Explainer: How ‘Soft-Landing’ and Stock Performance Correlate

As interest rate cuts become closer, investors are closely watching economic data to assess whether the “soft landing” scenario that has supported U.S. stock performance in 2024 can continue.

Fed Chair Jerome Powell recently signaled an impending reduction in interest rates. The process is expected to begin next month with a 25 basis-point cut during the Fed’s monetary policy meeting on September 17-18.

While this dovish stance was welcomed by investors, it’s not a definitive signal. With the S&P 500 up 18% year-to-date and equities already richly valued, continued evidence of a resilient economy is crucial for a successful soft landing.

Historically, stocks tend to perform better when rate cuts occur during periods of robust growth rather than sharp economic slowdowns. Since 1970, the S&P 500 has seen an average 18% increase one year after the first rate cut in non-recessionary periods.

Key upcoming data points include the U.S. employment report on September 6 (providing insights into job growth) and inflation reports such as the personal consumption expenditures price index (August 30) and the consumer price index (September 11).

Expectations for rate cuts currently stand at around 35% for a 50 basis-point cut and 65% for a 25-basis point cut. The Fed’s response will depend on economic conditions.

While rate cuts are imminent, the market’s focus remains on economic resilience and inflation trends. Investors are navigating uncertain waters, hoping for a smooth landing rather than turbulence ahead.

Current Situation

The S&P 500 has surged 18% this year, but equities are richly valued. Market participants seek evidence that the economy is smoothly transitioning to a soft landing, with resilient growth and cooling inflation.

Fed’s Messages

The market anticipated a rate-cutting cycle, but the Fed’s recent communication raises questions. Is the Fed genuinely concerned about the economy? Perhaps we should reconsider our perspective on rate cuts.

Historical Insights

• Stocks tend to perform better when rate cuts occur during periods of robust growth.

• Since 1970, the S&P 500 has gained an average of 18% one year after the first rate cut in non-recessionary times.

• In recessionary periods, the index only climbed by an average of 2% annually following the initial cut.

Upcoming Data

Investors and market players keep an eye on two critical inflation reports:
• Personal Consumption Expenditures Price Index (Aug. 30)
• Consumer Price Index (Sept. 11)

Market Expectations

If signs of economic weakness persist, stocks may react negatively. Expectations currently lean toward a 25-basis-point cut, but the possibility of a 50-basis-point cut remains. Friday’s pricing indicated around 35% probability for the latter, up from 29% before the recent speech.

Fed’s Approach

Fed is easing despite the economy not being particularly weak. Inflation remains above target, but the Fed has room to ease further if needed due to any acute economic weakness. The critical question for stocks is whether rate cuts are driven by moderating inflation or labour market weakness. Encouraging economic data could support stocks during a potentially turbulent period.

Historically, September is the weakest month for stock performance, with the S&P 500 averaging a 0.78% decline since World War Two (according to CFRA data).

Valuations, Investor Sentiment

Elevated stock valuations may make investors less willing to hold equities in the face of negative news. The forward price-to-earnings ratio for the S&P 500 is currently 21 (up from 19.6 in early August), compared to the long-term average of 15.7 (according to LSEG Datastream).

Political Uncertainty

The tight presidential race between Vice President Kamala Harris and former President Donald Trump adds to uncertainty. Investors should expect choppy, erratic, and volatile market moves as Powell’s intentions become clearer.

Long-Term Trends

Despite short-term fluctuations, the longer-term trends in stocks remain solid, presenting opportunities for exposure.