Markets are strongly focused on next week's Federal Reserve meeting, at which a 25-basis-point (or 0.25%) short-term interest rate cut is widely expected. Some market watchers are even calling for a 50-basis-point cut. However, investors should be careful what they wish for in hoping for an aggressive Fed rate cutting cycle, given stocks tend to do better when cuts are slow and steady.
There has been a distinct difference in the path of the stock market (represented by the S&P 500® index) after different types of cutting cycles. The chart below covers the post-WWII period of Fed rate-cutting cycles, dividing them into fast (at least five cuts in a year), slow (less than five cuts in a year) and non-cycles (only one cut). Slow cutting cycles have been much more rewarding for equities (especially within the first year after the initial rate cut) than either fast or non-cycles. This should be intuitive: If the Fed is cutting aggressively, it's likely because it's combatting a recession and/or financial crisis. It's why our mantra of late has been "be careful what you wish for" if you're hoping for an aggressive (fast-moving) Fed this time.
Sector trends are also noteworthy in fast vs. slow cutting cycles. Slow cutting cycles have benefited economically sensitive, or "cyclical" sectors (Energy, Materials, Industrials, Consumer Discretionary, Financials, Information Technology, and Communication Services, based on the Global Industry Classification Standard, or GICS®) relative to historically "defensive" sectors (Consumer Staples, Health Care, Utilities, and the former Telecommunication Services sector, which was split up in a GICS restructuring in 2018).
Fixed income: How fast will the Fed cut?
The bond market is pricing in the potential for the Fed to take the express lane to much lower interest rates, despite the Fed's hesitancy in this cycle. Barring a recession, we expect the Fed to maintain a more measured pace. Fast or slow, the important message for investors is that the central bank is exiting its tight policy stance. All roads lead to lower interest rates.
In the last six months, conditions have developed that allow the Fed to ease policy. Inflation has slowed and the labor market has cooled. These satisfy the criteria for the Fed's dual mandate to maintain price stability while aiming for full employment. The inflation metric that the Fed favors in setting policy, the personal consumption expenditures index excluding food and energy prices, or "core PCE," has fallen by half, from a peak year-over-year rate of 5.2% in 2022 to 2.6% currently.
The Fed could start the cycle by cutting the federal funds rate by 50 basis points (or 0.5%) at its September 17-18 meeting and then moderating the speed depending on conditions. However, as noted above, in past cycles the Fed has cut rapidly when the economy was in recession or in crisis, such as the COVID-19 pandemic. In cycles when the Fed is cutting in response to falling inflation, the pace has been moderate.
With the Federal Reserve and most major central banks in easing mode and Treasury yields well above the inflation rate, the direction of travel for rates appears lower. Despite the strong bond market rally over the past few months, we still see room for yields to fall further.
International stocks and economy: September surprises
So far, the third quarter has seen the opposite of the second quarter in terms of relative performance of sectors, the average stock, and international stocks. Surprising? Not to us. At the start of the third quarter we wrote about what surprises may be in store for investors during Q3; the top surprises we highlighted were the potential for a return to a more broad-based market leadership and international markets driven by a rotation in sector leadership. The Q2 phenomenon of market-capitalization-weighted indexes (which weight stocks based on the total dollar value of a company's outstanding shares) posting positive returns while equal-weighted indexes (which assign the same weight to each stock in an index) posted losses was very rare. There have been only five incidents in the past 30 years, which were fueled by mega-cap artificial intelligence (AI) stocks such as Nvidia and Microsoft. The rotation out of those high-flying stocks and solid gains by the rest of the world's stock market has helped the performance of the average stock in Q3, measured by the equal-weighted version of the index.
Despite this summer's overseas turmoil surrounding the French elections, the abrupt yen carry trade unwind, and geopolitical developments, international developed stocks, measured by the MSCI EAFE, are outperforming U.S. stocks, measured by the S&P 500, since the beginning of third quarter. This is due, in part, to the broadening of market performance from the handful of AI-driven U.S. stocks that led in the first half of 2024. The MSCI EAFE Index of international developed stocks has posted a quarter-to-date total return of 3%, well above the loss for the S&P 500 Index, as of Friday,
September 6.
Are there any further surprises in store over the remainder of Q3? September 20 is a key date to watch because it holds both a meeting for the Bank of Japan—a catalyst for a possible renewed unwinding of the yen carry trade—and the deadline for France to submit its fiscal plans to the European Union that could drive bond yields higher.
While the Bank of Japan meeting may feature a renewed commitment by Governor Kazuo Ueda to continue to hike rates, which may lift the yen, the risk of another shock as seen in early August is unlikely. In early August, speculators like hedge funds were short 190,000 yen contracts (near $16 billion) and were forced to close out trades rapidly—selling stocks and buying back yen. Currently they are net long 39,000 yen contracts, so there isn't the same vulnerability for a short-term shock to markets. Nevertheless, investors—both Japanese and international—had borrowed heavily in yen at low rates for years to invest in high-return assets outside Japan, like AI stocks, and may be compelled to unwind these loans at a more rapid pace that could weigh on markets.
France's budget deficit stands at 5.5% of gross domestic product—considerably wider than the 3% allowed by European Union (EU) rules. The Excessive Deficit Procedure requires France's new parliament to submit a plan to the EU by September 20 to reduce the deficit to 3% by 2027 and agree on a budget by October 1. Despite naming a new prime minister on September 5, France's hung parliament makes meeting this deadline a challenge. Originally, the outgoing caretaker government (in which ministers remain temporarily in office to ensure the continuity of government services) planned to bring the 2025 budget deficit down to 4.1% by freezing spending at 2024 levels. But, with the far-left and far-right campaigns featuring giveaways such as reversing pension reforms, resuming energy subsidies, and lifting the government-funded minimum wage, there seems to be a desire among some for a less austere budget. Bond yields and stock prices may respond negatively to the budget deliberations if it appears a new budget with higher spending levels may emerge.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Past performance is no guarantee of future results, and the opinions presented cannot be viewed as an indicator of future performance.
Investing involves risk, including loss of principal.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.
Currency trading is speculative, volatile and not suitable for all investors.
Performance may be affected by risks associated with non-diversification, including investments in specific countries or sectors. Additional risks may also include, but are not limited to, investments in foreign securities, especially emerging markets, real estate investment trusts (REITs), fixed income and small capitalization securities. Each individual investor should consider these risks carefully before investing in a particular security or strategy.
Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
All corporate names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security. Supporting documentation for any claims or statistical information is available upon request.
The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.
Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. For more information on indexes, please see schwab.com/indexdefinitions.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). Bloomberg or Bloomberg's licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg’s licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
0924-SBW8
A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out our most recent market outlooks.
© Charles Schwab
More Emerging Markets Topics >
