What is the impact of the Federal Reserve's interest rate cuts on the stock market? How should investors select stocks during a rate-cutting cycle?

September 18, the Federal Reserve announced its first 50 bps rate cut, lowering the federal funds target range to 4.75% to 5.00%. This is the Fed’s first rate cut since 2020, marking a formal shift from a tightening cycle to an easing era. The 50 bps cut exceeded market expectations and drew widespread attention from global investors.

Once the rate cut begins, will the US stock market usher in a new bull run or face new risks? The answer is more complex than it seems. This article will analyze the multi-dimensional impact of rate cuts on the stock market, review the evolution of the Fed’s rate cut cycles since the beginning of this century, and explore which industries and stocks are most likely to gain excess returns in an environment of easing.

Why did the Fed initiate the rate cut engine?

The Fed’s decision to cut rates usually implies concerns about economic prospects. What are the real reasons behind this rate cut?

Labor market signals red flags. The unemployment rate rose from 3.80% in March 2024 to 4.30% in July, after four consecutive months of increases, triggering a “recession warning” among economists. Although it slightly retreated to 4.20% in August, the overall upward trend remains clear. This weakening employment market typically indicates a slowdown in economic growth.

Manufacturing sector continues to contract. The ISM Manufacturing PMI has been below 50 for five consecutive months, reflecting significant weakness in manufacturing activity. As a result, the Fed lowered its GDP growth forecast for this year from 2.1% to 2.0%.

Comprehensive signals from economic data. The labor market is shifting from relative balance to easing, manufacturing investment momentum is insufficient, and various signs point to a further slowdown in economic growth. Based on these real data, the Fed adopted a dovish stance and initiated rate cuts.

Generally, central banks consider lowering rates in situations such as: slowing economic growth, rising unemployment, to stimulate recovery; falling prices and emerging deflation risks, to increase money supply; financial market turbulence and tight credit conditions, to provide liquidity; external economic pressures, to enhance resilience; or during special shocks like pandemics or natural disasters, to support economic recovery.

Impact of rate cuts on the stock market: not a simple bullish or bearish logic

Many investors often make the mistake of equating rate cuts with stock market rises. In fact, historical data contradicts this simplistic idea.

According to Goldman Sachs analysis, since the mid-1980s, the Fed has implemented 10 rate cut cycles. Four of these were associated with recessions, while six were not. The key difference is: when the Fed successfully prevents a recession, stocks tend to rise; when a recession occurs as expected, stocks mostly decline. In other words, rate cuts themselves are not decisive; the decisive factor is whether rate cuts effectively prevent a recession.

The market currently expects a “soft landing” for the US economy. However, some analysts warn of risks including rising energy costs, potential port strikes, and global geopolitical conflicts, which could cause economic challenges to exceed expectations.

What do market participants think? According to the latest MLIVPulse survey, with the Fed continuing rate cuts, 60% of respondents are optimistic about US stocks in Q4, 59% prefer emerging markets over developed markets, and they are starting to avoid traditional safe-haven assets like US Treasuries, the US dollar, and gold.

The true picture of the four Fed rate cut cycles this century

To understand the current rate environment, reviewing historical experience is crucial.

2001-2002: Dot-com bubble burst, rate cuts failed to save

In early 2001, facing slowing growth and the bursting of the tech bubble, the Fed began cutting rates. However, corporate earnings expectations were lowered, and tech stock valuations were inflated, leading to a collapse in market confidence.

During that crash, Nasdaq plunged from 5048 in March 2000 to 1114 in October 2002, a decline of 78%; S&P 500 fell from 1520 to 777, a drop of about 49%. Despite rate cuts, investor pessimism about the economy dominated the market.

2007-2008: Financial crisis rages, limited effect of rate cuts

Between 2004-2006, the Fed gradually raised rates to 5.25% to curb housing overheating. But in September 2007, the subprime crisis erupted, severely damaging the banking system and freezing credit markets. The Fed quickly shifted to rate cuts but found the economy already mired in recession—unemployment soared, bankruptcies surged, and consumer spending collapsed.

The effectiveness of rate cuts was weak in the face of the crisis. The S&P 500 plummeted from 1565 in October 2007 to 676 in March 2009, a nearly 57% decline; Dow Jones dropped from 14,164 to 6,547, a 54% fall.

