Equity markets recovered in June as the US Federal Reserve turned decidedly dovish, coming in line with most central banks around the world. But after posting strong gains, to end the quarter close to a record high, how much more steam do US stocks have left?

Over the last seven months, the Fed shifted its policy stance dramatically. From a perceived hawkish bias in December, the US central bank turned neutral by February and became accommodative in June. Increasing signs of a weakening macroeconomic environment in the US and around the world precipitated the adjustments.

Fed Policy Moves: Two Effects on US Stocks

From a stock investor’s perspective, the market is valuing two dynamics: lower interest rates and an expectation that the Fed is now ready to stimulate the US economy if needed. The 10-year Treasury has fallen to around 2%, which has both a conceptual and a real impact on equity valuations.

The conceptual impact is driven by the discount rate. When future company cash flows are discounted back at a lower discount rate, those cash flows are worth more today. The real impact is because a meager 2% yield from Treasury bonds over the next 10 years makes the higher return potential of equities look more attractive. Both forces serve to push up equity prices—especially for growth stocks, which have more distant cash flows—as we saw in June.

What if the Economy Weakens Further?

The Fed’s position is more controversial for several reasons. First, much of today’s economic weakness has been driven by political decisions. Second, the US economy is still relatively robust, with an average GDP growth of 3% over the last two years, unemployment at generational lows below 4% and wage inflation over 3%. Third, by loosening policy today, it’s unclear whether the Fed will have any weapons left in its arsenal to combat a real downturn, should one emerge.

Two questions are worth asking: will the cuts stimulate the economy, and what happens in 2020 and beyond if we really need stimulus? The answer to the first question is unclear. Lower rates aim to incentivize companies to borrow and invest more. But capital-spending projects that weren’t feasible at a 2.5% interest rate probably won’t make sense at 2.0%, so the decline in rates is unlikely to energize the economy on that front. Regarding the second question, in the event of a significant economic pullback, the Fed will have to get extremely creative because the cupboard is relatively bare. That’s why the Fed wanted to bring rates back up toward long-term norms before its recent shift.