The Federal Reserve probably won’t cut interest rates at its meeting next week, but Wall Street is nearly 100% certain that it will lower rates in September.
That cut would almost certainly start an easing cycle, setting up for at least one more in 2024 and several more in 2025. The market has grown excited about that possibility: Stocks are near record highs.
The enthusiasm is understandable. The unemployment rate is at a relatively low level of 4.1%, and according to the Fed’s latest projections, central bankers only think it will inch up slightly in 2025. So the Fed will be lowering rates to try to create a soft landing, a managed slowdown that cools off inflation (and perhaps speculative excesses in the market) without leading to rampant job losses and a recession.
If it can pull that off, stocks could be off to the races.
“Stocks typically rallied into the first rate cut, consolidated in the one to three months after the first cut, and then resumed the upward move—when there was no recession,” said Anastasia Amoroso, chief investment strategist with iCapital, in a report looking at how the markets reacted during rate-cut cycles going back more than forty years.
She added that defensive stocks, such as consumer staples, healthcare, and utilities, posted the best results.
Real estate stocks could also be compelling buys now that rates are expected to fall, noted Jason Yablon, head of listed real estate at CNS, a firm that runs mutual funds and closed-end funds that invest in real estate investment trusts, or REITs. The sector’s stocks should become more attractive options over bonds for fixed income investors, thanks to their dividends.
Yablon said publicly traded REITs with exposure to data centers, senior living facilities, single-family housing rentals, and cellphone towers look attractive and sport big dividend yields.
It’s also worth noting that many of these sectors have lagged behind the broader market’s gains this year, particularly the huge moves in tech and its leading Magnificent Seven companies, up until recently. So they have more room to catch up.
“I’m not concerned about a pullback once the Fed cuts rates. We went from expectations of seven rate cuts earlier this year to zero,” said Ivana Delevska, founder and chief investment officer with Spear Invest. “That was a headwind. That kept some people on the sidelines.”
So what else should investors be doing now to prepare for a decline in rates?
Sandy Villere, a portfolio manager with Villere & Co., said small caps look attractive and that their recent rebound is only just starting. The Russell 2000 index has jumped 10% since the end of June, but is still lagging behind the S&P 500’s performance for the full year.
“When rates go lower, small caps have a nice tailwind,” he told Barron’s. “A lot of investors need to get positioned for the foregone conclusion of lower rates. This is not a head fake.”
Villere said he has recently bought shares of First Interstate Bancsystem, a small-cap regional bank in Montana with a dividend yield of nearly 6%, as well as Option Care Health, a company that specializes in home infusion services for chronic conditions. But he also says investors should look for more defensive, larger companies that could continue to do well in a slowing economy. Two examples? Garbage and recycling firm Republic and frozen french fries leader Lamb Weston Holdings, Inc..
Delevska adds that tech stocks could still get a rate-cut bump, too. That’s because cash parked on the sidelines sitting in money-market accounts could flow to tech along with other sectors.
“If the Fed cuts, there will be an influx of money into the market that will benefit everyone,” she said.
Delevska likes software stocks, which haven’t rallied as sharply as semiconductor manufacturers like NVIDIA Corp have, thanks to the artificial intelligence boom. In particular, she thinks cybersecurity companies Zscaler Inc., Cloudflare, Inc., Datadog, SentinelOne, Inc and even CrowdStrike Holdings, Inc. —which has been hit hard lately due to a massive global outage—look attractive.
Vance Howard, CEO and portfolio manager with Howard Capital Management, told Barron’s that he likes stocks ranging from healthcare giants Eli Lilly, Regeneron Pharmaceuticals, and Merck to software giant Salesforce.com. He also says rate-sensitive small caps—such as regional banks and real estate stocks—are also bargains.
“The biggest risk people are taking is not taking enough risk,” Howard said. “Stocks may power higher during Fed easing. It’s a wonderful environment right now.”
Of course, stocks don’t always go up immediately after rate cuts. Sometimes the anticipation of easing gets priced in to the market. It’s also often the case that the Fed cuts rates in response to a negative shock—such as the 2000/2001 dot-com bubble bursting, the 2007-2008 global financial crisis, or the 2020 Covid pandemic—and no amount of rate cuts can dull the damage to corporate earnings and investor sentiment during a crisis.
But the Fed isn’t in panic mode. That’s why there could be a “rally of everything” once the rate cuts start. The broadening out of stock gains, or the so-called Great Rotation that many have been calling for, could finally begin in earnest and last for a while.
Comments