Podcast: How markets perform when rates are cut

On the latest Investor Download, Duncan Lamont, Head of Strategic Research, takes us through what happens in markets when interest rates are cut.



David Brett
Multi-media Editor
Duncan Lamont, CFA
Head of Strategic Research, Schroders

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You can read a full transcription below:

[00:00:00.580] - Announcer

Welcome to the Investor Download, the podcast about the themes driving markets and the economy now and in the future. I'm your host, David Brett.

[00:00:23.240] - David Brett

Despite markets wobbling after a surprise rise in US inflation, the general assumption remains the Federal Reserve will begin cutting rates this year. So we delved into the data to find out what happens in markets when central banks begin cutting rates. My colleague, Duncan Lamont, Head of Strategic Research, is our guide for this episode.

[00:00:52.190] - Announcer

On Apple Podcasts, Spotify, or wherever you get your podcasts, you're listening to the Investor Download.

[00:00:59.210] - David Brett

Duncan, welcome back to the show. It's been a while. We're in this strange holding pattern. The US Federal Reserve has signalled that there will be rate cuts at some point this year. The original bet from investors was June, but recent data suggests that might not be the case. However, rates are still expected to be cut. I guess what most investors, like me, want to know is what happens to markets when rates are cut?

[00:01:27.240] - Duncan Lamont

We looked at data all the way back to the 1920s, so it's almost a hundred-year horizon. Over that, I think it was 22 interest rate cutting cycles.

[00:01:35.670] - David Brett

It's worth just mentioning here, you're looking at the S&P 500 data and past performance is not a guide to future returns. With that said, what did you find?

[00:01:44.300] - Duncan Lamont

On average, The stock market does pretty well, actually very well, I would say, once the Federal Reserve starts cutting interest rates. The average real return, so that's return in excess of inflation, 12 months after rates start getting cut, is 11%. So 11% ahead of inflation.

[00:02:02.580] - David Brett

So 11% is the real return, which is the total return minus whatever the inflation level is at the time. And 11% ahead of inflation sounds like a lot. How does that compare with other assets?

[00:02:16.300] - Duncan Lamont

Government bonds, corporate bonds, you're about 5 or 6%, cash, about 2%. So on average, investing in the stock market and actually investing in bonds have delivered pretty good real returns, handsomely beating cash in the process.

[00:02:31.770] - David Brett

So according to your research, stocks comfortably outperform fixed income or bonds, and certainly cash when the Fed starts cutting rates. But I presume over those 100 odd years, the reasons for the Fed cutting rates aren't always the same. I mean, for instance, sometimes they've cut rates to try to head off recession, or perhaps because the economy is in recession. So my question is, does the environment in which central banks cut rates affect returns?

[00:02:58.910] - Duncan Lamont

Yeah, so I guess that was those 22 interest rate cutting cycles, that covers a range of different economic backgrounds. Sixteen of those was either the US economy was already in a recession or went into one within 12 months of the rate cutting starting. And that's because often the Fed is cutting rates because it's worried about the economic outlook. Conditions are too weak. We need to actually stimulate. And actually in that situation where it's a recession, equities don't do as well in the rate cutting cycle. But the number, still, I think it was 8% average real return. It's not as good as 11, but it's still a pretty good number. Actually, if a recession is avoided, which is the soft landing narrative that we're hoping to see happen right now, then actually equities do even better. The Fed cutting interest rates right now because they no longer think they have to be so restrictive because inflation is coming under control, playing into that soft landing narrative. The average real return from equities in that environment was actually, I think, about 17% ahead of inflation. Right. But I think the important point here is they do well for recessions avoided.

[00:04:05.810] - Duncan Lamont

But even if one's not, actually, stocks have still done pretty well in a rate-cutting cycle.

[00:04:10.430] - David Brett

That's another compelling case for stocks. But with the markets already near record highs, where else my investors look. That's coming up in part two.

[00:04:19.120] - Duncan Lamont

Get in touch with us by email at schroderspodcasts@schroders.com or visit our website, schroders.com/theinvestordownload.

[00:04:29.900] - David Brett

As we've talked about a few times on this podcast in recent weeks, stock markets have already risen on the expectation of a rate cut. So if we don't avoid a recession, what are investors' options?

