Understanding how macroeconomic changes, including shifts in monetary policy, affect investment strategies is crucial when making investment decisions. This Investment Update by Carmine De Franco delves into how various style factors perform during periods of falling US policy rates. This matters given the scope for looser US monetary policy in 2025.
The current cycle of US rate cuts
After raising policy rates between March 2022 and June 2023, the US Federal Reserve shifted course in September 2024 in response to signs of a weakening labour market. Fed policymakers began by cutting policy rates by 50bps. More rate cuts have followed, and market expectations are for monetary policy to be loosened further in 2025.
We analyse 11 episodes of rate-cutting cycles by the Fed since July 1963. On average, these cycles lasted 1.6 years, with policy rates cut by 4.8%. Interestingly, the US equity market often underperformed during these periods, with an average annualised return of 4.4%, well below its long-term average of 7%.
How have investment style factors performed?
Factors such as quality, size, momentum, and volatility have generally done well during rate-cutting cycles. Furthermore, a multi-factor portfolio which diversifies across several factors achieved high returns during these cycles. This indicates that such portfolios are resilient to changes in policy rates.
We note that different business sectors typically react differently to policy rate changes. Defensive sectors such as utilities and consumer staples tend to do well. In contrast, cyclical sectors such as oil, steel, and finance have often suffered, mainly because lower rates have historically followed severe market corrections.
Smaller companies tend to benefit from lower rates as their borrowing costs fall, and quality stocks are favoured for their resilience during economic slowdowns. Value stocks suffer in market downturns.
Rate cuts are supportive
While declining policy rates have historically coincided with lower equity market returns in the short term, they have been supportive of most investment style factors, and particularly multi-factor approaches. At the same time, sector allocation remains central to achieving one’s investment objectives in periods of falling policy rates.
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