Drawing lessons from history: how to invest in US stocks during the Fed rate cut cycle?

The Federal Reserve's rate cuts in 2024 have once again sparked a familiar debate among investors: will the easing cycle prolong the economic expansion or signal an impending economic recession? History serves as a guide for investors. Past cycles have revealed how monetary changes impact economic recessions, bear markets, and the dominance of investment styles. Given the ongoing threat of inflation, the Fed's next steps will have a tangible impact on investment portfolios. This article evaluates the relationship between the Fed rate cycles and various market dynamics by studying the historical context. In the past 10 rate-cut cycles, 2 have successfully avoided economic recessions. If the current cycle also manages to avoid a recession, then the rate cut cycle in 2024 will be the 3rd out of 11. Whether in a recession or non-recession period, the performance of stock styles after rate cuts varies significantly. Out of the 12 rate-hike cycles since 1965, the US has experienced yield curve inversions 10 times and 8 economic recessions. If the current inversion persists, an economic recession may be inevitable. The only rate hike cycle that had an inversion but did not lead to a recession was in 1966 (similar to the current period), when the fiscal deficit as a percentage of GDP was around 3%, comparable to the fiscal expansion of about 3% in the past four years. In nine out of the nine yield curve inversions, eight occurred before an economic recession, with a time span from the inversion to the market peak ranging from 2 to 15 months. Currently, the US Treasury yield curve has been inverted for 35 months. There was one instance of a yield curve inversion in 1966 that did not lead to an economic recession. As the yield curve normalized, growth, high-beta, and quality styles led the market performance, similar to the current situation. The graph below shows the stock market performance in the first 12 months, months 13-24, and months 25-36 after the first rate cut by the Fed. Although the overall return is generally positive, the lack of a consistent pattern between cycles suggests that the results largely depend on the specific macroeconomic environment during each easing cycle. The graph also illustrates the historical relationship between Fed rate cut cycles, economic recessions, and bear markets. Analysis of 12 different cycles shows that in 10 rate-cut cycles, the Fed began cutting rates after the stock market peaked, indicating a lag in policy response. Additionally, the National Bureau of Economic Research (NBER) typically confirms a recession 4 to 21 months after it has already begun. Notably, since the highly volatile monetary conditions of the 1970s, the Fed has been more frequent in starting rate cuts before officially confirming an economic recession. The performance of various investment styles after the start of a Fed rate cut cycle shows complex and diverse patterns, highlighting the uniqueness of each cycle. This diversity may be explained by the fact that loose monetary policy does not always align with stock market cycles and can sometimes lead to divergent performances in different investment styles. The relationship between rate cuts, economic recession, and market risk behavior appears to be unpredictable, making it challenging to forecast the continuity of investment styles. Since 1965, there have been 12 different rate-hike cycles, with 8 eventually leading to economic recessions. Yield curve inversions occurred in 10 out of the 12 cycles, and 9 coincided with bear markets. The median duration of these cycles was 18 months, ranging from 12 to 39 months, with the median increase in the federal funds rate being 3.75%, ranging from 1.75% to 13%. The median time from the start of a rate hike cycle to the market peak preceding an economic recession was 22 months, ranging from 4 to 51 months. In most rate-hike cycles, the Fed continued to tighten monetary policy even after the stock market peaked. This pattern reinforces the long-standing adage that bull markets do not end due to the passage of time but rather due to Fed actions. While this tough stance often leads to economic contraction, sometimes the Fed tries to alleviate recession pressures in advance. Out of the eight economic recessions observed since 1965, in five instances, the Fed started lowering rates before the economy officially entered a recession, indicating proactive policy adjustments to alleviate economic pressures. However, these five cases suggest that early rate cuts may not always prevent an economic recession, highlighting the limitations of monetary policy when the overall economic momentum deteriorates. In the year following the end of a rate hike cycle, the performance of various investment styles is mixed, reflecting the cyclical nature of monetary policy and market dynamics. This difference is likely due to the fact that monetary policy cycles do not always synchronize with stock market cycles. For example, in the 1970s, the Fed often transitioned directly from rate hikes to cuts, making it difficult to distinguish between the returns after rate hikes and rate cuts. A lasting historical phenomenon is that stocks with high beta coefficients often perform either exceptionally well or poorly, while value and quality stocks tend to outperform the average level and rarely fall into the worst category. This phenomenon persists even after the end of rate hike cycles. Out of the 12 significant monetary tightening cycles observed, 10 were accompanied by yield curve inversions. Among these 10 inversions, 8 were followed by economic recessions, underscoring the predictive power of the yield curve as a leading economic indicator. Yield curve inversions typically coincide with economic recessions and bear markets. The relationship between yield curve inversions and market peaks varies significantly, ranging from 12 months before an inversion to 15 months after. This diversity highlights the complexity of market reactions to changes in monetary policy. Two rate hike cycles in 1984 and 1995 were exceptions as they achieved a "soft landing" without yield curve inversions or economic recessions. Conversely, the rate hike cycles of 1966 and 2022 had yield curve inversions but avoided economic recessions. Analysis suggests that the avoidance of a recession in these cases was due to highly stimulative fiscal policies. However, this policy backdrop ultimately led to recessions and bear markets in 1968. There are similarities between the fiscal environment in the mid-1960s and the current economic situation. In both periods, high levels of deficit spending have promoted economic activity. The reversal that began in 2022 is the longest and third-most severe in duration and severity. Despite these unfavorable signals, the US economy and labor market have demonstrated remarkable resilience. Consistent with the previous scenarios, the performance of various investment styles in the year following a yield curve inversion shows significant differences, highlighting the cyclical nature of monetary policy and market behavior. Yield curve inversions may indicate that the market is entering the later stages of the economic cycle. In this environment, it is not surprising to see quality and growth stocks perform well, as these sectors typically thrive in the later stages of the economic cycle with resilient earnings. The historical rate fluctuations of the Federal Reserve suggest that there is always a lag in its policy response compared to market and economic inflection points, highlighting the "long and variable lags of monetary policy." While yield curve inversions have been proven to be a reliable indicator of economic recessions, the timing of their occurrence and their impact on markets still present uncertainties, making predictions complex. For investors, statistical data shows that no single policy adjustment can provide clear operational guidelines. The results of rate cuts vary significantly, emphasizing the importance of considering policy statements in conjunction with the economic background. In rate hike cycles, allocating to value and quality assets typically produces more stable returns, while high beta exposure often brings significant gains and losses. After an inversion period, growth and quality assets usually dominate, with high beta exposure offering upside potential but also increased risk. The weight of history suggests that investors should view the current easing cycle with the perspective of the late stages of an economic recession. In 1966, economic growth was sustained by fiscal expansion, avoiding a recession. A similar situation may be present now. If this similarity holds true, investment portfolios tilted towards quality and growth styles may continue to perform well, with high beta exposure preferred among various styles. Meanwhile, inflation remains a key factor: if inflation rises again, it may force the Fed to revert to tightening policies, which historically has brought about challenging market environments. For investors, the priority is to prepare for market fluctuations and be ready to adjust strategies as needed to respond to potential policy changes.