Hello, everyone, and welcome to the September Market Compass. This has been a big month for the markets and economy, perhaps even a historic one, as the Federal Reserve finally began its rate-cutting cycle, lowering interest rates for the first time since March of 2020. Now, at its September 18 meeting, the Fed cut the federal funds rate by 0.5% to between 4.75% and 5%.
And it indicated it likely has begun a multi-year rate-cutting cycle that could bring policy rates close to 3%. So what does this rate cutting cycle mean for markets and the economy? We discuss the implications on the broader economy, stock markets, and bond markets in this month's Market Compass.
At the September Federal Open Market Committee meeting, the Fed took the first step to move interest rates lower, in large part, because both sides of its dual mandate, inflation, and the labor market are now in focus. Chair Jerome Powell indicated the Fed has more confidence that inflation is moving in the right direction, but the labor market has shown clear signs of cooling.
While it doesn't see an outright downturn or recession on the horizon, the Fed now prefers to support the economy and labor market with less restrictive interest rates. So what is the path of policy rates from here? Well, the Fed also released what's known as the dot plot. It's a best guess from all its voting members on the path of the Fed funds rate going forward.
This dot plot indicates that most members of the FOMC see interest rates heading towards 3% by the end of 2026 or another nearly 2 percentage points lower from here. Now, also keep in mind that the Fed is not the only major global central bank cutting interest rates. We know central banks around the world, including the Bank of Canada, European Central Bank, and the Bank of England, are embarking on rate-cutting cycles as well.
Perhaps the only major central bank raising rates this year is the Bank of Japan, as they seek to break their decades-long cycle of deflation and weak growth. Now, lower interest rates globally do have an impact to economic growth and consumption. Now, on one hand, we know that lower rates can support economic growth. They bring down borrowing costs for consumers in areas such as mortgages, credit cards, and auto loans.
Similarly, for corporations, the cost of borrowing is lower to spend on projects or invest in growing the business. Now, these lower rates can help support consumption and economic growth broadly. On the other hand, for savers, lower rates mean the interest paid on savings accounts is lower. For investors with outsized positions in cash or cash-like instruments, such as CDs or money market funds, now may be a good time to start thinking about gradually investing these cash-like positions in more traditional asset classes, such as stocks and bonds.
Speaking of stocks and bonds, how should we think about these investments now that the Fed has begun to cut interest rates? Well, with stocks, there are three key takeaways. First, history tells us if the Fed is cutting rates and the economy is not falling into an imminent recession, stocks are well supported. Now, we can see in this chart, however, if the economy is in a recession, stock markets tend to sell off after the Fed cuts rates.
Now, in the current environment, we believe the most likely outcome is that economic growth cools but does not fall into negative growth or recession. Thus, while markets may not move in a straight line higher from here, we do believe the underpinnings of the bull market expansion are intact for now. Second, when the Fed starts cutting rates, market valuations tend to be supportive. We see valuation metrics, such as the price-to-earnings multiples, expand.
Market returns are driven by earnings growth and valuation expansion, both of which may move higher as the Fed cuts rates. Now, for this cycle, we believe that those sectors that have the most scope for valuation expansion, including cyclical and defensive sectors, may play some catch-up as the Fed cuts rates. And third and finally, some asset classes and sectors tend to perform well when the Fed starts cutting rates and there is no recession.
Historically, US large and mid-cap equities tend to do well in this backdrop, as do US and international bond markets, particularly emerging market debt, all of which are supported by lower rates. Now, from a sector perspective, cyclical parts of the market, such as financials and industrials, as well as some defensive areas, such as health care and utilities, can do well alongside your technology and growth markets.
Overall, keep in mind that Fed rate cuts should be a positive, albeit well-known catalyst for financial markets, especially if the economy avoids a recession. Now, we believe that over time, lower rates, easing inflation, and an economy that is cooling but still positive should support the bull market and the ongoing broadening of market leadership. However, keep in mind, stocks have already had a nice run this year. The S&P 500 is up nearly 18%.
And we are entering a seasonally choppier September and October period and heading towards that US election day. So in the weeks ahead, we may continue to face bouts of volatility, which, of course, are normal in any given year. But we believe investors can lean into any market corrections as opportunities to rebalance, diversify, and add quality investments at lower prices. Consider US mid and large-cap stocks, growth and value sectors, and domestic and international bond markets.
At the end of the day, diversification remains a cornerstone for investment portfolios, and especially so as the Fed cuts rates. So with that, I thank you for your time. And we'll see you right back here next month on the Market Compass.