What’s a Federal Reserve Board interest rate cut worth to the stock market? We’ll soon find out, but history suggest it’s quite valuable to investors when the Fed reduces rates during an expansionary period rather than ahead of or during a recession. As you’ll see below, such a move will boost U.S. cyclical, growth and large cap stocks, among other asset classes.

As the second quarter earnings reporting season gets underway, I’ve heard a growing chorus of strategists and investors call for a pullback in equities. Such bearishness is perhaps no surprise given the S&P 500 index is already up ~20% YTD, and given an earnings recession is underway, the third one since 2009. (For more on this see page 1.)

Two weeks from now, the U.S. central bank is likely to make its first interest rate cut in almost 5 years and, as I’ve pointed out previously, such a move has dramatic impacts on markets. Moreover, given the paucity of investor conviction, one could argue there is a lot of cash on the sidelines, especially considering the substantial retail outflows from equity mutual funds in 2019 YTD.

Equities are likely to see a strong boost from a cut. Since 1971, when the Fed makes its first cut and Leading Economic Indicators (LEIs) are still positive (as is the case currently, hence, we are not in recession), stocks have risen 100% of the time three, six, nine and 12 months later. In other words, don’t fight the Fed.

Don't Fight the Fed: Go for Growth and Cyclical Sectors

The timing is key. When the Fed cuts and the U.S. economy is in expansion, the move drives positive equity returns. 100% of the time. (See nearby table.) The median nine months gain is ~18%, hence, we expect stocks to rise strongly into YE and believe our current 3,125 target is low.

Cyclicals, which are outperforming the market by 280 basis points and defensives groups by 690 bp, is a group that should be positively affected. Multiple factors are behind this but I think the rally in high-yield and easing financial conditions are supportive. Moreover, the steepening of the U.S. Treasury 30 year – 10 year yield curve spread historically is coincident with cyclical outperformance.

The rate reduction is also likely to favor growth stocks over value stocks, a continuation of the dominant theme for roughly the last decade. I have written extensively on the thesis that rising interest rates favor asset intensive businesses, such as value stocks, so the cut is likely a headwind for value.

Similarly, the Fed’s anticipated move will probably help boost large market capitalization stocks over small. While this may sound counterintuitive, I see large-caps benefitting. Why? This further amplifies the equity “there is no alternative” (TINA) to stocks thesis, and US TINA in particular. I believe investor equity flows will more likely accrue to the big guys over the small fry.

Additionally, I am beginning to wonder if a long-term mean reversion is underway. Since 1999, small-caps massively outperformed large-caps, but in the past eight years performance has really flattened. Further back, from 1990-1999, there was massive small-cap underperformance—is this a repeat?

I’ve favored U.S. equities over the rest of the world (ROW) for some time now, but I expect the likely impact of a cut is for the S&P 500 to further pull away from the ROW. I base this on three cornerstone arguments: (i) US corporates have strong franchises; (ii) supportive White House/gov’t policy and (iii) accommodative financial conditions in US. A Fed cut is icing on the cake. My assessment since the start of the year is that the U.S. continues its relentless outperformance versus ROW. (See chart below.)

Don't Fight the Fed: Go for Growth and Cyclical Sectors
Source: FS Insight, Bloomberg, FactSet

Finally, I think gold will gain traction as a “hedge” around negative rates, but it will likely also be good for emerging markets. Gold outperformance is supported by Fed cuts (weaker USD, more zero rate bonds). But there is a curious positive relationship between rising gold and rising EM equities. While weaker USD is the likely link, I wonder if this means EM could lift-off on a Fed cut.

Bottom line: While consensus may be right on a pullback, Fed cuts matter more. We see a 2H19 rally and recommend the following stocks: The tickers are GOOG, MNST, NKE, TSLA, AAPL, AMGN, AMP, AMZN, AXP, BF/B, BKNG, CSCO, FB, GRMN, NVDA, PM, PYPL, ROK, XLNX, ADP, CLX, MA, PG, V.

Don't Fight the Fed: Go for Growth and Cyclical Sectors
Figure: Comparative matrix of risk/reward drivers in 2019
Per FS insight
Don't Fight the Fed: Go for Growth and Cyclical Sectors
Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019

More from the author

Disclosures (show)

Stay up to date with the latest articles and business updates. Subscribe to our newsletter

Articles Read 1/2

🎁 Unlock 1 extra article by joining our Community!

Stay up to date with the latest articles. You’ll even get special recommendations weekly.

Already have an account? Sign In

Want to receive Regular Market Updates to your Inbox?

I am your default error :)