An equity rally built on expectations for aggressive rate cuts is inherently paradoxical.

If you’re expecting meaningful central bank easing, you’re expecting an economic slowdown almost by definition, and a corollary of a slowdown is weaker revenue and profit growth. Slower profits are bearish for ownership stakes in corporates and while this’ll be news to scores of investors minted in the post-pandemic era, that’s what stocks are: Ownership stakes in corporations. They aren’t poker chips.

So while lower rates can bolster equity prices through the valuation channel, at the end of the day there’s something fundamentally incongruous about expectations for deep rate cuts and buoyant equities.

In his latest, SocGen’s Andrew Lapthorne underscored the point. “Once again we have the contradiction of an expensive US equity market expecting both strong EPS growth over the coming years yet accompanied by significant interest rate cuts to stave off recession,” he said. “Both cannot be right.”

Not to split hairs, but the veracity of Andrew’s assessment depends quite a lot on his characterization of rate cuts — i.e., his description of cuts as necessary “to stave off recession.” Easing to combat a downturn is different than so-called “insurance cuts” designed to, among other things, keep real rates steady as inflation pressures recede. Those kind of rate cuts are the stuff multi-year stock melt-ups are made of.

Of course, endeavoring to classify cuts as “recession cuts” or, alternatively, “soft landing” cuts in real-time is to assume we know how the economy’s going to develop. Plainly, we don’t know that. So when the Fed takes the plunge next month, the only way it’ll be possible to definitively classify the first cut is if the economy suffers a Wile E. Coyote moment between now and then in which case yeah, “recession cuts.” Otherwise, it’ll be months, quarters or maybe even a year before it’s possible to say whether the Fed safely landed the plane, again assuming the data doesn’t take an abrupt cliff-dive.

In any event, the figures below from Lapthorne give you a sense of history — of how profits and earnings forecasts map to changes in Fed funds.

The implication’s clear: When rates fall sharply, it typically means lower profit growth and lower earnings forecasts.

“Historically, the current market expectations for rate cuts would imply a 20% decline in profit from a 10% increase amount[ing] to a 30% cut in forward expectations,” Lapthorne said. “So either interest rate markets are wrong (once again) or analysts are going to be very busy over the coming quarters downgrading currently very rosy profit expectations.”