The Fed starts strong with rate cuts

The U.S. Federal Reserve started the cycle of cutting interest rates today, by lowering the policy rate by 50 basis points and setting up several more cuts for later this year.

What happened?

The Federal Reserve cut interest rates by 50 basis points (bps) at today’s meeting, exceeding market expectations. The Fed’s dot plot of rate expectations showed additional cuts are expected later this year and into 2025, though fewer than markets had expected. Overall, this dovish decision and hawkish rates guidance resulted in a modestly dovish takeaway.

In the policy statement, the Fed downgraded the language around the labor market, saying that “job gains have slowed” rather than “have moderated.” On inflation, the committee added a sentence saying it has “gained great confidence that inflation is moving sustainably toward 2 percent.” Instead of saying that the risks “continue to move into better balance,” the statement asserts that the risks “are roughly in balance.”

The summary of economic projections also showed a worse employment outlook and a better inflation forecast. The unemployment rate is now expected to rise to 4.4% this year, up from 4.0% previously. Core PCE inflation is forecast at 2.6% rather than 2.8% previously. As a result of this shift in the outlook toward weaker employment and better inflation, the FOMC now expects another 50 bps of rate cuts this year, on top of today’s 50 bps cut. Next year, the dot plot pencils-in another 100 bps of rate cuts, the same as in June.

In his press conference, Chair Powell leaned hawkish, somewhat offsetting the headline dovish cut. He explicitly said that 50 bps increments are not “the new pace” for the cycle, and that they will continue to “make decisions meeting by meeting.” Powell left the door open to future 50 bps moves, saying “we can go quicker if that’s appropriate, we can go slower if that’s appropriate.”

Ultimately, we expect the Fed to continue cutting rates at every meeting through the middle of 2025, though we expect all of those cuts to be in 25 bps increments. We still view the terminal rate of the cutting cycle at 3.25%-3.50% and now think that will be achieved in June, rather than July, of next year.

Economic data shows further modest slowdown

Overall U.S. economic growth has continued its recent trend, with growth slowing steadily but not collapsing. While the labor market has deteriorated more notably, consumer spending remains robust and supports the expansion. 

Since the last FOMC meeting, employment data has weakened more substantially. The unemployment rate rose to 4.2%, while headline job creation slowed to a three-month pace of +116,000 per month. Both measures are now markedly weaker than pre-Covid levels. Other indicators – including the number of job openings, the quits rate and the hiring rate indicators – have continued to weaken. Nevertheless, layoffs remain very low, which has insulated the labor market from a worse outcome.

On the inflation front, progress toward the 2% target continues, although it has been uneven. While the overall trend for core inflation is much improved versus the first quarter of the year, the most recent data showed a slight uptick in shelter inflation and other core services. Forward-looking indicators still point to improvement ahead, and with the labor market now producing softer wage inflation, we expect the disinflationary trend to continue.

Despite the weaker pace of job creation, consumer spending remains robust. Core retail sales are still running almost +4% year-over-year, and other measures of consumer spending remain strong. After expanding at an annualized pace of 1.5%-3.0% in the first half of the year, overall consumption is set to end the third quarter at a similar pace.

Looking ahead, we expect economic growth to slow in the quarters ahead. Underlying growth, which has already declined from more than 3% last year to around 2.75% in the first half, should continue to moderate toward 2% over the rest of 2024. We also expect further progress on inflation, with steady Fed rate cuts supporting economic activity and avoiding a recession.

What does this mean for investors?

With the Fed now cutting rates and the economic outlook pointing toward slower but still-healthy growth, we believe investors should position somewhat more defensively. However, it should still pay to have exposure to risk assets over the coming quarters.

In equities, volatility has picked up recently. We expect that dynamic to continue, given worries about economic growth and heightened uncertainty ahead of the U.S. elections. This backdrop favors defensive equities, especially dividend growers, which offer more attractive valuations and have historically been less volatile relative to the overall stock market.

Additionally, dividend growers have historically been an effective diversifier of large cap growth stocks, the largest allocation in many investor portfolios. With inflation improving but still above-target, we are focused on companies with a combination of capital flexibility and balance sheet strength within the dividend growth space. These companies should be able to mitigate inflationary input cost pressures, thereby maintaining or even expanding profit margins – ultimately a plus for shareholders.

Away from equities, municipal bonds are having a strong year and remain one of our favorite asset classes in the current market environment. We’re particularly constructive on high yield municipals, which have returned +6.5% year-to-date through August, as measured by the Bloomberg High Yield Municipal TR Index. With a taxable-equivalent yield of 8.9% (for those in the top income tax bracket), high yield munis offer an attractive source of income.

With rate cuts now started, investors with large cash allocations have the opportunity to rotate into fixed income sectors to lock in attractive starting yields, if they haven’t already done so. Cash yields are poised to decline as the Fed lowers its policy rate.

Meanwhile, the municipal yield curve is positively sloping, and investors are being rewarded for extending duration. High yield munis generally have longer durations than their investment grade counterparts, allowing investors to take advantage of higher yields further out on the curve.

The current municipal landscape is built on a solid foundation. About 75% of the high yield municipal bond index, for example, is made up of higher- quality (BB rated) issues. Default rates for these BB rated municipals roughly equal those of investment grade (BBB rated) corporate bonds. This attractive fundamental backdrop is complemented by favorable supply and demand factors. According to Lipper, high yield muni fund inflows totaled $9.9 billion year-to-date through August. That amount represents more than 50% of all municipal fund flows in 2024, exceeding the typical 15% to 20%.

In taxable fixed income, we suggest taking advantage of higher-income sectors like preferreds, high yield corporates and areas of securitized products. Within these asset classes, we favor an up-in-quality bias, e.g., BB- and high-B rated corporates within high yield. While Fed rate cuts may help the cash flows of more distressed, CCC rated companies, we are cautious about downside risk in a slowing economy. With yields ranging from 6%-7%, higher-rated high yield corporates provide plenty of income, which investors may lock in today before cash yields drop more sharply as the Fed cuts rates.