The Fed Goes Big: What’s Next for Asset Allocation?

The Fed Builds Its Case

The view that the economy will achieve a soft landing might become a reality over time. In a post-meeting press conference, Chairman Powell pointed to evidence for why this rate cut is a down payment on making that scenario likely. The market’s expectations for the path forward for interest rates and the Fed’s dot plot also confirm the confidence in that outcome.

Interest rates will follow a slow and steady path if the inflation data continues to trend downward and if the economic data, particularly employment data, continues to support economic expansion.

Are Declining Rates Good for Stocks?

Over the past 15 years, investors have learned that when rates go down, stocks tend to go up. This recency bias is perhaps the biggest driver behind investors’ asking when the Fed will cut rates. On multiple occasions over the past 18 months, we have seen where the market has been trying to lead the Fed to rate cuts. In fact, expectations coming into this year were that the Fed would cut rates six times in 2024.

But let’s consider what happens when we look through a longer lens. The Fed’s cutting cycles haven’t always equated to strong return periods in the market. Looking under the hood, the market seems to understand that.

Throughout much of 2024, stocks rallied on weak economic data because they believed it would lead to rate cuts and sold off on strong data as it seemed to indicate the Fed pause would last longer. But as can be seen in the chart above, the market has rallied on stronger economic data because the focus has shifted away from rates moving lower to the reason rates will move lower going forward. That reason will depend on what type of economic backdrop we have.

Fed Rate Cuts and Their Effect on Asset Allocation

If one had a crystal ball that revealed the economy’s future path with 100 percent certainty, then a portfolio could be constructed to maximize returns for that scenario. But we don’t. So, it is important to understand how the path of economic growth has historically impacted different asset classes.

Investors like the potential of a soft-landing scenario because they believe the markets should act well. Historically, all asset classes have had positive returns in a soft-landing scenario. But if the consensus is wrong and we have a recession? Then there is room for disappointment and much different returns for various asset classes historically.

What Should We Be Watching?

Broadly speaking, the consensus for a soft landing continues to be supported by economic data. But we should pay attention to some of the upcoming economic reports to try to gain insight into whether the Fed has fallen behind the curve.

Some of it is obvious. In an economy 70 percent driven by the consumer, jobs data is front and center. If people have jobs, they have money. And if they have money, they spend it. While recent earnings reports have shown some weakness in the lower-end consumer, in general, the consumer remains healthy. But the jobs created data has shown a cooling in the employment market over the last couple of months. Going forward, the health of the employment market can certainly be gleaned from the monthly employment data, released for the most part on the first Friday of the month. The Jobs Opening and Labor Turnover report, more commonly referred to as the JOLTs report, is also released monthly and is another look at the health of the jobs market. Finally, the initial jobless claims report is released weekly on Thursday mornings. All these releases are quite popular and can be scrutinized for information regularly.

Unprompted, Chairman Powell also brought up a report that doesn’t always get the full attention of investors: the Beige Book. The Beige Book is released eight times a year and summarizes economic activity across 12 Fed districts.

Recent reports show an economy muddling along, with the most recent data pointing in negative territory but not yet indicative of a recession. But if the Fed is paying attention to the data, then investors would be well served to do so, too. The next Beige Book report comes out on October 23.

Navigate Uncertainty Through Diversification

The questions facing the market are certainly complicated. But maybe the answers are indeed simple. No one knows with certainty what the path forward is for the economy. Positioning portfolios for a soft landing that turns into a recession will cause unintended risk. But constructing portfolios for a hard landing will cause underperformance if the economy continues to grow in the intermediate to long term.

Consider balancing portfolios across equity and fixed income asset classes. Within equities, we believe representation across market caps, styles, and geographies is appropriate in a well-constructed, balanced portfolio as value, small-cap, and international equities have historically had very different return profiles depending on why the Fed cut rates. The same holds for the fixed income side of the portfolio, as balance across durations and credit qualities seems appropriate. Declining rate environments have historically been a good backdrop for fixed income investors no matter the ultimate reason the Fed cuts rates. Over time, when Fed funds rates have declined, high-quality bonds have outperformed cash. On both sides of a balanced portfolio, we must be cognizant of the risk inherent in each asset class and right-size those positions for the current opportunity set based on what we have learned from the past. (Note that diversification does not assure a profit or protect against losses in declining markets, and diversification cannot guarantee that any objective will be achieved.)

So, while Dr. Seuss wasn’t a market strategist, this quote from Oh, the Places You’ll Goseems an appropriate one for how to think about your portfolios currently.“So be sure when you step, step with care and great tact. And remember that life's a great balancing act.”

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