the markets will react and what it means for their portfolios.
With history as our guide, we know that rate cuts typically signal a shift in economic conditions but predicting market behaviour is never straightforward.
It is, nonetheless, worth exploring the potential impact of the Fed’s upcoming rate cut, drawing on historical trends, current economic conditions, and the broader implications for South African investors.
Historical context and market reactions
Looking back at the 14 Federal Reserve rate cycles since the Great Depression in 1929, there is a clear trend: the S&P 500 has posted positive returns in the 12 months following the first rate cut 86% of the time. However, it is crucial to note that the two exceptions — during the dot-com bubble and the subprime mortgage crisis — were both periods of significant economic upheaval. This historical context suggests that while markets generally respond favourably to rate cuts, they are not immune to broader economic crises.
Given the current economic environment, characterised by unique conditions such as elevated valuations, geopolitical tensions, and the lingering effects of a pandemic, it is challenging to predict whether the market will react similarly this time. Hedge fund guru Ray Dalio famously quipped that those who live by crystal balls will end up eating shattered glass. And forecasting is not something we like to do at 10X Investments. I prefer to look at the fundamentals and what valuations are telling us about where the margins of safety can be found. If we draw parallels to the past, particularly the year 2000, which also saw high market valuations coupled with the beginnings of a recession, we might be in for a comparable market response over the next 12 to 18 months.
The Fed’s unconventional rate cycle
Traditionally, the Federal Reserve has taken a gradual approach to raising rates (“taking the stairs up”) and a more aggressive stance when cutting them (“taking the elevator down”). However, the current cycle has been anything but typical. After a period of rapid rate hikes, we are now on the brink of what is expected to be a more measured approach to rate cuts.
The market is currently pricing in a reduction of about 100 basis points by the end of this year, followed by another 100 basis points by the end of 2025. This would bring the Fed funds rate down from approximately 5.25% to around 3.25%. But in reality, monetary policy changes are rarely this smooth – more akin to landing a plane in a storm than following a straight line. A reduction of this magnitude without accompanying economic turbulence would be unprecedented. Our view is therefore, that while the market expects a soft landing, the path to achieving this remains fraught with challenges.
The recession conundrum
The potential for a recession in the world’s largest economy remains a concern. Historically, there is a lag between the peak in interest rates and the onset of a recession, typically ranging from 18 months to two years. We are now approaching that timeline, and several indicators suggest that a recession in the US is a real possibility within the next six to 12 months.
Warren Buffett’s recent shift towards a more defensive cash position, reducing his stakes in major companies such as Apple and Bank of America is worth noting. Such moves are often seen as cautionary steps in anticipation of a market downturn. While the exact timing of a recession is impossible to predict, the probability, based on historical trends and current market dynamics, is high.
Sectoral shifts and market volatility
Assuming a recession does not materialise in the next six to 12 months, certain sectors traditionally perform well in a rate-cut environment. Cyclical sectors like consumer discretionary and industrials have historically benefited from lower interest rates, as have utilities, healthcare, financials, and real estate investment trusts (REITs).
However, the current market environment presents a unique challenge. Unlike in previous cycles, where tech companies were relatively minor players or speculative ventures with very little real cash generation, today’s tech giants – the so-called “Magnificent Seven” – have become the dominant forces in the market, exerting much greater influence.
The big question is whether these tech companies are defensive or cyclical. Historically, companies involved in semiconductors and advertising have shown high sensitivity to economic cycles, but the resilience of today’s tech giants remains untested through a full interest rate and recession cycle. This clouds the crystal ball even further.
Fixed income as a safe haven
Given this uncertain environment, South African investors should consider their fixed-income allocations carefully. Historically, bonds – particularly those with longer durations – have performed well following rate cuts. We have seen a strong performance in the local bond market this year, with 10-year yields dropping nearly 200 basis points from their highs in April, resulting in a total return of around 15%.
Looking ahead, there is still room for growth in the local bond market. The expected Fed rate cuts could lead to a drop in real rates, which would be bullish for fixed income. From an asset allocation perspective, both inflation-linked bonds and nominal government bonds remain attractive options for South African investors, offering favourable valuations and potential for further gains.
Final thoughts
As we approach the Fed’s anticipated rate cut, global markets are poised for a period of stomach-churning change. While history provides some guidance, the current economic environment is unlike any we have seen before, marked by unprecedented challenges and opportunities.
For South African investors, this means staying vigilant and bracing for the volatility ahead, being prepared to adapt, and considering a diversified portfolio approach that includes a strong focus on fixed income.