After the exuberance surrounding last Friday's anticipated Federal Reserve interest rate cut, American equities quickly returned to calm on Monday. As the fears of recession that had plagued the market earlier in the month begin to fade, investors are increasingly attuned to upcoming economic data that will provide insights into whether a “soft landing” is feasible for the U.S. economy. Historically, how this narrative unfolds will play a crucial role in determining the future trajectory of the stock market.

Typically, an interest rate cut does not automatically usher in a new bull market. Following signals from the Federal Reserve’s recent meeting minutes about a possible rate cut in September, Chairman Jerome Powell's latest remarks at the Jackson Hole global central bank symposium highlight that a policy pivot may be imminent. Current pricing of interest rate futures indicates a potential 25 basis points reduction in September.

However, a shift in monetary policy does not consistently correlate with the inception of a bull market. This year, for instance, the S&P 500 index has surged approximately 18%, with overall valuations hovering at historical highs. Market participants are now on the lookout for sustained evidence that, with inflation cooling down, economic growth remains robust enough to achieve a soft landing.

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Alessio de Longis, a senior portfolio manager and head of investments at Invesco Solutions, remarked, “The market is certainly eager to hear the news of a rate cut cycle beginning. However, the current concern for the Federal Reserve is how serious their worries about the economy really are. This should prompt differing views on the implications of a rate cut cycle.”

In a recent column, Richmond Fed President Thomas Barkin noted that the current approach of U.S. firms—“low hiring and low firing”—is unlikely to last. He emphasized that if the economic outlook worsens, companies might be forced to consider layoffs. In recent weeks, the Federal Reserve's anxiety regarding the labor market has intensified, with Powell suggesting that rate cuts may be necessary to prevent unemployment from continuing to decline too sharply. “Either demand will remain, and companies will start hiring again, or layoffs will become a reality,” Barkin stated.

Historical trends imply that the stock market tends to perform significantly better when interest rate cuts are implemented in the context of resilient economic growth rather than amidst a sharp economic downturn. The years 2001 and 2007 serve as reminders, as rate cuts during those periods ushered in recessions that led to major adjustments in the stock market. Evercore ISI strategists pointed out that since 1970, the S&P 500 has averaged an 18% increase one year after a first interest rate cut in a non-recession period, whereas the index has only seen a 2% average increase in the first year of rate cuts during recessionary times.

In a report sent to media outlets, UBS reiterated their expectation that the Federal Reserve will likely commence lowering interest rates in September and will follow it up with further cuts in November and December. This perspective is bolstered by findings that rate cuts during non-recessionary periods tend to favor the stock market, leading them to continue advocating for high-quality growth stocks.

Despite such optimism, potential risks and challenges loom ahead. Before the next Federal Reserve meeting, analysts will be closely monitoring three pivotal reports: the Personal Consumption Expenditures (PCE) price index due on August 30, the non-farm payroll report set for September 6, and the Consumer Price Index (CPI) scheduled for September 11.

Following the turmoil that swept through markets after last month’s non-farm payroll report, any further signs of economic weakness could once again unsettle investors, shifting rate cut expectations towards a larger reduction of 50 basis points. Quincy Krosby, chief global strategist at LPL Financial, commented, “The market is hopeful about the onset of a rate-cutting cycle due to decreasing inflation. The pivotal question remains whether we will witness further deterioration in the labor market.”

Moreover, the market is about to enter a historically weaker seasonal phase. According to data from the Center for Financial Research and Analysis (CFRA), September has historically been characterized by poor stock performance, with the S&P 500 averaging a decline of 0.78% since World War II. Should negative news emerge, this could escalate concerns over rising stock valuations which may deter investors from maintaining or acquiring equity positions. As reported by LSEG Datastream, the forward price-to-earnings ratio of the S&P 500 has ballooned back up to 21 times earnings, exceeding the 19.6 times it registered at the beginning of August, and notably higher than its long-term average of 15.7 times.

Notably, a recent analysis by Goldman Sachs revealed that hedge funds have retreated in the wake of the market’s rebound, with fund managers collectively reducing their equity exposure at the most rapid pace since March 2022. Despite the resurgence of the market, overall leverage and net leverage among these funds have both declined thus far in August, indicating that risk appetite has not resumed following the impact of yen carry trade unwinding.

Bruno Schneller, managing partner at Erlen Capital Management, explained, “While the broader market appears optimistic, hedge funds seem to harbor skepticism about the sustainability of the rebound, staying alert to potential headwinds.” This suggests that hedge funds might be pursuing strategies to hedge against downside risks as they await a clearer economic and market outlook. There are concerns that market optimism could be premature, and that deteriorating economic conditions prior to the effects of any interest rate cuts might lead to yet another recession.

Likewise, Andrew Beer, managing director of Dynamic Beta Investments, indicated that many hedge funds may be biding their time, looking for clarity before reinvesting, as some institutions worry about relinquishing gains accrued in the first half of the year. “From a risk-reward standpoint, many hedge funds are currently focused on shifts happening globally. There are plenty of reasons to remain cautious, particularly given the consistently concerning geopolitical backdrop. Economic growth could soon hit a wall,” he warned.