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What’s Next After the Fed’s Rate Cut

Sep 25, 2024

The rate cut could bode well for an economic soft landing, but now companies will need to deliver on ambitious earnings growth. Here’s why.

Author
Lisa Shalett
Lisa Shalett

Key Takeaways

  • The Fed’s highly anticipated rate cut has improved the odds of a soft landing, but economic stability and market growth likely hinge on corporate fundamentals.
  • Companies’ earnings forecasts remain ambitious and depend on rosy predictions for significant productivity gains, which may be difficult to realize.
  • Adding to uncertainty, interest rate cuts may not have as much of a stimulative effect on the economy as anticipated.
  • Consider active stock-picking with a focus on quality U.S. equities in cyclical and defensive sectors.

When the U.S. Federal Reserve cut its benchmark interest rate by a half-point last week, it began a rate-cutting cycle that follows one of the most aggressive rate-hiking cycles in decades. While relieved equity investors pushed the S&P 500 Index to a new all-time high, and even as the rate cut boosts the likelihood of an economic soft landing, the question remains: What’s next?

 

Corporate fundamentals may hold the key. Morgan Stanley’s Global Investment Committee sees economic stability as well as market growth increasingly hinging on companies’ ability to meet earnings expectations – but these are already ambitious. Consider this:

 

  • Earnings are estimated to grow about 13-14% through the end of 2025 — roughly double the normal year-over-year pace.
  • Specifically, the Magnificent 7 mega-cap tech stocks are expected to see their earnings growth decelerate, to about 15-18%, while the other 493 companies in the S&P 500 are expected to boost their profit growth rate to about 10-11%.
  • Those earnings gains are expected to come from expanding margins. Estimates imply margins for the S&P 500 will increase to an all-time high of 17.8% by the end of 2025, up from 13.5% last year.

Underlying Assumptions

Is such extraordinary margin expansion realistic, and where would it come from? Investors are tying the expansion to productivity gains, rather than cost-cutting efforts.

 

At first glance, it may be an easy case to make. Capital spending since the pandemic remains above average and has been accompanied by government-linked investments in infrastructure, clean energy, semiconductor competitiveness, and supply-chain realignment. In addition, investors hope that integrating generative AI into business operations could boost productivity across a wide range of sectors. 

Wealth Management

Up Next, the Earnings Rebound?

The Fed delivered its first rate cut of the cycle, with a half-point opening move. What comes next? Here's what investors should be thinking about especially amid lofty market expectations.

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In fact, economy-wide productivity has improved, with U.S. labor productivity increasing 2.5% in the second quarter, versus the annualized rate of 1.6% over this current business cycle starting in late 2019. However, it remains to be seen whether capital expenditures or new technology can unlock the additional productivity required to achieve the market’s lofty expectations for margin growth.

 

Similarly, even as layoffs remain benign, especially considering the continued softness in manufacturing data, job openings have now normalized to pre-pandemic levels. It’s an open question whether companies can achieve additional productivity gains without job cuts.

Limits of the Fed Rate Cut

Potentially complicating the picture for the economy moving forward is its relative lack of sensitivity to changes in interest rates during this cycle. For instance, the rate hikes of the last few years should, in theory, have had a restrictive effect on spending or incomes, but in aggregate they haven’t quite had such an effect.

 

Now, on the flip side, reductions in interest rates may have less of a stimulus effect on the economy than anticipated. For example, corporate debt burdens are modest and the average cost of capital for the largest borrowers remains at just about 4%. Since that is already lower than the new benchmark interest rate of 4.75-5%, it is likely to limit the effect of the initial rate cut. In addition, the housing market remains relatively frozen, as the majority of homeowners either own their homes outright or hold mortgages with rates below 4%. Rate cuts may do little to motivate homeowners to sell or new buyers to borrow when a 30-year mortgage is still pricing well above 6%.

What Should Investors Do Next?

Now that the drama surrounding the timing and amount of the Fed’s first rate cut has been resolved, the power of macro dynamics to singularly drive the market has diminished. Corporate fundamentals will now need to come into sharper focus, though expectations there are already ambitious.

 

Given this backdrop, investors should consider reducing ultra-short and money market positions in favor of locking in longer-dated rates. The equal-weighted S&P 500 Index may provide better risk-adjusted exposure than its market-cap-weighted counterpart. As for sectors, we continue to find compelling opportunities in financial services, industrials, energy, healthcare and materials, as well as parts of technology such as software. Look for defensive ideas in residential REITs and utilities, while also considering non-U.S. assets.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from September 23, 2024, “Up Next, the Earnings Rebound?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report. 

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Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market.  Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds.  High yield bonds should comprise only a limited portion of a balanced portfolio.

Ultrashort-term fixed income asset class is comprised of fixed income securities with high quality, very short maturities. They are therefore subject to the risks associated with debt securities such as credit and interest rate risk.

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.

REITs investing risks are similar to those associated with direct investments in real estate: property value fluctuations, lack of liquidity, limited diversification and sensitivity to economic factors such as interest rate changes and market recessions.

Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets and frontier markets, since these countries may have relatively unstable governments and less established markets and economies.

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Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Health care sector stocks are subject to government regulation, as well as government approval of products and services, which can significantly impact price and availability, and which can also be significantly affected by rapid obsolescence and patent expirations.

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