The Federal Reserve’s next policy meeting is shaping up to be a pivotal moment for the financial markets, with many investors and analysts forecasting a significant shift in monetary policy. Although the Fed is not expected to make any changes to interest rates in its upcoming meeting, Wall Street is nearly unanimous in its expectation that the central bank will initiate a rate cut in September. Such a move would mark the beginning of an easing cycle, potentially leading to additional rate reductions both later in 2024 and into 2025. This prospect has significantly buoyed market sentiment, propelling stock indices close to their all-time highs.
The current economic environment provides a supportive backdrop for these anticipated changes. The U.S. unemployment rate stands at a relatively low 4.1%, and the Federal Reserve’s latest projections suggest that this rate may rise only slightly in the coming years. This economic stability creates a conducive environment for the Fed to lower rates in an effort to manage inflation and mitigate potential speculative bubbles, all while avoiding severe job losses or a recession.
Historically, the stock market tends to react positively to the initial rate cut by the Fed. Anastasia Amoroso, chief investment strategist at iCapital, highlights that stocks usually experience a rally leading up to the first rate cut. Following this initial boost, the market often undergoes a consolidation phase over the next one to three months before resuming its upward trajectory, provided there is no accompanying recession. Defensive sectors such as consumer staples, healthcare, and utilities often perform well during these periods of economic adjustment.
In addition to the overall market dynamics, certain sectors are expected to see enhanced attractiveness as a result of lower interest rates. Real estate stocks, for instance, are likely to benefit significantly. As rates decline, real estate investment trusts (REITs) become more competitive relative to bonds, particularly because of their higher dividend yields. Jason Yablon, head of listed real estate at Cohen & Steers, points out that REITs with exposure to sectors such as data centers, senior living facilities, single-family housing rentals, and cellphone towers offer compelling investment opportunities due to their strong dividend yields and potential for catching up with broader market gains.
Small-cap stocks also stand out as an area of interest. Sandy Villere, a portfolio manager at Villere & Co., suggests that small-cap stocks are poised for a rebound, especially given their recent performance. Although the Russell 2000 index has gained 10% since the end of June, it still lags behind the S&P 500’s performance for the full year. Lower interest rates typically provide a favorable environment for small-cap stocks by reducing borrowing costs and enhancing growth prospects. Villere highlights specific investments, such as First Interstate Bancsystem, a small-cap regional bank with a nearly 6% dividend yield, and Option Care Health, which specializes in home infusion services for chronic conditions. He also advises looking at larger, more defensive companies that might continue to perform well in a slowing economy, citing Republic Services, a leader in waste management, and Lamb Weston, a major producer of frozen fries.
The technology sector also remains a focal point for potential gains. Ivana Delevska, founder and CIO of Spear Invest, notes that technology stocks could receive a boost from the anticipated rate cuts. As cash previously held in money-market accounts flows into the market, tech stocks could benefit from increased investment. Companies in the software and cybersecurity sectors, such as Zscaler, Cloudflare, Datadog, SentinelOne, and even CrowdStrike, which has faced challenges due to a global outage, are highlighted as attractive opportunities.
Vance Howard, CEO and portfolio manager at Howard Capital Management, further emphasizes the potential for a broad rally in stocks across various sectors in response to rate cuts. He suggests that investors may be underestimating the potential gains in a rate-cut environment and highlights that rate-sensitive small-cap stocks, regional banks, and real estate stocks could offer significant bargains.
However, it’s important to consider that stock market responses to rate cuts can be complex. The market does not always rise immediately following a rate cut, as expectations of easing may already be priced in. Additionally, rate cuts often occur in response to economic shocks, such as the bursting of the dot-com bubble, the global financial crisis, or the COVID-19 pandemic. In such cases, the damage to corporate earnings and investor sentiment might overshadow the positive effects of rate cuts.
Overall, while the anticipated rate cuts by the Fed could ignite a broad market rally, investors should remain mindful of the broader economic context and potential for varied market reactions. The beginning of an easing cycle might indeed set the stage for a significant rally, potentially marking the start of a broader market rotation and sustained growth. As always, careful consideration of individual investment strategies and sector-specific opportunities will be crucial in navigating this evolving economic landscape.