Lower prices bringing shifts in market dynamics.
On a Wednesday visit, the Fed reduced interest rates, signifying the first reduction since March 2020. This action follows the central bank's aggressive increase of rates to a 23-year peak to manage excess inflation fueled by minimal borrowing expenses during the Covid pandemic.
Conceptually, a reduction in interest rates might imply good news for the stock market. Decreased borrowing costs leave businesses with additional cash for self-investment and shareholder returns. However, this situation has wider ramifications related to the economy's health and potential future trajectory.
The Dow has advanced 1.3% for the week, while the S&P 500 has also climbed by 1.1%. Both indexes reached new high points this week. Additionally, the Nasdaq Composite has increased by 1.2%.
Historically, the S&P 500 has grown by an average of 5.5% over the course of 12 months following a rate cut, according to LPL Financial statistics based on nine cycles of interest rate hikes dating back to the 1970s. Nonetheless, some market observers anticipate a period of volatility in the upcoming months as investors deal with a variety of uncertainties.
Although the labor market has exhibited notable strength compared to historical norms, there have been recent signs of weakness. Inflation has improved significantly since the Fed initiated rate hikes in 2022, but Fed Chair Jerome Powell acknowledged that it has yet to reach the central bank's 2% target. It remains uncertain whether the U.S. economy will manage to dodge a recession.
As expressed by Jeff Buchbinder, chief equity strategist at LPL Financial, in a Wednesday statement, "While a soft landing is still feasible, concerns that the Fed may still be trailing behind and policy uncertainty surrounding the upcoming presidential election indicate that stocks could experience a potentially volatile decline."
The Fed is unlikely to adopt a rapid decrease in interest rates if the economy does not require such conditions due to a downturn. Powell also warned that half-point reductions will not be the standard pace for future rate cuts. Fed officials have projected half a point more cuts in 2024 and a full percentage point's worth of cuts for the following year.
Changes in interest rates take time to influence the economy. Despite apparent reductions in mortgage rates and bond yields, businesses and consumers might not fully experience the positive effects of lowered rates right away.
As per Buchbinder, defensive sectors, such as health care, utilities, and consumer staples, often perform well during the initial six months of a rate-cutting phase. Powell mentioned that the economy remains robust and this rate reduction was intended to support the labor market. Nevertheless, the Fed typically lowers rates when the economy is weakening, indicating a potentially profitable move for investors to invest in traditionally secure stocks during a rate-cutting period.
According to Eric Diton, managing director of the Wealth Alliance, investors could consider investing in growth stocks with robust earnings growth. Tech stocks have seen significant gains following the Fed's rate reduction. Shares of Tesla have risen by 3.7%, Meta Platforms shares have gone up by 6.7%, and Apple shares have added 3.4%.
However, Diton recommends that investors with substantial investments in Big Tech stocks consider diversifying into underperforming market sectors that can benefit from reduced interest rates.
Small-cap stocks, as an example, often thrive with lowered rates since they often feature high amounts of adjustable-rate debt that moves up and down in response to the economic and financial climate. The S&P SmallCap 600 index has increased by 2.5% this week.
As suggested by Diton, "Take some money off the table and diversify."
Following the Fed's interest rate reduction, businesses might have extra funds for self-investment and dividend distribution. This reduction could potentially motivate investors to invest in traditionally secure stocks during a rate-cutting period.
In response to the Fed's rate cut, some market sectors, like small-cap stocks, could benefit due to their high adjustable-rate debt, making them a potential investment opportunity for diversification.
