Markets may still be oblivious, but major banks are already bracing themselves for imminent interest-rate cuts. These financial institutions envision a scenario that could have a significant positive impact on the stock market.

While rate cuts are not a certainty as far as markets are concerned, there are indications pointing in that direction. The two-year Treasury yield, which serves as a gauge for expectations about the federal-funds rate, currently stands at 5%, only slightly below the multiyear high of approximately 5.2% reached in October. Additionally, the S&P 500 remains approximately 8% below its all-time high.

Despite these factors, most investors do not anticipate rate cuts. One reason for this skepticism is that the rate of inflation has not dipped significantly, prompting the Federal Reserve to potentially maintain higher rates for an extended period, as repeatedly signaled by policymakers. The core consumer price index, which excludes volatile food and energy costs, has been hovering just above 4% in recent months—roughly double the bank’s target of 2%.

However, investment banks hold a different perspective.

In a recent statement, UBS economist Jonathan Pingle emphasized, “As the economy experiences a slowdown and enters into a disinflationary phase, we predict that the Federal Reserve will implement more rate reductions in the second half of the year.” Pingle forecasts that the fed-funds rate will decrease to slightly below 3% by the end of next year, compared to its current level of over 5%.

This viewpoint centers on the fact that the impact of higher rates on consumer spending is yet to be fully realized, suggesting that demand is likely to moderate. In recent times, various forms of consumer debt, such as credit-card balances, have seen an uptick in interest rates. Consequently, personal interest payments now account for almost 2.5% of personal income—an amount not reached since the early 2000s and significantly higher than the approximately 1% seen during the low point of the pandemic.

Savings and Economic Growth: Assessing the Impact of Lower Savings and Inflation

Despite experiencing a surge in savings early in the pandemic, as a result of government economic support, recent data suggests that these savings have dwindled. Cash savings increased by approximately $2 trillion between the pre-pandemic period and mid-2020. However, more than half of this surplus has already been spent, leaving us with less than $1 trillion in extra savings.

This decline in savings, coupled with persistently high inflation rates, is expected to have a detrimental effect on consumer spending. Ultimately, this could potentially lead to a rise in the unemployment rate from its current level of 3.9% in October to 5% by the end of 2024. Exacerbating the situation, this increase in joblessness may lead to further reductions in consumer expenditure, subsequently decreasing the rate of inflation. This scenario would enable the Federal Reserve (Fed) to adopt a looser monetary policy in order to mitigate an excessive slowdown in the economy.

With UBS joining the ranks, Goldman Sachs economists also anticipate a decrease in interest rates. They predict that the fed-funds rate will fall between 3.50% and 3.75% by 2026, primarily as a response to the deceleration in consumer spending and inflationary pressures.

Interestingly, such developments could potentially benefit the stock market. The most favorable outcome would be for the market to witness an economy that is growing at a slower pace but not contracting, with minimal layoffs. This aligns with both UBS and Goldman Sachs’ projections.

According to UBS, they expect real gross domestic product (GDP) growth of 0.3% in 2024. Meanwhile, Goldman Sachs assigns an 85% probability that the economy will continue to grow at some rate.

For corporations, this would translate into increased earnings. Analysts indicate that aggregate sales for S&P 500 companies are projected to grow by 5% annually over the next two years, according to FactSet. Combined with the slower rise in wages and the reduced cost of raw materials, stemming from lower inflation, this could potentially lead to improved profit margins. In fact, analysts tracked by FactSet anticipate a 12% annual growth in aggregate earnings per share for S&P 500 companies.

Consequently, with growing earnings and declining interest rates, which make fixed-income investments less attractive, the favorable conditions set the stage for a robust stock market. Some equity strategists have already identified this positive trend.

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