What if the plane we’re trying to land is only a connecting flight?

The past year in financial markets has caused many investors to scratch their heads. Equity markets continued to climb a wall of worry in the face of a widely expected recession in the US. In 2023, we quickly re-learned that the economy and the stock market are not tethered at the hip but operate independently.

In 2024, market participants again overestimated interest rate cuts at the start of the year. However, various global central banks, including the Bank of England (BoE) and European Central Bank (ECB), have finally cut interest rates after many months of holding steady. Now all eyes are on the US Federal Reserve (Fed) and its Chair, Jerome Powell, for a move which will influence policy for many other central banks, including the South African Reserve Bank (SARB). According to Bank of America Global Research, 2024 has aptly been named ‘The Year of the Landing’.

 What does the ‘landing’ talk really mean?

• Soft landing

According to an article on US financial news website The Street.com, a soft landing’ may be regarded as a way to tame inflationary pressures while avoiding a recession. The Street’s analogy paints the picture: ‘Imagine that the pilot is the US Fed and the aeroplane is the US economy. Interest rates are the landing gear — they must be steered correctly to ensure safety, all the while battling headwinds such as volatility, negative investor sentiment, and even capitulation’. Alan Greenspan (the 13^th Chairman of the US Fed) achieved the elusive ‘soft’ landing in 1995.

• Hard landing

Investopedia defines a hard landing as a marked economic slowdown or sharp downturn following a period of rapid growth. Economies that experience a hard landing often slip into a recessionary period. US Fed Chair Paul Volcker dealt with inflation in the 1970s by raising interest rates, but at the expense of back-to-back recessions in 1980-1981 and 1982.

• No landing

The chief economist at Ned Davis Research told CNBC, ‘No landing means above-trend growth, and also above-trend inflation’. He was describing an economy that is ‘overheating’.  The senior economist for the American Institute for Economic Research, referring to the US, said: ‘For example: if economic growth were to continue at or above trend, but inflation failed to return to the 2-2.25% annualised rate range, it could be viewed as a no-landing environment’.

What landing are we heading for?

Predicting economic direction has been historically almost impossible, but global fund managers seem to be leaning toward a soft landing. In the latest Bank of America Survey, 76% of fund managers indicated they expected a soft landing. However, a McKinsey Global Survey on economic conditions paints a different picture. Respondents were more likely to predict a near-term recession at the end of the second quarter than in the previous quarter.

Figure 1: What is the most likely outcome for the global economy in the next 12 months (%)?

Source: Bank of America Global Research, 2024

Given such contrasting views, it’s crucial that you do not direct your investments dogmatically in line with your economic forecast.

How do the S&P 500 and JSE perform when the US Fed starts cutting rates?

On 23 August 2024, the CME Fed Watch Tool[1] was pricing in a 67.5% and 32.5% chance of a 25 and 50 basis point rate cut respectively at the US Fed’s September meeting. With markets already anticipating cuts, we took a closer look at the historical patterns of rate reductions in the US.

Since 1928, the US Fed has initiated 22 rate-cutting cycles, and in 16 of them, the US economy was either already in a recession when the cuts began or entered one within 12 months, according to a long-term analysis conducted by Schroders.

In simple terms, in previous cutting cycles, there was a 72.27% association with a recession, so you cannot automatically assume that cutting cycles results in recessions. More importantly, history also shows that recessions are not always to be feared – although there are notable exceptions.

To gain further insight, we analysed previous rate-cutting cycles since 1970 to see how returns have varied in different scenarios.

Figure 2: S&P 500 performance 18 months after first US Fed rate cut

Source: Bloomberg, IRESS, Sanlam Investments Multi-Manager 2024* Indicates that the US was in a recession when cuts begun or entered one within 12 months, dates provided by Schroders.

The data above shows that markets tend to continue their trend if interest rates are cut without a recession, but outcomes are wider during recessionary periods as each recession has its own nuances.

