The Fed “Recalibrates” to Buy Some Insurance—CIO Weekly Perspectives

By Joseph V. Amato, President and Chief Investment Officer—Equities

Rate-cutting cycles have tended to favor risk assets, so it was gratifying to see the central bank get started with a meaningful move.

Last week’s rate cut from the U.S. Federal Reserve (Fed) was not only the first of this cycle, but the most suspenseful in a decade and a half.

Generally, interest-rate markets price decisively for the size of the move they expect from the Fed well ahead of the announcement, and most of the time they are correct. This time, however, markets were evenly split between 25 and 50 basis points right up to the wire, and usually well-informed members of the press offered no clues.

But for all the suspense and debate about what 50-versus-25 implies about the state of the economy, the simple fact that we have had a rate cut is the most important thing, in our view. It amounts to one of the most critical—and positive—inflection points for long-term investors.

Struggling Smaller Companies

Here at Neuberger Berman, opinion on the Fed cut was split just as it was in the rest of the market.

While many on our Fixed Income team thought the Fed should cut by only 25 basis points, they also suspected 50 was where things would fall out. It would make up for missing the opportunity to cut in July and enable some catch-up with other central banks. The Fed was essentially buying some insurance to protect against a slowing economy.

My own view is that 50 was the right thing to do—not because we see a big risk of recession ahead, but because the U.S. economy may not be as strong as the headline data suggest, and almost certainly isn’t strong enough to justify the restrictive nature of 2.5% real rates (the difference between nominal rates and inflation).

As Shannon Saccocia wrote last week, there’s a reason why consumers and small businesses feel so gloomy despite the 2%-plus growth rate, resilient payrolls data and the S&P 500 Index consistently testing new highs.

The reality is the S&P 500 Index doesn’t represent the broad-based economy. These 500 largest U.S. companies are not borrowing from the local bank to try to expand their business. They generate free cash flow and, if they choose to borrow, it’s in investment-grade corporate bond markets at very tight spreads. Life generally gets tougher, and financial conditions tighter, as you move down the pecking order. Conditions have become more favorable over the past year, but there are still more U.S. banks tightening loan standards for small businesses than loosening them, according to the Fed’s latest surveys.

Those struggling smaller companies are the ones most Americans work for. Most estimates put the proportion of the workforce employed by S&P 500 Index firms at around 25 – 30%. Moreover, headline nonfarm payrolls data can obscure the extent to which the resilient jobs market is really resilience in government jobs, or narrowly focused in education and healthcare services in the private sector. Recent ADP National Employment Reports suggest that private-sector job creation is at its weakest since January 2021—and that kind of weakness has tended to herald economic weakness.

Foot Off the Brakes

This is the bifurcation?we have been describing for the past year, whether between large and small companies, or between higher-income consumers who have been largely shielded from the cost-of-living and interest-rate shock and the lower-income consumers who continue to be hit hard.

Last week’s move from the Fed suggests it knows it needs to take its lead from the broader economy rather than take reassurance from a narrow group of leaders.

To be clear, however, this is about the Fed’s “confidence,” in Chair Jerome Powell’s words, that inflation has declined enough to allow for insurance measures, for the constraints to be lifted from these less well-off consumers and businesses. Even at 50 basis points, it’s about taking the central bank’s foot off the brakes, in our view, not worrying about whether we’ll make it up the next hill.

Powell underlined this in his press conference, describing the move as a “recalibration” many times (a piece of Powell-speak that may go down in Fed history with terms like “transitory” and “irrational exuberance”). He also downplayed suggestions that more 50-basis-point cuts might come, but the market is not fully convinced, continuing to price for a more aggressive set of cuts than the Fed currently projects. If investors fear the Fed is still behind the curve, they may price for even faster cuts and slower growth over the coming weeks, and this may be unnerving.

However, the immediate response—a steeper yield curve, a moderate bid for small caps—appears to reflect greater confidence in the longer-term outlook. Markets have often taken time to adjust to the start of rate-cutting cycles, but for long-term equity investors, they have almost always proven to be a positive development.

They mark the point at which inflation and rates are no longer holding us back, and instead begin to build a foundation for the next economic expansion.