U.S. Stock Market Gains 17% Post-Fed Cut Without Recession, Loses 6% With Recession

Recent analysis has highlighted that the performance of the U.S. stock market following a Federal Reserve interest rate cut is heavily dependent on whether the economy is in a recession. Historical data shows that over the past 50 years, there have been seven instances where the Federal Reserve resumed interest rate cuts after a significant pause. In four of these instances, the economy entered a recession, while in the other three, the economy continued to expand. The stock market's performance in these two scenarios was markedly different.

In scenarios without a recession, the MSCI World Index showed average gains of 1%, 2%, 8%, and 17% at 1 month, 3 months, 6 months, and 12 months after the rate cut, respectively. In contrast, during recessionary periods, the index saw declines of -2%, 2%, 0%, and 6% over the same periods. This data underscores the importance of economic conditions in determining the stock market's response to interest rate cuts.

Unemployment rate is a critical indicator in distinguishing between economic expansion and recession. Historical data indicates that during recessions, the unemployment rate continues to rise for nearly a year after the rate cut, increasing by 2-3 percentage points. In contrast, during periods of economic expansion, the unemployment rate rises slightly before beginning to decline within a few quarters. Currently, the U.S. unemployment rate has risen to 4.3%, a key factor influencing the Federal Reserve's consideration of a rate cut.

Economic indicators such as the ISM Manufacturing Index and employment growth trends also play a significant role. The ISM Manufacturing Index typically improves within a quarter after a rate cut in non-recessionary periods but continues to decline for several quarters before bottoming out during recessions. Similarly, employment growth trends, as indicated by the ISM Employment Index, show a weakening momentum but remain strong, contrasting with the sharp decline in interest rate expectations.

The shape of the yield curve also influences sector performance. Historically, a flattening yield curve during a bull market has been most favorable for the stock market, with broad participation across sectors and a slight bias towards cyclical sectors. Conversely, cyclical sectors perform best during a steepening yield curve in a bear market but underperform during a flattening yield curve in both bull and bear markets. Currently, the decline in real interest rates is the primary driver of lower yields, which has historically benefited sectors such as capital goods, durable consumer goods, chemicals, construction materials, automobiles, mining, and transportation.