By Lewis Krauskopf
NEW YORK (Reuters) -The resumption of monetary easing by the U.S. central bank could add to and broaden Wall Street’s rally, investors say, though such a boost might already be priced in and could depend on whether lower interest rates help the economy avoid a significant downturn.
The Federal Reserve is widely expected to reduce its benchmark rate for the first time since December at the end of its two-day monetary policy meeting on Wednesday, in an effort to shore up a weakening labor market. The move is expected to kick off a series of reductions, with nearly six standard quarter-point cuts priced into markets by the end of next year.
STOCK GAINS TEND TO FOLLOW RATE CUTS, WITH EXCEPTIONS
Historically, the start of an easing cycle has led to stock gains over the next year, on average. Lower interest rates could particularly lift a range of stocks tied to the cyclicality of the domestic economy, including banks, homebuilders, materials companies and smaller firms, investors said.
Such strength could create new leadership in a bull market that has been driven by megacap technology companies.
“Rate cuts to me really open up the opportunities for more segments of the market to participate in terms of leadership,” said Matt Stucky, chief portfolio manager, equities, for Northwestern Mutual Wealth Management. “A broadening out of the economy because we have a lower policy rate can help to broaden out the overall market as well.”
Some investors already may be making bets ahead of the widely telegraphed rate cuts, however. One indication is gains for the small-cap Russell 2000, which is outperforming the large-cap S&P 500 this quarter after trailing it for most of the past decade.
At the same time, investors are counting on the rate cuts to help prevent further weakness in the labor market, leading to a “Goldlilocks” environment where rates fall but the economy stays stable. Should the economy deteriorate, however, stocks already trading at lofty valuations will be vulnerable.
“The tail risk for equities in the U.S. is that the soft landing scenario is false and that we’re actually already in a recession,” said Bob Savage, head of markets macro strategy at BNY. “That’s not our central scenario, but it is not a zero scenario.”
On top of the rate decision, stocks will be tested by the accompanying Federal Open Market Committee statement, its economic projections and comments in a press conference from Fed Chair Jerome Powell to see if they line up with market expectations.
“Stocks are hinging on a few things. One is … that the Fed confirms that what the market thinks is going to happen, is likely to happen,” said Scott Wren, senior global market strategist at Wells Fargo Investment Institute.
The expected resumption of cuts comes after the central bank lowered its benchmark rate by a full percentage point from last September to December to its current level of 4.25% to 4.5%. It raised rates from March 2022 to July 2023 to get inflation under control.
Of 10 cycles since 1982 when the Fed started or resumed rate cuts, the S&P 500 gained an average of 11% over the next 12 months, according to an analysis by Brian Belski, chief investment strategist at BMO Capital Markets. The index rose eight of the 10 times.
However, in two instances where the start of rate cuts coincided with recessions, in 2001 and 2007, the S&P 500 posted 12-month declines of 13.5% and 23.9%, Belski said.
“As of right now, we’re not fighting off recession,” said Michael Mullaney, director of global markets research at Boston Partners. “So this is more of the normalization process, which generally bodes very well for stocks.”
RATE CUTS COULD BENEFIT STOCK GROUPS BEYOND BIG TECH
The dominance of tech and other megacap stocks has raised concerns about equity indexes becoming overly weighted in these massive names.
Lower rates could benefit a wider group of stocks by lowering borrowing costs, which aids companies that use debt financing, while also providing a broad boost to areas such as housing and consumer spending, benefiting those stocks particularly tied to economic cycles.
According to JPMorgan strategists, in past instances of the Fed resuming cuts after a pause, cyclical sectors lagged defensives initially, but tended to perform better after six months.
Nelson Yu, head of equities at AllianceBernstein, said shares of some industrial and financial companies that have lagged in the market’s recent rally are the “kind of high-quality cyclical stocks that could do well given some relief on rates.”
Areas of the market that are underheld by investors, including materials and real estate stocks, also stand to benefit from a rate-induced broadening, said BNY’s Savage.
Given that stocks have already performed well despite tighter monetary policy, how much of a tailwind lower rates will provide remains to be seen. The benchmark S&P 500 has gained over 12% this year, and about 85% since the bull market began in October 2022.
“It’s hard to argue that rate levels have been a binding constraint on the U.S. stock market,” said Doug Ramsey, chief investment officer at The Leuthold Group.
(Reporting by Lewis Krauskopf; Editing by Alden Bentley and Nick Zieminski)
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