To gain further insights into the US Fed cutting cycles, we examined how the JSE All Share Index has performed historically over the same period, and whether it was consistent with the data observed in the US.

Figure 3: JSE All Share Index performance 18 months after first US Fed cut

Source: Bloomberg, IRESS, Sanlam Investments Multi-Manager, 2024* Indicates that the US was in a recession when cuts begun or entered one within 12 months, dates provided by Schroders.

Recently, the Sahm’s rule[2] was triggered. Many economists are asking whether the indicator’s track record in predicting that the economy is currently in a recession will be maintained.   Economist Claudia Sahm, who founded the Sahm rule, has also recently warned that there should not be an over-reliance on her measure, due to the changing employment dynamics post Covid.

When looking at past recessions (including recessions not in a cutting cycle) from 1948, the data below indicates that equity markets fall to reflect the economic environment, but then recover as the economic environment changes. It is important to understand that economic data is backward-looking, while financial markets price for the future, so markets tend to recover well ahead of economic metrics.

Figure 4: S&P 500 returns around recession

Source: Yahoo Finance, 2024

How do South African equities perform when the SARB starts cutting rates?

Firstly, we observed how the JSE All Share Index has performed, with mostly positive sloping graphs shown below. While the data set below is not as comprehensive as that available for the US, it’s still useful to see whether the same relationship holds between equity market performance and interest rate cuts. In three of the four interest rate cutting cycles below, South African equities ended higher 18 months later.

Figure 5: JSE All Share Index performance 18 months after first SARB cut

Source: Bloomberg, IRESS, Sanlam Investments Multi-Manager 2024* Indicates that the US was in a recession when cuts begun or entered one within 12 months.

The table below displays further insights into how other asset classes performed since 2002 when the SARB cut rates.

Table 1: 12-month returns across South African asset classes

Source: Morningstar, Sanlam Investments Multi-Manager 2024 *Indicates that the US was in a recession when cuts begun or entered one within 12 months.

On average, South African equities and cash seem to react more positively to rate cutting cycles relative to the US. Domestic bonds lagged US bonds on average, but still produced a positive return. Domestic listed property was the only asset class to deliver a negative return on average.

Does the SARB follow the US Fed or vice versa?

Many economists continue to debate whether the SARB waits for the US Fed to cut rates first, and then follows. Historically, the SARB and US Fed rates have followed the same direction, but in different magnitudes. While they appear to follow each other, there is no automatic causal relationship between the two. In the past 22 years the SARB deployed four cutting cycles, while the US Fed lagged with two.

Figure 6: Fed funds rate vs Repo rate (2002 – 2024)

Source: Bloomberg, IRESS, Sanlam Investments Multi-Manager 2024

Both the US Federal Open Market Committee (FOMC) and South African Monetary Policy Committee (MPC) meetings will occur a day apart in September. The base case is for rate cuts. The outcome of these meetings could be expected to reflect the symmetry shown above, as expressed by current interest rate futures markets.

While recessions are often viewed with apprehension, history shows that stock market investors have not always had reason to fear them over time.

Historically it has proved incredibly challenging to forecast the approaching economic environment, the subsequent policy response, the speed and magnitude of asset price moves, and the date when markets will touch bottom. Instead of spending time guessing any of these variables, we believe it’s more important to continue to hold a robust portfolio which can weather any storm and still continue to serve the long-term objectives of investors. We will continue to manage risk, and as always, please keep your seatbelt loosely fastened in the event of turbulence.

[1] The CME Fed Watch Tool analyses the probability of FOMC rate moves for upcoming meetings. It uses 30-Day fed funds futures pricing data, which has long been relied upon to express the market’s views on the likelihood of changes in US monetary policy.

[2] Sahm’s Rule: A recession is probably under way if the three-month moving average of the national unemployment rate rises by 0.5 percentage points or more relative to its low during the previous 12 months.