[00:04:41.510] - Duncan Lamont

One of the other bits of work that I did was having a look at the degree of concentration in the US. I'm sure everybody, listeners, heard about the magnificent seven of your Apple, Amazon, Alphabets, Meta, Microsoft, NVIDIA, and Tesla. That is seven. I can't count. Although Tesla's performance has tailed off recently. The last year, since the start of 2023, they're up, I think, over 90%, whereas the rest of the global stock market, if you add it all together, is up 20%. They are the power horses of performance. But they now make up more of a global portfolio than the next Five biggest countries added together. Japan, China, UK, France, Canada, seven stocks, five countries. That's quite an astonishing statistic. But when people look at the US and you see the headline valuations, what this means is they look like they're very expensive, but that's a lot because of these seven companies are actually quite expensive. And instead, if you look at valuations of the equal weighted version of the index, which just says we put the same amount in the average company rather than the big companies. Actually, they're not as expensive.

[00:05:47.860] - David Brett

Okay, so you have these huge seven companies that are doing the bulk of the legwork in markets. Of course, we've had the AI phenomenon, too, over the last 18 months, which has added a further leg to that run, and which is why we now see companies like chipmaker NVIDIA as one of the magnificent seven. But what does that mean for investors who might have missed out on those gains that have already been accrued?

[00:06:12.310] - Duncan Lamont

And when we looked historically as well, something It means there's a lot of opportunities to pick up cheaper companies if you decide to do the work. And I looked at historically, if you looked at periods when the US stock market was very concentrated, what did that mean for future performance? And the way I looked at this was looking at the performance of of that market cap weighted index compared with the equal weighted one. You can almost think of this as saying, when we looked forward, periods where the market had been very concentrated, the next five years, the equal weighted version of the index did much better on average, considerably better, suggesting that periods of heightened concentration, it is not a good time just to go out and buy the index and buy the more expensive stocks. It is a much better time to be looking at for pretty much anything that deviates from that benchmark. You can go and pick in your cheap stocks. You can be putting it together in different ways from doing value approaches, other things. But just simply buying the market and buying the index, historically, that would have done far worse than actually other versions which are deviating from it.

[00:07:17.290] - Duncan Lamont

It does really speak to that point about, don't just get taken in by the headline numbers and say every US company is expensive. Lots of them are not.

[00:07:24.840] - David Brett

What you're saying is that there are vast swathes of the market that have missed out on this headline rally. I presume this isn't just a US story. This must be global.

[00:07:35.250] - Duncan Lamont

The data I looked at went back to the '80s, looking at the degree of stock concentration within the US stock market, and then looking at what that meant for future returns. But if we look at actually, over the very long run, the US has been the standout global stock market in terms of performance. It's slightly tricky. There's the advantage that there's more data on the US, so we can run this longer term analysis. However, we do have to be aware that US has historically delivered better returns than other markets, so that's going to influence the outcomes a bit. I guess many people be familiar with what happened with Japan, obviously, when it grew to be a very large part of global stock markets in the '80s, and then went through a more challenging period. What people forget is even before the 2010 period, ex-US stock markets were outperforming US ones. Emerging markets were doing better, Europe were doing better. The past 10, 15 years, the US has consistently done better. It's not always been that way. Actually, when one market or one set of stocks becomes more expensive, the odds of them being able to continue doing that are lower.

[00:08:39.100] - Duncan Lamont

It doesn't mean it can't happen. The US has been expensive, looked expensive for a while. It's almost reassuringly expensive. It's actually managed to keep performing despite being expensive. It's hard to call these turning points, but there's a lot of great opportunities outside of the US that people actually are prepared to look at it.

[00:08:56.970] - David Brett

But not all investors have the time to do the research and or are afraid of investing in international markets. So what happens to returns if they invest when markets are already at all-time highs? That's coming up in the final part of the show.

[00:09:16.340] - David Brett

It's a topic we've touched upon in previous shows, but it's about investors feeling nervous about putting their money into markets when they're already at all-time highs. But since we have our statsman here, Duncan, what does the data tell us?

[00:09:29.930] - Duncan Lamont

I get this. It makes complete sense. It feels uncomfortable to invest when you're reading the headlines about the S&P 500 hitting another all-time high. I think especially if you were thinking about investing maybe last September and you decided not to, and you've seen the market go up since then, to almost get over that hurdle ourselves is quite challenging. What I did is actually I looked at historically returns again back to the 1920s. What would be the 12-month return and the two-year and the three-year return? If you invested when the market was at an all-time high compared with at any other time. So I think if I went and asked 100 people, including many people in the industry, do you think you would get a better return if you invested when the market was at an all-time high, or would you get a better return if you invested when it was at a cheaper level. The intuitive response is, Surely the returns are higher when it's cheaper, but it's wrong. Actually, if you invest when the market was at an all-time high, the average return, just checking my notes here, was 10.3% ahead of inflation over the next 12 months, compared with 8.6 at any other time.

