Investors cheer a soft landing scenario after Fed's big rate cut. But they're still keeping their guard up for a downturn.

By Gordon Gottsegen

Thanks to the 50 basis point rate cut, a soft landing scenario is looking more likely

The Federal Reserve finally gave stock-market investors what they wanted by cutting interest rates for the first time since March 2020, making a soft landing for the economy more likely now that inflation has fallen.

The Fed left its benchmark rate at 5.25%-5.5% for over a year before deciding to cut it half a percentage point at the Sept. 18 policy meeting. Up until the last minute, many investors weren't entirely sure whether they would see a 25 basis point or 50 basis point cut. But by settling on the larger 50 bps cut, the Fed sent a clear signal to investors that it was willing to do what it takes to support economic growth and prevent a labor market slowdown.

However, investors may be wondering if the 50 basis point cut seals the deal on a soft landing scenario - where inflation gets under control without economic growth slowing sharply - or if it proves that the Fed was behind the curve on stopping a recession.

Markets celebrated the larger rate cut, with the stock market rallying the next day. The Dow Jones Industrial Average DJIA was up around 1.3%, while the S&P 500 SPX grew 1.7% and Nasdaq Composite COMP grew 2.5% that day. Both the Dow and S&P 500 closed at new record highs.

While rate cuts can help boost equities on their own, getting the first rate cut out of the way may have provided an additional boost by dispelling some of the uncertainty surrounding when rate cuts were coming and what they would look like.

"The market doesn't like uncertainty, and uncertainty was removed yesterday," Bill Merz, the head of capital markets research at U.S. Bank Wealth Management, told MarketWatch the day after the Fed's rate cut. "Not only was uncertainty removed but policy is tilting more accommodative."

With the Fed taking a more accommodating stance, Merz said that he sees the market pricing in a greater chance for a soft landing without letting go of the potential for risk. This manifested through higher valuations and solid stock performance across cyclical growth categories and secular growth categories, as well as a recent rally in defensive categories. He said this "natural hedging" points to investor optimism about the long-term growth potential for the U.S. economy, while preparing for the chance that the economy could decelerate in the near term.

"That's telling us that the market is leaning towards that outcome of a softer landing, while acknowledging that risks exist. Growth is decelerating, the labor market is decelerating, and we're not sure yet where that action slows, stops and stabilizes," Merz said.

The Fed's decision moved the needle towards the soft landing scenario, and it showed the Fed's willingness to act. During the FOMC meeting, Fed chair Jerome Powell made it clear that he would do what it takes to boost the economy.

"You can take this as a sign of our commitment not to get behind," Powell said during the meeting.

That commitment helped give people more hope for a soft landing.

"[The Fed] being determined not to fall behind the curve is something that could enable the U.S. to avoid a recession or a protracted slowdown," JoAnne Bianco, a partner and investment strategist at BondBloxx, told MarketWatch.

What could still trigger a growth scare?

However, the recent rally in defensive stocks showed that investors were still positioning themselves for some risk.

Data that points towards a decelerating economy could lead to a growth scare and spook investors - similar to what happened in early August when the market reacted to rising unemployment.

A significant slowdown in consumer spending or further cooling of the labor market could be blows to the economy that could cause the markets to react negatively.

Powell claimed that he doesn't think this is happening, saying, "I don't see anything in the economy right now that suggests that the likelihood of a downturn is elevated."

The Fed's reassuring tone on the economy could help comfort investors, which may result in a higher bar for what triggers a growth scare. Still, it's not entirely out of the picture.

For example, Thomas Urano, a managing partner and co-chief investment officer at Sage Advisory, thinks that a rise in inflation could cause the market to reverse its optimistic view on the economy.

"I think everyone was under the impression that inflation is softening and unemployment is going up, and the Fed is fully engaged in trying to prevent unemployment from getting out of hand," Urano told MarketWatch. "I think the market would have to reconsider that if inflation prints tick a bit higher."

Of course, stagflation would be the worst of both worlds for the Fed's dual-mandate of keeping prices stable while ensuring maximum employment. For that reason investors will still be paying attention to inflation reports. But luckily, both the Fed and Urano don't expect inflation to reaccelerate.

"I think that's one of the least likely outcomes. But if it does come to fruition that's a scenario where [the market] has to correct, because this current state of a supportive Fed, falling inflation and rising unemployment - that goes out the window with stagflation," Urano said. "I think the Fed would revert to accepting a recession and rising unemployment in order to combat inflation."

It may be too early to determine whether the Fed was behind the curve with its rate cut or able to pull off a soft landing because the economy is still in the midst of things.

"There's no referee on the field that's going to call the soft landing or throw the recession flag in real-time. And that's part of the problem with central bank policy," Urano said.

Only hindsight will provide a true answer to that question. But while investors wait, the Fed helped provide a little optimism about the soft landing.

"That's my prediction," Bianco said. "We're going to end 2024 and look back and say this was a strong year for corporate earnings."

The U.S. Bureau of Economic Analysis is slated to deliver an updated figure for Q2 GDP growth on Thursday, as well as the personal consumption expenditure index measure of inflation for August on Friday. Several members of the Federal Reserve were slated to give speeches, providing more context to their monetary policy decision.

Read: Labor market is not 'flashing red,' two top Fed officials say

Futures ticked higher for the major U.S. stock market indexes on Monday before market open. Dow futures gained about 0.1%, while S&P futures were up 0.2% and Nasdaq futures grew around 0.3%.

-Gordon Gottsegen

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09-23-24 0919ET

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