Fed "recalibrate" easing cycle = investors to "recalibrate" and embrace small-caps

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This is day two since the Fed initiated a rate cutting cycle, and markets are reacting positively. Most notably, small-caps (IWM 0.62% ) are leading gains, even as markets have seen a broad-based rally. This is consistent with our thesis that small-caps would lead post-Fed easing and this note is focused on why this small-cap strength could be the start of a multi-year cycle of small-cap outperformance.

• In initiating this rate cut, Fed Chair Powell mentioned “recalibration” multiple times. The message being the Fed is adjusting real interest rates to keep healthy the business cycle. This is a complete reversal of the last 30 months of Fed fighting an “inflation war.”
• The obvious question is what groups are most levered to a Fed “recalibration” easing cycle. Many pundits point to history and noted that in an easing cycle, defensive stocks lead, and thus, investors needed to avoid small-caps.

• As our clients know, our research continuously pointed to small-caps (IWM 0.62% ) as the single most positively levered to an easing cycle, premised upon:
  – easing cost of capital boosts industrials, financials, biotech
  – this is 49% of the Russell 2000 (R2K)
  – M&A would accelerate = boosts small-caps
  – small-caps have attractive valuations
  – median P/E R2K 10.7X vs 16.7X for S&P 500 (SPY 0.41% )
• We had advanced this view for many months (and perhaps a “touch” early), but the key is how small-caps would react to the first cut. And as we have seen for the past few days, indeed, small-caps have gained the most in the past week.

• The last time small-caps traded at this relative P/B to S&P 500 (44%) was 1999, and as we noted many times, this was the launch point for 12-years of relative outperformance of small-caps. From 1999 to 2010, small-caps outperformed by 650bp annually.
• Many investors wonder if the economy is late cycle. But businesses have been cautious for the past 2.5 years as the Fed signaled in early 2022 their intention to raise interest rates sharply. And as such, corporations have been cautious about over-expanding. Private investment to GDP (ratio) sits at 25%, below the long-term average of 27%. And since 1970, no major recession (except pandemic) started without this figure exceeding 28%.
• Similarly, while there are signs of stress for the consumer, the debt service ratio sits at 10% and in the last 2 recessions, signs of consumer stress only seen when this exceeded 13%. The Fed cutting rates is delivering lower cost of money for credit cards, auto loans, adjustable rate mortgages and even installment debt. So, this should lower the debt service ratio.
• In other words, if the business cycle remains healthy (our view), then the shift in Fed policy makes sense. And this is supportive for equities. But as noted above, this is arguably most positive for small-caps and cyclicals.
• We continue to see a challenging 8 weeks into election day but we have repeatedly noted this does not detract from the strong upside into YE. The second half of 2024 should gain sharply based on history. And since 1928, when the first half of a year sees gains >10%, the median second half gain is 9.8%. And the win ratio is 83%. The only down years took place when Paul Volcker was Fed Chair.
• As for risk assets broadly, the Fed “put” is back. That means, the Fed’s mandate is now primarily supporting a strong labor market. The July and August jobs report show a labor market that is slowing and if it weakens too far, this could trigger a contraction cycle (recession). That means the Fed wants a healthy economy.
• Key to a “healthy” economy is keeping consumers and business leaders confident. After all, if CEOs are cautious, then they will defer spending activity and expansion. This is the mode of most CEOs since the Fed unleashed its “inflation war” March 17, 2022 or two years ago. This is the psychology the Fed wants to reverse, meaning the Fed wants confidence to return.
• The biggest barometer, in our view, is the stock market. If the stock market falls 20%, this raises the risk of a recession sharply. And if it falls 30%, the wealth destruction would almost guarantee a recession. Even a decline of 10%, in a soft labor market environment, risks businesses getting cautious.
• Do you see what this implies? We think the Fed does not want the S&P 500 to falter. This is the Fed “put” — since the start of the inflation war, this was not always true. The Fed in 2022 probably found the 27% decline of stocks as supporting their attempt to control inflation and manage inflation expectations. This is not the case any longer.
• What else would the Fed like to see? The Fed would probably be supportive of bank lending to expand and for bank’s balance sheets to remain healthy. The drop in interest rates and the normalization of the yield curve are supportive of this. Hence, we think the Fed would like to see financials (XLF 0.40% ) and regional banks (KRE 1.10% ) trade well. Thus, there is a “put” on financials in a way.
• You might think that the markets are already expecting this, so this Fed “put” is not supportive of stocks going forward. But we have three reasons to strongly argue against that view of “good news is priced in.”
• First, there is well documented data (past 50 years) that shows stocks positively react to Fed cuts, when the economy is not landing (into recession). We published this many times, but the stats are compelling:
  – since 1971, 7 Fed first cuts
  – 1M return +2.9%, 71% win-ratio
  – 3M return +8.4%, 100% win-ratio
  – 6M return +12.8%, 100% win-ratio
  – hard to argue against history
• Second, there is room for “positive surprise” as many investors and pundits believe the US is already in recession. We are at FutureProof, the conference in Huntington Beach, right now and at a CIO panel yesterday, 3 of 3 senior CIOs said the US is in recession NOW. This is a widely held view, with many citing the “Sahm rule” (unemployment rose +50bp from low) or the fact the Fed has a history of being late. In any case, there are many who think the economy is contracting and thus, scope for positive surprise.
• Third, there is a bona fide tailwind from Fed cuts. There are parts of the US economy in a recession, which we discussed previously. And this is an important lifeline to these sectors:
  – durable goods are in a recession
  – automobile sales are in a recession
  – housing sales are in a recession
• Each of these 3 sectors will get a meaningful boost in affordability as the Fed starts cutting rates. This is a long winded way of saying the Fed is not “pushing on a string.” And this is a reason we expect small-caps IWM 0.62%  to perform well after the Fed cuts rates.

