The Fed's major policy shift is imminent! But there's no need to be too "anxious"

As the Federal Reserve prepares to cut interest rates starting on Thursday, some strategists advise investors not to feel "anxious" about the Fed's policy, calling for a gradual relaxation of monetary policy to boost market confidence.

David Kelly, Global Chief Strategist at Morgan Asset Management, said that if the Fed is too aggressive, it could "scare people."

In an interview, Kelly said, "If they cut rates significantly here, it will damage market confidence. It's like dropping a piano from the fourth floor of a building, you have to cut rates slowly and carefully."

The formal end of the Federal Open Market Committee's years-long tightening monetary policy marks a significant policy shift. The latest CPI data shows that the August CPI rose by 2.5% year-on-year, the lowest increase since 2021, bringing the inflation rate close to the Fed's 2% target.

However, Wall Street remains divided on whether the Fed should take more aggressive measures to protect the labor market and avoid a recession, and whether rates should be cut by 25 basis points or 50 basis points. Kelly stated that while economic growth may slow down, the risk of a significant economic downturn remains low.

Kelly said, "Ultimately, you have to tell me why consumers would stop spending, I think it takes a lot of factors to make American consumers stop spending."

Retail sales data released on Tuesday indicated that consumers are relatively resilient. Sales in August unexpectedly increased by 0.1%, while July's data was revised up to 1.1%. Meanwhile, there are signs of a slowdown in the labor market as the U.S. added fewer jobs than expected in August.

Saira Malik, Head of Equities and Fixed Income at Nuveen, stated that high inflation and a rate hike cycle will eventually hit consumers. She predicts that the economy will enter a recession at "some point" in 2025.

Malik said, "We are definitely cautious. Look at history, the labor market often shows cracks at the beginning of an economic recession, so you can't rely on employment data to tell you when an economic recession will arrive."

Bryan Whalen, Chief Investment Officer of Fixed Income at TCW, expressed a similar view. He said that the Fed's policy shift may delay an economic recession, but is unlikely to prevent it.

Whalen said, "I think whether the U.S. falls into a mild recession or a moderate recession largely depends on the Fed's response mechanism and how bad the situation is. Will there be issues in the capital markets? And then, how will they react from the perspective of interest rates and quantitative easing? This will determine the depth of this recession."

The Biggest Concern for Investors

The rise in interest rates over the past few years has driven a significant demand for cash and short-term assets, including time deposits and short-term notes. Some strategists suggest that now is a good time to reconsider these positions as the Fed prepares to cut rates Lauren Goodwin, Chief Market Strategist at New York Life Investment Management, stated, "Reinvestment risk is currently the biggest issue and threat facing investors."

Callie Cox, Chief Market Strategist at Ritholtz Wealth Management, emphasized the importance of monitoring declining interest rates in an interview: "We have seen the 10-year U.S. Treasury yield drop from 4.7% to 3.7%. We recommend locking in this yield now and understanding why you are holding cash."

Cox is guiding clients to adjust their investment portfolios. She mentioned, "Now is the time to invest in risk assets, especially if you are a long-term investor who can withstand some of the volatility we are seeing. At the same time, be prepared for an economic downturn and have a plan in place."

The traditional portfolio allocation of 60% in stocks and 40% in fixed income has long been a subject of debate among investors and investment advisors. Malik and Goodwin suggest that this model should be adjusted.

Goodwin said, "We are considering a balance, such as large-cap stocks, which have seen significant returns in recent years, as well as mid-cap private equity, which presents an opportunity for a balanced portfolio."

Malik further elaborated, "The 60-40 strategy can evolve into a 50-30-20 strategy, with 50% in stocks, 30% in fixed income, and the remaining 20% in alternative investments."

Kelly also pointed out that during periods of strong economic performance, such as the past decade, the returns of the 60-40 strategy may decrease.

Kelly mentioned, "You must have discipline, add international stocks to your portfolio because we do believe that in the long run, this will bring you higher returns. Additionally, focus on alternative investments—such as infrastructure, transportation, and certain real estate sectors, if you can find suitable managers."

As the Chief Investment Officer of fixed income giant TCW, Whalen defended bonds regardless of the economic backdrop. He stated, "If the Fed successfully avoids an economic recession, your investment-grade corporate bond fund could bring you around a 5% return, which is not bad."