(Bloomberg) - Wall Street pros are warning investors who bid up US stocks on expectations the Federal Reserve will soon be cutting interest rates to remember an old cliche: Be careful what you wish for.
Even after Fed Chair Jerome Powell on Wednesday pushed back on speculation the central bank is poised to reverse course, the stock market largely ignored that message, rallying Thursday on anticipation the central bank will start pumping stimulus into the economy during the second half of the year. The gains were led by rate-sensitive stocks like fast-growing technology companies that were hammered last year.
But by late afternoon, the gains shrank as the downside risks of a Fed pivot belatedly sunk in: The scale of the rate cuts now being priced into the financial markets suggests the central bank will be fighting a steep economic slowdown or recession that would batter corporate earnings. In other words, what looked like a bullish moment for stocks may not be so bullish at all.
“Rate cuts would actually be negative for the stock market,” said Todd Sohn, managing director of technical strategy at Strategas Securities. “It’s cuts that get stocks and especially growth corners of the market in trouble, with the most glaring recent examples being 2000 and 2008.”
The stock market’s swings underscore the difficulty for investors trying to navigate through a period of unusually high uncertainty, with turmoil in the banking industry casting fresh risks even as inflation remains stubbornly elevated. Powell, who said the central bank considered keeping rates steady on Wednesday, still moved forward with another quarter-point hike and said more may be needed to bring consumer-price increases back toward its target.
“The ‘pause’ comment from Powell was interesting because it would suggest the end of the hiking cycle could be coming — but then he dropped the ‘H-bomb’ later in the press conference, suggesting rates could go higher if needed depending on inflation,” Sohn said. “Now there’s definitely confusion.”
The comments also highlighted the risk that the data-dependent Fed will wait too long to loosen policy enough to avert a significant economic slowdown, Nicholas Colas, co-founder of DataTrek, wrote in a note to clients.
“If banks tighten lending standards and financial conditions worsen as a result, by the time this shows up in the data it may be too late to avoid a recession even if the Fed cuts rates this year,” Colas explained. “That strikes us a recipe for continued equity market churn.”
The divergences in the direction of stock prices during Thursday’s volatile trading session showed that investors are mindful of some of the blows that would come with a steep slowdown. While tech-heavy indexes like the Nasdaq 100 led the gains, rising 1.3%, other more economically sensitive stocks slipped, with the S&P Smallcap 600 Index ending down 2.6%.
Historically, a pause in rate increases has helped the stock market. In most of the six instances since 1970 when the Fed raised borrowing costs by over 100 basis points for a period of a year or more and then paused hikes for at least three months, US stocks have rallied, with the S&P 500 returning 8.2% on average, according to Bloomberg Intelligence. The lone exception is the bursting of the dot-com bubble in 2000, when stocks fell from May to December during a rate-hike pause.
“Investors always try to be a step ahead. So it’s that anticipation that they’re pricing in,” said Adrianne Yamaki, founder of Strategic Wealth Capital. “They just don’t want to be late.”
Of course, not everyone is ready to jump back into growth stocks, as multiple bank collapses and the plunge in bond yields in recent weeks has spoked some Wall Street pros.
Paul Eitelman, chief investment strategist for North America at Russell Investments, has largely stuck with the firm’s defensive portfolio strategy, which broadly emphasizes exposure to so-called safety sectors like utilities, consumer staples and health care stocks over lofty technology and growth companies whose profit margins are vulnerable to a cooling economy, he said.
“It’s a really a tough environment because volatility is high from the banking stress,” Eitelman said. “The risks of a recession still remain elevated. To get more optimistic on the outlook for stocks from here, inflation would need to significantly cool and we need to see further moderation in wage growth.”
By Jessica Menton