BOTTOM LINE: Small-caps lead, Fed is dovish

• Keep in mind the Fed is dovish and there is a focus on keeping labor markets strong. We could be seeing turbulence for the next 8 weeks, but this is also in the context of a very strong stock market in 2024. One where the S&P 500 has gained in 7 of the last 8 months.
• And with inflation softening, the mandate focuses on strong jobs. That acts as an implicit “put” on the equity market, as falling asset prices would threaten to weaken labor markets.

Given the dovish Fed, this remains our 2024 playbook:

• Stick with what is working
• Small-caps IWM 0.62%  IJR 0.64%
• Financials and Industrials XLI 0.57%  XLF 0.40%
• AI/Tech NVDA 0.26%  CDNS 0.89%  ARM AMD 3.31%  AIQ 2.13%
• Ozempic-related LLY -1.69%  NVO -2.08%
• Bitcoin & Proxies:
  BTC MARA 8.43%  PYPL 3.52%  COIN 7.43%  MSTR 9.15%  SMLR 3.71%
• But as we noted multiple times, we stick with the top 2 (small-caps and financials and industrials).

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Key incoming data September:

• 9/3 9:45 AM ET: Aug F S&P Global Manufacturing PMI Tame
• 9/3 10:00 AM ET: Aug ISM Manufacturing PMI Tame
• 9/4 8:30 AM ET: Jul Trade Balance Tame
• 9/4 10:00 AM ET: Jul JOLTS Job Openings Tame
• 9/4 10:00 AM ET: Jul F Durable Goods Orders Tame
• 9/4 2:00 PM ET:  Fed Releases Beige Book Tame
• 9/5 8:30 AM ET: 2Q F Non-Farm Productivity Tame
• 9/5 8:30 AM ET: 2Q F Unit Labor Costs Tame
• 9/5 9:45 AM ET: Aug F S&P Global Services PMI Tame
• 9/5 10:00 AM ET: Aug ISM Services PMI Tame
• 9/6 8:30 AM ET: Aug Non-Farm Payrolls Tame
• 9/9 9:00 AM ET: Aug F Manheim Used vehicle index Mixed
• 9/9 11:00 AM ET: Aug NY Fed 1yr Inf Exp Tame
• 9/10 6:00 AM ET: Aug Small Business Optimism Survey Tame
• 9/11 8:30 AM ET: Aug CPI Tame
• 9/12 8:30 AM ET: Aug PPI Tame
• 9/13 10:00 AM ET: Sep P U. Mich. Sentiment and Inflation Expectation Tame
• 9/16 8:30 AM ET: Sep Empire Manufacturing Survey Tame
• 9/17 8:30 AM ET: Aug Retail Sales Data Tame
• 9/17 9:00 AM ET: Sep M Manheim Used vehicle index Tame
• 9/17 10:00 AM ET: Sep NAHB Housing Market Index Tame
• 9/18 2:00 PM ET: Sep FOMC Decision Tame
• 9/18 4:00 PM ET: Jul Net TIC Flows Tame
• 9/19 8:30 AM ET: Sep Philly Fed Business Outlook Tame
• 9/19 10:00 AM ET: Aug Existing Home Sales Tame
• 9/23 8:30 AM ET: Aug Chicago Fed Nat Activity Index
• 9/23 9:45 AM ET: Sep P S&P Global Manufacturing PMI
• 9/23 9:45 AM ET: Sep P S&P Global Services PMI
• 9/24 9:00 AM ET: Jul S&P CoreLogic CS home price
• 9/24 10:00 AM ET: Sep Conference Board Consumer Confidence
• 9/25 10:00 AM ET: Aug New Home Sales
• 9/26 8:30 AM ET: 2Q T 2024 GDP
• 9/26 10:00 AM ET: Aug P Durable Goods Orders
• 9/27 8:30 AM ET: Aug PCE Deflator
• 9/27 10:00 AM ET: Sep F U. Mich. Sentiment and Inflation Expectation
• 9/30 10:30 AM ET: Sep Dallas Fed Manuf. Activity Survey

Economic Data Performance Tracker 2024:

Economic Data Performance Tracker 2023: