Experts largely agree that the Federal Reserve will begin cutting interest rates next month, with futures prices pointing to a 67% probability of a 0.25-percentage-point move.
So what does that mean for stocks? Let’s look at what happened in previous Fed rate-cut campaigns.
In 12 of the Fed’s 14 rate cycles since 1929, the S&P 500 posted a positive return 12 months after the initial cuts, according to a Schwab report. The authors are Liz Ann Sonders, Schwab’s chief investment strategist, and Kevin Gordon, senior investment strategist.
The two exceptions occurred after the Fed began lowering rates in 2001 and in 2007. “They may feel uncomfortably recent, but neither economic environment resembles today's,” the report said.
“The former happened amid the dot-com implosion and the latter was precipitated by the subprime mortgage crisis.”
When defense beats offense
Let’s have a look at how Fed rate changes affect market sectors.
“Defensive sectors — essential industries that tend to be more resistant to economic uncertainty, such as health care and utilities — generally perform well when interest rates are rising,” the commentary said.
“Conversely, cyclicals — sectors that benefit from an accelerating economy, such as consumer discretionary and industrials — have greater potential when rates drop,” the report said.
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So does that mean a shift to cyclicals is on the horizon?
“This is another market dynamic that depends on how fast the Fed is cutting rates,” the report said.
When cyclical stocks do best
“Based on analysis from Ned Davis Research, cyclicals have often done best when the Fed enters into a period of gradual rate decreases, as is expected in this cycle.”
But there is a twist here: The definitions of defensive and cyclical sectors have themselves shifted over time, Schwab said.
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“For example, technology historically has been in the cyclicals group,” the report said. “But in this Fed tightening cycle, large technology companies have taken on many of the characteristics of more defensive companies.” The Fed lifted rates from March 2022 through July 2023.
And the tech companies have outperformed the market. “Their huge cash holdings (among other factors) have insulated them from higher borrowing costs and helped generate income as rising rates made cash more rewarding,” Schwab said.
The securities firm Jefferies put together a list of stocks to buy when the Fed lowers rates. CNBC described Jefferies’ report.
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The investment firm chose stocks that have outperformed in months when markets expected imminent rate cuts, and a soft economic landing — easing inflation with no recession — was forecast.
Expectations of a rate cut were indicated by falling two-year Treasury yields, and a soft economic landing was indicated by 10-year Treasury yields either falling just a bit or rising.
In this environment, investors should seek value stocks with strong earnings momentum, Jefferies said. The stocks it selected are all “attractively valued,” it said, with price-to-earnings multiples below 20.
Jefferies’s fearsome fivesome
The picks include Internet search giant Alphabet (GOOGL) , shoe company Crocs (CROX) , banking titan JP Morgan Chase (JPM) , oil producer Marathon Oil (MRO) and glass-fiber maker Owens- Corning (OC) .
Here are Morningstar’s ratings of the stocks, in descending order of market capitalization:
Alphabet
Moat: wide. This means Morningstar’s analyst sees the company with competitive advantages that will last at least 20 years. Morningstar’s fair value estimate: $209. Wednesday quote: $166.
JP Morgan Chase
Moat: wide. Morningstar’s fair value estimate: $178. Wednesday quote: $214.
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Marathon Oil
Moat: none, meaning Morningstar sees the company having no sustainable competitive advantage. Morningstar’s fair value estimate: $27. Wednesday quote: $27.70.
Owens-Corning
Moat: narrow, meaning Morningstar see the companies with competitive advantages that will last at least 10 years. Morningstar’s fair value estimate: $164. Wednesday quote: $163.
Crocs
Moat: none. Morningstar’s fair value estimate: $160.40. Wednesday quote: $140.45.
The author owns shares of Alphabet and JPMorgan.
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