[00:10:34.610] - Duncan Lamont

You were getting a higher return if you invested when the market was at an all-time high.

[00:10:39.690] - David Brett

That sounds counterintuitive, but what you're saying is that you get a higher return even if you've invested at an all-time high.

[00:10:48.350] - Duncan Lamont

Even if you look at over a three-year horizon, also slightly better three-year return if you invest when the market was at an all-time high than when it wasn't. When you step back and think about it, it's It's not quite as counterintuitive as first seems. The market actually, over the long run, goes up over time. What does that mean? It means it's hitting all-time highs on a fairly regular basis. Actually, again, it might It surprise people to hear the market has been at an all-time high 30% of the time. It isn't actually as unusual as you think. Because the market does tend to go up over time, whilst it feels hard, actually, you would have done It's better if you invested when the market was high than if you hadn't. I actually drilled through this a little bit further to look at the questions slightly differently. Let's say you get nervous, you get twitchy when the market hits a high and you say, I'm going to put it in cash, and then I'm just going to wait for a better entry point. A better entry point just means any time at all that the market isn't at an all-time high, and then I'm going to go back into the market.

[00:11:54.620] - Duncan Lamont

So all you're doing is you're saying the very high points, I don't like that. But then I'm maintaining my market exposure the rest of the time. I've looked at this data back to 1926, I think it goes back to, so almost 100 years. So fair enough, that's longer than most people's investment horizon. How much wealth do you think it would have destroyed if you had I need to do that switching strategy? Just saying the market's at high, I'll go into cash, and then I'll go straight back in again whenever it's not. How much do you think that would have cost you?

[00:12:23.600] - David Brett

I don't know, but I feel like you're going to tell me.

[00:12:26.570] - Duncan Lamont

This is a leading question, I guess. But yes, it would have destroyed 90% of your wealth. That's a huge cut to the amount of wealth you could have generated. To everybody who's turning around saying, 100 years is too long, my client is thinking, well, let's look at 10 years, 20, 30 years. Okay, 10-year period, you You'd have destroyed about a quarter of the wealth. 20-year period, you'd have destroyed about a third of the wealth. 30-year period, about 50% of the wealth. Actually, if you're sitting there thinking, I am nervous about the market being high, I'm tempted to be more in cash than shares. One, your average returns would typically have been worse over the next 1-3 years if you'd been in cash. Secondly, if you'd done it over a longer term, that strategy of switching out, you would have cost yourself quite a lot of wealth in the long run.

[00:13:16.140] - David Brett

It sounds like what you're saying is that with rates looking like they're going to be cut and inflation while coming down, still set to remain at a higher level than we've been used to in recent years, I should be putting any spare cash to use rather than sitting on it.

[00:13:32.370] - Duncan Lamont

It's quite simple, actually. If you're sitting in cash waiting for the perfect time to invest, you could be waiting forever. It will always feel uncomfortable putting that cash to work. Actually, probably the thing that I feel most strongly about is actually any knee-jerk reaction of going all in or all out in the market actually is quite a risky thing to think that you can call those tops and bottoms perfectly ever. Actually, a more systematic way of investing consistently over time is going to lead to better long-term returns.

[00:14:06.580] - David Brett

Duncan Lamont, thank you so much for joining us.

[00:14:09.670] - David Brett

That was the show. We very much hope you enjoyed it. You can subscribe to the investor download wherever you get your podcast. And if you want to get in touch with us, it's schroderspodcasts@schroders.com. And you can find out much, much more at schroders.com/insights. New shows drop every other Thursday at 05:00 PM UK time. In the meantime, keep safe and go well.

[00:14:33.840] - Duncan Lamont

The value of investments and the income from them may go down as well as up, and investors may not get back the amounts originally invested. Past performance is not a guide to future performance. The information is not an offer, solicitation, or recommendation of any funds, services, or products, or to adopt any investment strategy.


David Brett
Multi-media Editor
Duncan Lamont, CFA
Head of Strategic Research, Schroders


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