The year 2024 has seen a positive trend in the stock market, but recent concerns about a potential economic slowdown leading to a recession have made investors anxious. To counter this possibility, the Federal Reserve is prepared to lower interest rates, aiming to provide a stimulus to consumers and businesses that have been struggling despite overall economic growth.
Will the reduction in interest rates be sufficient to stabilize the economy and turn things around, or does the Fed’s initial interest rate cut signal a decline in the market? This question is on the minds of many investors, but recent research suggests that there is reason for optimism.
Stocks see gains following Fed rate cuts
Investors may understandably be worried about the state of the economy as the Fed prepares to lower interest rates after one of the quickest rate increase campaigns in history, spanning from 2023 to 2023. Typically, the Fed starts cutting rates when the economy shows signs of weakness, so lower rates often indicate an impending recession.
However, lower rates can have positive implications for companies and stock valuations. Businesses that are sensitive to interest rates, such as small banks, real estate investment trusts (REITs), and heavy borrowers, can benefit significantly from lower rates. Additionally, lower rates can boost stock prices as investors adjust future earnings at reduced rates, increasing the present value of those earnings today.
Despite these advantages, investors must navigate the period between the Fed’s actions and their impact. Monetary policy typically has a lag effect, often lasting around six months. While the Fed’s actions may not be immediately felt, a declining economy can continue to deteriorate during this time, potentially necessitating further rate cuts and intervention from the Fed. As the economy weakens, corporate profits may also suffer, impacting investor sentiment and stock prices.
Research conducted by Hartford Funds suggests that investors should maintain a positive outlook. The study found that U.S. stocks tend to perform well, with an average 11% increase after adjusting for inflation, one year after the Fed initiates rate cuts.
The Hartford team analyzed 22 instances from 1929 to 2019 when the Fed first lowered rates and examined the performance of stocks, bonds, and cash over the following 12 months. On average, stocks saw an 11% increase after adjusting for inflation, with varying returns based on whether the rate cut coincided with a recession.
Lower interest rates are generally beneficial for stocks due to two main reasons: they reduce the appeal of safe investments like cash and fixed income as rates decline, and they facilitate companies’ ability to borrow, expand, and enhance growth, which can drive corporate earnings and stock prices higher,” explains Greg McBride, CFA, Bankrate’s chief financial analyst.
Notably, returns for stocks following the rate cuts in June 1995 and September 1998 were 23% and 25%, respectively, in the subsequent year. Similar to the present scenario, the mid-1990s saw moderate slowdowns amid a robust economy.
While stocks tended to outperform other asset classes, the after-inflation returns for government bonds were 5% higher after a year, corporate bonds were 6% higher, and cash saw a modest 2% increase.
Although there were instances where stocks underperformed the average, only six out of the 22 periods reviewed by Hartford resulted in negative after-inflation losses.
“The superior performance of stocks compared to bonds and cash, particularly during periods when the Federal Reserve commences rate cuts, remains consistent over extended timeframes,” McBride highlights.
How should investors respond to declining interest rates?
Changes in investors’ expectations can create turbulence in the market, with some selling in anticipation of a recession while others buy during market downturns. However, Hartford’s findings suggest that investors who remain steadfast in their stock holdings amid the uncertainty ultimately benefit.
“While it may sound simple, investors must endure a barrage of fear and negative news in the interim to maintain their investment positions. Economic indicators may currently appear bleak and could worsen, requiring a strong resolve to withstand the situation without taking impulsive actions,” the article suggests.
So, what steps can investors take as interest rates decline and the U.S. economy faces the possibility of a recession?
Adopt a long-term perspective on thinking and investing
“For long-term investment goals, such as retirement planning, a significant allocation to stocks is crucial for generating compounded returns essential for building a secure financial future,” notes McBride.
The S&P 500 stock index has historically delivered 10% annual returns over extended periods. Investors can easily invest in an S&P 500 index fund at a low cost to achieve strong long-term returns, provided they remain invested through market fluctuations.
“Attempting to time the market is futile, as missing out on periods that yield substantial returns can significantly impact your overall financial portfolio when compounded over several years,” cautions McBride.
Continue to invest during market dips
Investors are advised to retain their investments and consider increasing their holdings during market downturns. By capitalizing on lower prices during market declines, investors may benefit from accelerated gains as stock prices eventually rise to their long-term averages.
However, this strategy is more feasible with a stock index fund, such as an S&P 500 fund, which offers lower volatility and greater diversification, thereby reducing risk. While individual stocks may offer higher returns over time, they also come with increased risk compared to index funds.
“An effective way to capitalize on market downturns is to automate your purchases. This approach, known as dollar-cost averaging, minimizes emotional decision-making and spreads out your investments over time to reduce risk and eliminate the need for market timing,” the article suggests.
Tune out the market noise
During market declines or heightened volatility, both investors and the media tend to become anxious, especially in the face of economic slowdowns and concerns about job security. The prevalence of fear-driven narratives in the media can make it challenging for long-term investors to stay committed to their investment strategies.
“In such scenarios, it can be beneficial to step back from the noise and refocus on your financial plan. Ensure that your emergency fund is adequately funded, as it will provide you with the necessary cushion to stay invested during turbulent market conditions,” advises the article.
“Reaffirm your long-term wealth-building goals and recognize how investing can help you achieve them. For those working with a financial advisor, seek their guidance as a source of stability amid market stress and receive valuable insights to navigate through challenging times,” it adds.
Conclusion
“Stock market research strongly indicates that investors generally fare better by avoiding frequent trading. Even during economic downturns, investors may benefit most from maintaining a long-term perspective on the market and aligning their actions with their overarching investment objectives,” the article concludes.
Editorial Disclaimer: All investors are urged to conduct their independent research on investment strategies before making any investment decisions. Additionally, investors are reminded that past performance of investment products does not guarantee future price appreciation.