Is the Fed Justified in Declaring Mission Accomplished? Insights from BCA Research

The Federal Reserve, under Chairman Jerome Powell, is poised to announce its decision regarding interest rates on September 18th. There are indications that the U.S. economy may be on track for a “soft landing,” suggesting that inflation could decline without triggering a significant economic downturn.

However, analysts from BCA Research expressed skepticism about this bullish outlook in a recent note, stating that the economy still faces various challenges. They pointed out that investor sentiment is notably optimistic, with minimal cash reserves, and U.S. equities are currently trading at a high multiple of 21 times projected forward earnings. This optimism reflects belief in the Fed’s capacity to navigate the economy without leading it into recession.

Both individual and institutional investors are heavily invested in the stock market, which leaves little cash unallocated. The analysts caution that such extreme levels of optimism often precede market corrections, especially if economic conditions start to worsen.

Historically, stock markets have tended to decline following the initial rate cut by the Federal Reserve in a cycle, a pattern noted during past market cycles in 2001 and 2007. An exception occurred in 1995 when the Fed’s successful rate cuts did not lead to a recession; however, current economic conditions differ significantly from those of the mid-1990s.

Currently, unemployment is rising, and signs of weakness are emerging in the job market. This is further evidenced by the Sahm rule, which was triggered last month and indicates that a recession may be on the horizon.

BCA analysts present a troubling view of the labor market, reporting that job creation has decreased by over one million over the past two years, and adjustments to nonfarm payroll data suggest prior growth estimates were overstated. Although unemployment claims have not surged, the overall trend points towards a declining labor market, raising worries about the sustainability of economic expansion and the Federal Reserve’s ability to navigate a gradual slowdown.

Even with anticipated rate cuts, the monetary environment will likely remain restrictive for some time. The analysts caution that any benefits from easing monetary policy may not materialize quickly enough to prevent an economic downturn. The typical delay of approximately 12 months between rate cuts and their economic impact implies that the economy may still encounter substantial obstacles even after the Fed begins to relax its policies.

In light of current economic risks, BCA Research advises investors to be prudent with their portfolios. They recommend holding fewer stocks and bonds, favoring government bonds as a safer option in the event of a recession. Within the stock market, they suggest focusing on defensive sectors such as consumer staples, healthcare, and utilities, which are generally less vulnerable to downturns. While they hold a slight preference for U.S. stocks, they caution that technology stocks may decline if economic conditions deteriorate.