Shares and bonds typically perform strongly when interest rates start to fall

Data analysis shows equities (shares) can perform particularly strongly in the periods after interest rates start to fall, even if this isn’t always the case. This conclusion follows on from my analysis of investment returns in the 22 periods of US interest rate cuts that took place since 1928. As the table below shows, average US equity returns beat inflation by 11 percent in the 12 months after US central bank the Federal Reserve (Fed) began to cut rates.

Inflation can pose a problem for investors. Inflation measures how much prices rise for goods and services. If goods and services become more expensive – in other words, if inflation rises – then we can buy less with our savings and investments. So inflation can erode the real value of investments.

Against this backdrop, the average inflation-beating returns of US equities in these 22 periods is reassuring. The table below shows equities have, on average in these periods, also performed more strongly than corporate bonds (with 6 percent average above-inflation returns), government bonds (with 5 percent average above-inflation returns) and cash (with 2 percent average above-inflation returns).

Investors should be mindful though that past performance is not a reliable indicator of future performance. Even so, investors may gain some comfort from the fact that all these types of investment assets beat inflation on average in these periods.

Above-inflation performance of equities, bonds and cash in the 12 months after the start of US interest rate cuts

Source: Schroder Investment Management, 30 January 2024. Table shows 12-month above-inflation returns from the date of the first interest rate cut. *Indicates a recession took place within 12 months of the first interest rate cut.

In 16 of the 22 periods, the US economy was either already in recession when interest rate cuts began or entered one within 12 months (recession dates are asterisked in the table above and shaded in the chart below). In these periods, average above-inflation equity returns were higher if a recession was avoided, at 17 percent, but they averaged 8 percent even when there was a recession.

So, historically, recessions were not on average accompanied by negative equity returns at times of falling interest rates. Far from it, in fact. Even so, there have been significant exceptions, most notably in 1929 and 1973, when equities fell dramatically. But the simple truth is the impact of recessions is generally felt most intensely by those who are directly affected by them, perhaps through job losses.

US interest rates and recessions since 1928

Source: Schroder Investment Management, 30 January 2024. Dots show when rates started to be cut, shaded areas represent recessions.

In contrast to equities, bonds often do better if a recession occurs when interest rates are falling, as investors can turn to the security of government-backed bonds in more uncertain economic times. This drives their prices higher and their yields lower (bond yields fall when bond prices rise). But they’ve also performed positively when a recession was avoided. Corporate bonds have, on average, performed more strongly than government bonds in the non-recessionary periods of interest rate falls.

Overall, the range of historic returns is wide for equities and bonds. But both have generally shown returns significantly above inflation when the Fed starts to cut interest rates, although again this is not always the case.

Current outlook

Could this tell us something about today’s markets? The Fed has, since March 2022, been raising interest rates in order to bring down high inflation. But inflation has now fallen significantly and the Fed is currently considering cutting rates from the current 5.25 percent target rate.

Fed chair Jerome Powell said ‘If the economy evolves as projected … the appropriate level of the federal funds rate will be 4.6 percent at the end of 2024, 3.6 percent at the end of 2025, and 2.9 percent at the end of 2026’ (1).

Significantly, Powell said the Fed anticipates economic growth to fall from an expected 2.5 percent in 2023 to 1.4 percent in 2024. If these economic projections are right, then we could expect to see an economic slowdown in the US rather than a recession. And my historical analysis suggests such a period of falling interest rates and non-recessionary economic conditions could have the potential to benefit equities.

Steve Mann, Head of Investment Specialists at Schroders Personal Wealth (SPW), said: ‘This could be a favourable backdrop for equities. Even so, markets are never fully predictable in the short term. At SPW, we favour a long-term approach to investing, in line with an investor’s approach to investment risk. As I often say: investing is about spending time in the markets, rather than trying to correctly time the markets.’

Source

Federal Reserve (www.federalreserve.gov), ‘Transcript of Chair Powell’s Press Conference, December 13, 2023’, 13 December 2023.

This is a revised version of an article published on the Schroder Investment Management (SIM) website on 30 January 2024.