Weakening economic conditions in the U.S. and globally forced the U.S. Federal Reserve (“Fed”) to cut rates not once but twice in the second quarter alone. In July, the Fed cut rates 25 bps or a quarter of one percent. This was the first rate cut since December 2008. In September, the Fed cut rates for the second time in less than three months. They again lowered rates 25 bps.

Bond yields peaked in November 2018 well before the Fed cut rates. The Fed raised rates four times in 2018. Bond markets had anticipated that the Fed would reverse course in 2019 and shift to stimulating the economy by cutting interest rates. With declining interest rates positive for bond returns, bonds, both U.S. and foreign, have outperformed stocks over the past year. U.S. bonds are up 10.3% year over year.

Lower interest rates are clearly good news for bond returns at least in the short-term. If the Fed is reacting to deteriorating economic trends, why should stocks benefit? U.S. stocks are up 20.1% year to date. Surely, a weak economy is not good for businesses. Stocks could benefit in two ways. First, lower interest rates could spur economic growth, albeit slower than desired, thus avoiding a recession. This is the “Fed saved the day” scenario.  Second, low interest rates may not re-accelerate growth, and the economy stalls and falls into a recession. However, the recession is shallow from the Fed cushioning the slowdown with lower interest rates. Companies could benefit financially from lower funding costs helping offset lower demand and revenues. This is the “worst-case was avoided” scenario.

Do we know which scenario the stock market is discounting? We do not. But, slowing economic growth is weighing on stock returns. While U.S. stocks are up 20.1% year to date, the one-year return is much lower at 2.9%.  Many investors ascribe slowing economic conditions to “self-inflicted” actions related to trade policy, foreign policy and political uncertainties. The upside is that these are more easily reversed than the systemic issues and irrational exuberance in real estate seen in most economies prior to the 2008-2009 downturn, which required major structural changes to correct.

While recession risks are higher, a bigger potential risk to portfolios is trying to “time the market.” Absent a high conviction view on future economic growth, sitting with more uncertainty than investors would like is often the most prudent course of action.