2019: Preemptive rate cuts turn the tide

This time was different. In July 2019, the Fed cut rates preemptively due to slowing global economy and trade uncertainties, not waiting for recession.

The key was timing. The rate cut signals were seen as “support for continued economic expansion,” greatly boosting investor confidence. Meanwhile, corporate earnings remained stable, especially in tech, and US-China trade negotiations made progress.

As a result, the S&P 500 rose 29% for the year, from 2507 to 3230; Nasdaq surged 35%, from 6635 to 8973. This rate cut triggered a genuine bull market.

2020: Unconventional rate cuts amid pandemic

COVID-19 caused a sudden halt in economic activity, with the S&P 500 plunging from a high of 3386 in February to 2237 in March, a 34% decline. The Fed swiftly launched two emergency rate cuts in March, bringing rates to 0-0.25%, and initiated quantitative easing.

Massive monetary and fiscal stimulus injected liquidity, and the pandemic accelerated digital transformation, benefiting tech companies. As vaccines advanced and recovery expectations grew, markets rebounded quickly. The S&P 500 ended the year at 3756, up 16%; Nasdaq gained 44%, ending at 8973.

Comparison of stock market performance after past rate cuts

The table below clearly shows the stock market performance and economic trends within 12 months after the start of each of the four rate cut cycles:

The logic behind the table is: rate cuts alone cannot reverse a recession, but preemptive, targeted rate cuts combined with stable corporate earnings can bring about a bull market.

Which industries benefit most during rate cut cycles?

Different industries perform very differently in an easing environment. Investors should choose based on their risk preferences.

Tech industry: biggest beneficiary of rate cuts. Historical data consistently shows tech stocks perform best during rate cut cycles. Low interest rates increase the present value of future cash flows for tech companies and significantly reduce financing costs, enabling more R&D and expansion.

In the 2019 rate cut cycle, tech stocks gained 25%; in 2020, they surged up to 50%. In contrast, during 2001 and 2007 recessions, tech stocks fell 5% and 25%, respectively.

Financial sector: short-term pressure, long-term depends on economy. Initially, rate cuts compress bank net interest margins, hurting profits, and financial stocks often underperform. But as economic recovery expectations rise, financials tend to rebound. During recessions, financial stocks fell sharply (2007 down 40%), but in stable growth periods like 2019, they rose 15%.

Consumer discretionary and healthcare: stable growth sectors. Healthcare and consumer non-durables tend to show steady growth after rate cuts. Increased consumer spending and active investment benefit these sectors. Historically, they rarely experience large declines.

Energy sector: most uncertain. Rising economic activity boosts energy demand, but oil price volatility and geopolitical factors make this sector highly variable.

Industry performance 12 months after rate cuts

Investment tips: During recessionary rate cuts, adopt a bearish view; in preemptive rate cuts with stable earnings, tech and consumer stocks are the main beneficiaries.

Key observation windows remaining in 2024

The Fed cut rates by 50 bps on September 18. What is the next pace of rate cuts?

According to the FOMC( meeting schedule, there are two important meetings in 2024: November 7 and December 18. Fed Chair Powell stated on September 30 that the Fed is “not in a hurry to cut rates quickly,” and may cut twice more this year, totaling 50 bps.

Market expectations: The Fed will cut rates by 25 bps each in November and December. This means by the end of 2024, the federal funds rate will be in the 4.25%-4.50% range.

Investors should closely monitor economic data before these meetings, especially unemployment, inflation, and manufacturing indicators, as they will directly influence the Fed’s rate decision.

The dual nature of rate cuts: benefits and risks

Economic benefits of rate cuts are clear: lower borrowing costs encourage consumers and businesses to borrow, boosting consumption and investment. Large purchases like homes and cars become cheaper, stimulating demand. Debt servicing costs for households and firms decrease, improving cash flow. Low rates inject liquidity into the financial system and reduce crisis risks.

However, rate cuts also have obvious drawbacks. Excessive easing may trigger overconsumption and overinvestment, pushing up prices and causing inflation. Low interest rates can inflate asset bubbles, which may burst and trigger financial crises. Additionally, encouraging borrowing can lead to excessive household and corporate debt over the long term, increasing systemic vulnerabilities.

Investors should enjoy the liquidity benefits of rate cuts but remain vigilant about hidden systemic risks.