The Federal Reserve is poised to lower interest rates at its September 18, 2024, meeting. Lower interest rates should stimulate economic growth—eventually. Before the U.S. economy feels the benefit of lower rates, however, it will first be exposed to a greater risk of recession.
Lower interest rates could both help and hurt the U.S. economy, depending on the pace, magnitude, and expected path of each. In April 2024, I described how higher interest rates are helping the economy by increasing the incomes of fixed-income and money-market investors. Lower interest rates could initially harm the economy by directing it onto a “J” path. The initial slope of the letter “J” is downward, then it bases out before accelerating upward.
Lower rates Immediately reduce the income of fixed-income investors, especially those holding money-market funds. There is an estimated $6.4 trillion in higher-yielding money-market funds.
That is a record high and double the cash typically held in higher-yielding money-market funds over the previous 30 years. Cutting interest rates means cutting the income of households that hold these funds.
The Schwab Value Advantage Money Fund yields about 5.12 percent, which is approximate to the federal funds rate set by the Federal Reserve. If the Fed cuts rates by one-quarter percentage points (AKA 25 basis points, or 25 bps), that cuts the yield by nearly five percent. As an analog to that reduction, it is as if your employer were paying you $100,000, and then they cut your salary to $95,000. Of course, most households have other sources of income, so let’s view that impact another way.
The income on $6.24 trillion of money-market funds is about $325 billion annually. Each 25-bps cut reduces income by $16 billion. In a world where we now talk about trillions of dollars, that may not seem like much at first blush, but it is.
According to the CME FedWatch Tool, there is a 96 percent chance that the Fed will cut rates by at least 150 bps through 2025. A 150-bps yield reduction on $6.24 trillion of assets equates to $96 billion less income. That is roughly the budget of New York City. Now, think about how the economy might respond if NYC stopped paying its bills. It becomes more apparent that lower interest rates could initially hurt the economy as it descends the initial slope of the “J” path.
There are also behavioral considerations for consumers and businesses. Suppose the Fed cuts rates in September 2024. The consensus is for at least six more rate cuts through 2025. If a company is looking to expand, does it invest in plants, property, and equipment now, or does it wait a while and let the cost of capital come down? It probably waits a while. If your family is looking for a new car or a house, do you buy those now or wait until they are more affordable? You probably wait a while. Stalled investment and consumption slow the economy.
Eventually, those considerations will bottom out at the lower part of the “J” path. On the other side of that curve is the upward slope. That is when businesses and households have either waited as long as they can, the cost of debt has bottomed, or both. At that point, lower interest rates help the economy.
Small companies finance their operations through bank loans; lower interest rates will reduce their debt burden. That lower cost of capital allows those businesses to expand and hire the workers they need. Households become more active consumers when rates are lower because they can afford more.
The economy is not the stock market
Despite the counterintuitive economic headwinds created by lower interest rates, equity prices can potentially move past the initial downward slope of the “J” path and toward the upside.
The Fed has reinstated a “put” on asset markets as they have made it clear that the time has come for a monetary policy change that supports the labor markets.
The “Fed put” is a term used to describe how the Federal Reserve intervenes to support the stock market—directly or indirectly—as it aims to support the economy. The Fed put is broadly supportive of the stock market, with an emphasis on the financial services sector. Asset management, lenders, credit card processors, and even insurance companies that invest their premiums into equity are sub-sectors of the financial sector that should perform well.
Before the U.S. economy benefits from lower interest rates, it could slow or contract. While economic slowing occurs, some stock market sectors can perform more favorably, likely at the expense of industries that have run ahead of themselves.
A crude way to determine if a sector is overbought is to consider its weighting within the S&P 500 Index. The historical weighting of the technology sector in the index has been 19.86 percent since 1980. It is over 32 percent today. There are fundamental reasons why the weighting should be well above 20 percent (the hierarchy of revenue, the shape of the U.S. economy today versus yesterday, and the momentum of the best management migrating to well-funded mega-cap tech companies). Getting from 32 percent of the index to 35 percent or 40 percent (i.e., outperforming the index) means a lot is going right in both the economy and the stock market. If that is the case, investors can still make money with potentially less risk by diversifying holdings away from technology stocks.
In contrast, the historical weighting of the financial sector in the S&P 500 has been 14.42 percent since 1980. (In 2016, the real estate industry was separated from financials. The weighting of the financial sector up until then was approximately 15 percent.) Today, the financial industry is about 12.6 percent of the S&P 500 (15 percent if you include real estate stocks). That is not a discount; in fact, financial stocks are trading at a higher price-to-earnings (P/E) valuation than their 10-year average.
The financial sector’s P/E is 15.4, versus its historical average of 13.3. The technology sector’s P/E is 29.4, versus its historical average of 20.8. Despite their valuations, I like both industries. At the expense of my technology allocation, I have been putting more of my portfolio into the stocks of financial companies, as they are primed to benefit from lower interest rates on the other side of the “J” path.
Allen Harris is an owner of Berkshire Money Management in Great Barrington and Dalton, managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
