Experts largely agree that the Federal Reserve will begin cutting interest rates next month, with futures prices pointing to a 67% chance of a 0.25 percentage point move.
What does this mean for stocks? Let's look at what happened in previous Fed rate-cutting campaigns.
In 12 of the 14 Fed rate cycles since 1929, the S&P 500 posted a positive return 12 months after the initial cuts, according to A Schwab reportThe authors are Liz Ann Sonders, Schwab's chief investment strategist, and Kevin Gordon, a senior investment strategist.
The two exceptions occurred after the Federal Reserve began cutting rates in 2001 and 2007. “They may seem uncomfortably recent, but neither economic environment resembles today’s,” the report notes.
“The first occurred in the midst of the dot-com implosion and the second was precipitated by the subprime mortgage crisis.”
When defense beats offense
Let's take a look at how Federal Reserve rate changes affect market sectors.
“Defensive sectors – core industries that tend to be more resilient to economic uncertainty, such as health care and utilities – generally perform well when interest rates rise,” the commentary said.
“By contrast, cyclicals – sectors that benefit from an accelerating economy, such as consumer discretionary and industrials – have greater potential when rates fall,” the report said.
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Does this mean that a shift towards cyclical instruments is on the horizon?
“This is another market dynamic that depends on how quickly the Fed cuts rates,” the report said.
When cyclical stocks outperform
“According to Ned Davis Research analysis, Cyclicals have often outperformed when the Fed enters a period of gradual rate cuts, as expected in this cycle.”
But here's a twist: The definitions of defensive and cyclical sectors have changed over time, Schwab said.
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“For example, technology has historically been in the cyclical camp,” the report notes. “But in this Fed tightening cycle, big tech companies have taken on many of the characteristics of more defensive companies.” The Fed raised rates from March 2022 through July 2023.
And tech companies have outperformed the market. “Their massive cash holdings (among other factors) have protected them from higher borrowing costs and helped them generate revenue as rising rates made cash more profitable,” Schwab said.
The securities firm Jefferies has compiled a list of stocks to buy when the Fed cuts rates. stocks-to-buy-when-the-fed-starts-cutting-according-to-jefferies.html”>CNBC profiled Jefferies report.
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The investment firm picked stocks that outperformed in months when markets expected imminent rate cuts and a soft economic landing (easing inflation without recession) was forecast.
Expectations for a rate cut were indicated by falling two-year Treasury yields, and a soft economic landing was indicated by 10-year Treasury yields falling only slightly or rising.
In this environment, investors should look for value stocks with strong earnings momentum, Jefferies said. The stocks it selected all have “attractive valuations,” it said, with price-earnings multiples below 20.
The fearsome Jefferies quintet
Selections include Internet search giant Alphabet (GOOGL) shoe company Crocs (CROSS) banking titan JP Morgan Chase (Ministry of Justice) oil producer Marathon oil (Maintenance, repair and upkeep) and fiberglass manufacturer Owens-Corning (boss) .
Below are Morningstar ratings for the stocks, in descending order of market capitalization:
Alphabet
Moat: Wide. This means the Morningstar analyst believes the company has competitive advantages that will last at least 20 years. Morningstar fair value estimate: $209. Wednesday's price: $166.
JP Morgan Chase
Moat: Wide. Morningstar fair value estimate: $178. Wednesday's price: $214.
More economic analysis:
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- After the Federal Reserve shook markets, what now?
- Jobs report raises key recession warning signal as stocks plunge
Marathon oil
Moat: None, meaning Morningstar believes the company has no sustainable competitive advantage. Morningstar fair value estimate: $27. Wednesday's price: $27.70.
Owens Corning
Moat: Narrow, meaning Morningstar sees companies with competitive advantages that will last at least 10 years. Morningstar fair value estimate: $164. Wednesday's quote: $163.
Crocs
Moat: None. Morningstar fair value estimate: $160.40. Wednesday's quote: $140.45.
The author owns shares in Alphabet and JPMorgan.
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