In the first half of 2019, major stock indexes including the S&P 500® reached new highs, yet the outlook for global economic growth softened. Recession risk has risen, and rising tariffs have created even more uncertainty.

We believe a few themes will be important to watch in the second half of the year:

  1. The U.S. stock market will balance recession risk vs. rate cuts.Recession risk is rising, but markets currently expect the Federal Reserve to keep it at bay by cutting short-term interest rates at least once before the end of the year. Lower rates—which tend to spur borrowing and business investment—could help balance out the negative effects of slowing global growth and an ongoing U.S.-China trade war.

However, Schwab Chief Investment Strategist Liz Ann Sonders notes in her mid-year U.S. stocks/economy outlook that the market’s response to rate cuts may depend on how close we are to a recession. “Initial rate cuts when no recession was underway or imminent were historically accompanied by stronger stock market performance over the subsequent year relative to recession periods,” she says.

Stock market action following an initial rate cut may depend on whether there’s a recession

Source: Charles Schwab, Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2019© Ned Davis Research, Inc. All rights reserved.). May 5, 1920-September 18, 2008. DJIA=Dow Jones Industrial Average. Recession cases: 1921, 1924, 1926, 1927, 1929, 1932, 1954, 1957, 1960, 1970, 1974, 1980, 1981, 2001, 2007. No recession cases: 1933, 1967, 1968, 1971, 1984, 1989, 1995, 1998.The two series represent the average of the DJIA over one year (in trading days) before and after an initial Fed rate cut, in cases when there was a recession in the next year and when there was not. The data is indexed to 100.

If the economy holds up and the rate cuts are simply “insurance,” stock markets could rally strongly. However, if the economy weakens or the Fed doesn’t ease monetary policy as expected, the market’s rate-cut optimism could become a negative.

The Fed’s benchmark short-term rate, the federal funds rate, is currently between 2.25% and 2.5%. Based on the federal funds futures market, investors now expect it to be 100 basis points1—that is, a full percentage point—lower by the end of 2020, Liz Ann says.

“Aside from ongoing trade war uncertainty, our other concern is the possibility that the market has gotten ahead of the Fed,” Liz Ann says. “With fed funds futures now discounting more than 100 basis points of easing by the end of next year, equities may be at risk if the economy’s deterioration supports that much easing—but also at risk if the Fed under-delivers.”