Which Equity Strategies Typically Perform Best Post Fed Monetary Easing?

There’s a lot of discussion right now about potential rate cuts from the Fed. Where does the Fed stand right now and what has been the impact on US markets? 

Monetary policy in the US has been in an extreme tightening mode since the middle of 2022 to combat accelerated inflation. This has pushed the policy rate in the US to a peak of 5.5%, the highest it’s been in the more than two decades since 2001. 

Now, we’re seeing one of the fastest rate hikes in recent memory coming to an end – the Fed has declared its reach at peak tightening, signaling an upcoming period of monetary easing.

As a result, markets are generally benefiting – risk assets are rallying and broad markets including the S&P 500 are hitting all-time highs, with gains of almost 20% over the past three months alone in anticipation of monetary accommodation.

Historically speaking, at what point in economic cycles do we tend to see monetary easing from the Fed? 

Monetary easing typically follows multi-year rate hikes at the latter stage of the business cycle. This stage is generally characterised by an extended period of economic growth on the verge of overheating. 

A peak in monetary tightening from the Fed often signifies a transition from this period of economic growth in the late phase of the market cycle to a period of significant economic slowdown. This usually entails reduced risk taking from investors and a slump in markets. 

What is your analysis telling you about how US markets will respond to upcoming rate cuts from the Fed?

While the long-term effect of monetary easing is beneficial in principle, the immediate market reaction following rate cuts varies considerably depending on the stage of the economic cycle we’re in. 

As noted previously, cutting rates in the twilight of a business cycle generally ushers in an economic downturn and lower investor sentiment, often accompanied by a recession. On the other hand, monetary easing in the mid-cycle typically supports broad market rallies and risk taking by investors. 

As such, whether the market gains we’ve seen recently are sustainable will depend on where the economy stands within its natural business cycle at the time of rate cuts. Broadly speaking, investors believe that the Fed’s recent rate hikes have engineered a successful soft-landing and that the upcoming rate cuts should extend the momentum of economic growth. 

What equity strategies tend to be more profitable in the wake of monetary easing? 

Monetary easing typically leads to stronger equity performance for cyclical or growth-oriented strategies at the expense of defensive strategies. However, the relative performance of defensive versus growth-oriented equity strategies in the wake of monetary easing will depend on the phase of the underlying economic cycle. 

Specifically, aggressive growth-oriented strategies tend to perform better following mid-cycle rate cuts given this period is often accompanied by increased risk-taking and broad market rallies. On the other hand, defensive strategies are designed to protect drawdowns in difficult market times and as such, tend to perform better in scenarios with late cycle tightening given this period is generally followed by an economic slowdown. 

Currently, the market is expecting rate cuts to start at the next June or July meeting so it will be interesting to see how this all plays out over the coming months.