The Fed’s misstep: cutting rates when it isn’t needed is a risk to the economy

Investment-grade corporate bonds are worth a look. It is not yet time to shift from U.S. equities to European ones. Gold remains an excellent hedge against fiscal excess, rising debt and excessive monetary expansion.

by Alberto Conca, manager of the Zest Quantamental Equity fund
The Federal Reserve is about to make, or has just started to make, a mistake. The Fed has in fact resumed its cycle of rate cuts, convinced that only lower rates can stimulate the economy. This could be the first misstep. However, we are even more concerned about a second possible error: cutting rates in a context that does not call for further stimulus. We believe the U.S. economy does not need additional support. Yet the fiscal deficit is expected to rise, and the Federal Reserve should cut rates five more times before the end of 2026. This double stimulus increases the risk of overheating, with the possibility that inflation will move well above the target.
A decade of extremely low interest rates failed to generate meaningful growth, and the fact that rates at 5% have had only a limited impact on the economy suggests that GDP growth is now less sensitive to monetary conditions. Moreover, cutting rates when the economy is growing above potential (positive output gap) and inflation is still well above the 2% target could put price stability at risk. As reflected in the latest dot plots, members of the FOMC (Federal Open Market Committee) have revised up their forecasts for GDP growth and inflation, while also projecting lower unemployment in 2026. The labor market has been slowing gradually over the past two years, and the revisions published this summer painted a somewhat gloomier picture than initially reported. Tariff uncertainty and the rise of artificial intelligence seem to be making companies cautious about hiring.
Turning to Europe, the picture resembles a modest Goldilocks scenario: moderate growth, contained inflation and stable unemployment allow the ECB to maintain a wait-and-see stance. Manufacturing is improving, supported by expectations that German fiscal stimulus will finally lift the core of the eurozone out of its slumber. Private consumption remains subdued, and most of the recovery comes from fiscal expansion rather than organic demand. Despite domestic political tensions and existential debates about Europe’s identity, the economic outlook remains favorable: tariff talks are off the table for now, and the ECB still has plenty of ammunition if needed.
The path of interest rates has clearly diverged between the United States and Europe. The European Central Bank has cut its main refinancing rate several times this year, bringing it to 2.15%. Together with Germany’s fiscal expansion plan, this has led to a modest steepening of the European sovereign yield curve, suggesting expectations of stronger growth ahead. By contrast, across the Atlantic, the Federal Reserve has kept rates broadly unchanged (apart from the September cut), causing a parallel downward shift in the U.S. yield curve. This can be interpreted in several ways, including the fact that some bond investors expect growth to slow because the Fed is not easing quickly enough.
Be that as it may, our stance on fixed income remains largely unchanged. In an environment where most asset classes look expensive, investors should focus on the securities offering the most attractive risk/reward profile. In our view, investment-grade corporate bonds continue to meet those requirements. Fundamentals remain solid on both sides of the Atlantic, the rating trend favors upgrades over downgrades, and valuations look more appealing than high-yield debt or emerging-market debt.
The U.S. economy remains resilient, supported by a strong services sector and an emerging recovery in manufacturing. In the second quarter, U.S. corporate earnings grew by almost 13% year on year, with revenue up by more than 6%. Positive earnings surprises in communication services, technology and financials made a major contribution to the upside; without them, earnings growth would have been a modest 2% year on year. For the second half of the year, consensus expects EPS, earnings per share, to grow in the high single digits, slightly below previous quarters, as the tariff impact begins to be felt. Even so, EPS forecasts have continued to trend higher, supported by resilient results in technology, communication services, financials and some industrial sectors.
Overall, the market has returned to a two-tier structure, with a handful of sectors and companies driving the aggregate numbers. Earnings growth remains above normal and operating margins are at record highs. The consensus, however, still expects margin expansion, which looks somewhat ambitious given where we are starting from, tariff risks, the rising capital intensity of Big Tech and the higher costs of reshoring. Even if U.S. growth were to accelerate further, we are not sure earnings will keep pace: potential gains in cyclical sectors could be offset by normalization in the best-performing areas. Share prices could keep rising unless there is a structural change. Traditional indicators already point to a significant overvaluation, even accounting for strong cash-flow generation. Still, investors can take some comfort from the fact that corporate balance sheets are exceptionally strong. Most companies refinanced their debt when rates were near zero, so refinancing risks should remain limited for at least another five years.
The current level of the S&P 500 index effectively discounts one of two scenarios: either a normalization of the price/earnings ratio to 15x, while maintaining earnings growth of 12%, or a slowdown in earnings growth to 9% while keeping a P/E multiple of 22x. It does not price in a recession (which we consider unlikely), but it also does not reflect a normalization of both earnings and valuations, a result that would imply an index level close to 5,000, nor a continuation of both at elevated levels (around 8,000). In short, the S&P 500 index is still priced to perfection, which means investors should brace for periods of greater volatility whenever the narrative falters.
From a sector perspective, the healthcare sector stands out as a clear value play: companies in the sector generate solid free cash flow and are currently trading at attractive valuations. Maintaining exposure to technology remains essential, at least on a relative basis. Financials should also benefit from a gradually steeper yield curve. By contrast, energy, consumer staples and consumer discretionary could face headwinds: energy because of rising supply, staples because of falling consumption among lower-income households, and discretionary because of the looming effects of tariffs.
In Europe, equity markets have been sluggish since early March. The Stoxx 600 has been essentially flat. This underperformance versus U.S. equities probably reflects the new tariffs imposed by the United States, as well as the appreciation of the euro, which further undermines the competitiveness of European exporters. Adding to the picture are a limited technology sector and a chronic innovation gap. There is, however, some good news. The phase of deleveraging in the European private sector is now largely behind us: leverage has fallen, liquidity is abundant and debt-service indicators are healthy (with France as a notable exception). Balance-sheet repair in banking and improving profitability are allowing Europe’s bank-centered financial system to better finance growth and investment. In addition, Europe is moving away from a decade of austerity toward moderately expansionary fiscal policy, led by Germany. This shift could help unlock a new tailwind for corporate earnings.
Valuations also leave room for multiple expansion: European equities continue to trade at a significant forward P/E discount to the United States, and the gap is wide across sectors. In today’s market, that relative cheapness provides a cushion against downside risk, in sharp contrast to the AI-driven concentration seen in the United States. Even so, we still do not think it is time to move wholesale from U.S. equities to European equities.
The fate of the U.S. dollar remains one of the main concerns for investors. Fundamentally, the dollar remains overvalued, even after its sharp decline this year. However, as in all markets, valuations matter only in the long run. In the short term, currency moves are driven by interest-rate differentials, geopolitical developments and technical positioning. The first two factors are inherently unpredictable; the third currently favors the greenback, as positioning has become excessively bearish. The main uncertainty lies in rate expectations: markets are pricing in five cuts by the end of 2026. For the dollar to regain some lost ground, the Fed would need not to deliver those cuts, a plausible scenario given everything discussed above.
The weaker dollar has clearly benefited gold. Its rise has been nothing short of spectacular (year to date: +60% at the time of writing) and seemingly unstoppable. Still, we fear the market may now be entering an euphoria phase; a pullback looks likely and, probably, healthy. Over the long term, gold remains an excellent hedge against fiscal excess, rising debt and excessive monetary expansion. Beyond the yellow metal, we would avoid oil, except as a tactical hedge against geopolitical shocks, as supply should outstrip demand in the near future. By contrast, the ongoing recovery in manufacturing could support industrial metals, provided China avoids a hard landing.