The great debate over when the Federal Reserve will cut interest rates rages on as the latest economic data rolls in, showing a strong economy and lower inflation. While Wall Street patiently waits from news from the Fed, earnings season is in full swing.

James Liu, Clearnomics Founder & CEO, believes that earnings may have more of an impact on the Fed's decision as to when to cut rates than most investors may think. He joins Yahoo Finance to discuss this insight and what investors should consider when managing their portfolios.

Liu explains: "If you think about that big tsunami of inflation that happened the last couple of years, really we're past that period now. Now the debate is not whether or not inflation will come down or get back to 'more historical normal' levels. The question is how quickly, and when will we get back to the 2, 2.5% inflation rate that the Fed wants. Based on the glide paths that we are seeing, that could happen in the second half of this year. So if you're an investor that has basically been planning your portfolio strategy around the last two years where you have that bear market in 2022, and sort of a stabilization and rebound of 2023, the next two years with Fed rate cuts will likely look very, very different. It does not mean the market will go straight up. You're going to see a lot of volatility as that happens."

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

Editor's note: This article was written by Nicholas Jacobino

Video Transcript

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RACHELLE AKUFFO: The hottest debate on Wall Street is when the Federal Reserve will start to cut interest rates. Talks about the Fed's potential timeline for a rate cuts have been a driving factor to the market's momentum in the last few weeks. But while the market may have gotten ahead of itself by pricing in the full impact of a possible rate cut decision, our next guest believes that what matters most to the Fed now is earnings season.

Let's bring in James Liu, Clearnomics founder and Chief Executive Officer, to weigh in. Thank you for joining us this morning. So James, how much of an impact will earnings season play into the Fed's decision to cut rates? Because that's not usually something that the Fed tends to pay attention to. They sort of like to cool market's expectations.

JAMES LIU: Yeah, Rachelle. It's great to chat with you. Basically, when you look at the debate right now in the market, it's no longer about whether or not a soft landing is going to happen. It's really a question about how soft it's going to be. And so that debate about whether it's going to be March or May, whether it's going to be three cuts this year or five cuts, that depends on the strength, of course, on the underlying economy.

And so when you look at the overall market performance last year, and that fantastic 26% return we had for the S&P, that was not driven by earnings per se, because we basically had flat earnings across 2023. That was all valuations. And so what will have to happen next in the story for both the market and the Fed is that we need to start seeing corporations start to perform better in terms of earnings.

And so a lot is priced in right now. The market right now expects about 10% earnings growth for the next year. And if we see that earnings growth, that will justify both the valuations. But it could potentially also give the Fed confidence that the underlying economy actually is quite strong, that business investment is happening, and that they are on a trajectory where they can start to cut rates in the middle of the year.

AKIKO FUJITA: And based on the results we got so far, James, are you seeing that?

JAMES LIU: Well, Akiko, it's a little bit too early to tell. So we're early in the Q4 earnings season. It looks like earnings are going to come in slightly negative on a quarter over quarter basis. But the key here, if you take a step back, is that we had an inflection point in the third quarter of last year, where earnings went from this earnings recessionary period to an uptick.

And so if you take a look at 2024, that's really what investors are looking forward to right now. The goal has to be that we see roughly 10% earnings growth, which is quite a bit. A lot of expectations are built into this. But of course, that's already reflected in valuations as well. So really, it's earnings growth in 2024 that will drive whether or not the soft landing is as soft as people hope for.

RACHELLE AKUFFO: And James, obviously, this is a very different period that we're entering into. We've had a history of low interest rates here from the Fed. How should investors be thinking about this period, if they're trying to jump into the market but knowing that we really are in a transitional stage at the moment?

JAMES LIU: Yeah, so that transition really is happening right now. And in fact, we're slightly past it, right? So if you think about that big tsunami of inflation that happened the last couple of years, really we're past that period now. Now the debate is not whether or not inflation will come down or get back to quote unquote, "more historical" normal levels, the question is how quickly. And when will we get back to that 2%-2.5% inflation rate that the Fed wants.

And based on the glide path that we're seeing, that could happen in the second half of this year. So if you're an investor that has basically been planning your portfolio strategy around the last two years, where you get that bear market in 2022 and sort of a stabilization and rebound in 2023, the next two years with Fed rate cuts will likely look very, very different.

It does not mean the market will go straight up. You're going to see a lot of volatility as that happens. Remember, the Magnificent Seven that everyone's talking about, they did very well last year. But they also lost half their value in 2022. So it's really this rocky ride.

So what matters, going back to earnings, is that corporations start to perform better that justifies a lot of the valuations we're seeing. And hopefully, because of that, you start seeing a broadening out of performance across the market, across sectors, and not just in areas like tech.

AKIKO FUJITA: And James, I see a big warning in your note that says the consumer slowdown is coming. You could argue that warning has already been messaged from some of these companies we've heard from in the earnings season so far, lower volume, consumers pulling back on discretionary spending. With that in mind, what are the names you think that investors should be getting out of in the anticipation of this slowdown accelerating? How do investors look at their portfolio?

JAMES LIU: Well, Akiko, you're right. We're in this interesting transition period where the backward looking data, like today's GDP report, still show very strong consumer spending. The retail sales numbers we got a few weeks ago showed the same thing.

And yet when you look at what companies are experiencing, they are already anticipating the slowdown and feeling a lot of that. And so areas like consumer discretionary and consumer staples, those sectors-- those should actually start to slow down if that continues to play out, because excess savings are being spent and consumer spending starts to decline.

However, if you look at areas like industrials and financials, they could potentially benefit from not just rate cuts, but also a re-steepening of the yield curve as we get back to a quote unquote, "more normal environment." And if you start to see business investment actually start to pick up and stabilize, that could help areas like manufacturing, industrials, and those sectors.

So again, the hope is that if last year was very much driven by the Magnificent Seven and technology-related sectors, that that performance will broaden out. Consumer discretionary, consumer staples will likely see a bit more of a headwind. But areas like industrials, financials-- hopefully, those start to benefit in the coming year.

RACHELLE AKUFFO: So, of course, with the Fed in mind, and with margins and earnings in mind, and of course, we are in an election year-- and you say that elections are less impactful than many investors believe. Why is that? And at what point do markets start to care?

JAMES LIU: Right, so that's a great question, Rachelle. So of course, elections are important. As voters, taxpayers, as citizens-- very, very important. But from a markets perspective, it's really a different story. It is not the case that when one political party gets into power, either White House or Congress, that you have a market collapse.

There's so many stories around this where investors were fearful of this over the last 20 years, and it didn't happen. In fact, you tend to have markets rising in all these periods once the political situation stabilizes. And so from an investment standpoint, of course, policy can affect specific sectors, specific companies, that's very important. There's taxes and trade policy.

But from the broadest perspective of the everyday investor, let's not overreact from our portfolios when it comes to the presidential election this year. Of course, it matters as voters and citizens, again, but let's not overreact when it comes to how we allocate our money.

AKIKO FUJITA: James Lu, Clearnomics founder and Chief Executive Officer. Always good to get your insights. Thanks so much.

JAMES LIU: Great. Thanks for having me on.