US rate cuts present investors with a tough choice

Looming US interest rate cuts are presenting investors with a tough choice: stick with the Big Tech stocks that have driven returns for more than a year or turn to less-loved areas of the market that could benefit from easing monetary policy.

Owning massive tech and growth companies such as Nvidia, Microsoft and Amazon has been a hugely profitable strategy for investors since early 2023, even as the stocks’ market dominance has drawn comparisons to the dot-com bubble of the late 1990s.

That calculus may start to change following Thursday’s surprisingly cool inflation report, which solidified expectations for a near-term rate cut by the Federal Reserve. Lower rates are seen as beneficial to many corners of the market whose performance has lagged this year, including small-caps, real estate and economically sensitive areas such as industrials.

Market action at the end of the week showed a nascent shift may have already begun. The tech-heavy Nasdaq 100 suffered its biggest drop of the year on Thursday while the small-cap Russell 2000 had its best day of 2024. The Nasdaq 100 has gained about 21% this year while the Russell 2000 is up just 6%.

Also on Thursday, the equal-weight S&P 500 - a proxy for the average stock in the benchmark index - had its biggest relative gain since 2020 over the S&P 500, which is more heavily influenced by the largest tech and growth stocks. That chipped away at the huge advantage for the S&P 500, which remains up about 18% in 2024 against a 6.7% gain for the equal-weight index.

“The trade got too one-sided and we’re seeing some reversal of this,” said Walter Todd, chief investment officer at Greenwood Capital.

Small caps and the equal-weight S&P 500 extended their gains on Friday even as tech stocks rebounded.

Investors cautioned that the moves could be a snap-back after the disparity in performance between tech and other market sectors reached extremes. Further, recent periods of market broadening have been short-lived: for example, small caps surged at the end of 2023, when investors believed rate cuts were imminent, only to lag in the following months.

Still, there are reasons for optimism about the broadening trade. Fed fund futures on Friday were pricing in nearly 90% odds of a 25 basis point rate cut at the central bank’s September meeting, according to CME FedWatch.

Smaller companies, including biotech firms, that are heavily dependent on credit are among those that stand to benefit most from lower rates, said Matthew McAleer, president and director of private wealth at Cumberland Advisors. Industrial companies, which can rely on debt for capital intensive projects, also could be winners, McAleer said.

Equity valuations across the market could also become more attractive if bond yields continue falling as traders price in lower rates. Lower yields mean bonds offer less competition to equities while stock valuations improve in many analysts’ models.

The benchmark 10-year Treasury yield, which moves inversely to prices, was last around 4.2%, down some 50 basis points below April highs. The S&P 500 was recently trading at 21.4 times forward earnings, compared to a historical average of 15.7, according to LSEG Datastream.

“If we can start to stall (near 4%)... I think you’re going to see better breadth across multiple areas in the equity market,” McAleer said.

Many are skeptical that investors will stay away from shares of megacap companies, which are expected to be more resilient in uncertain economic environments. Big Tech could be an appealing destination if the US economy starts to weaken more than expected after months of elevated interest rates, said Chuck Carlson, chief executive officer at Horizon Investment Services.

Megacap tech stocks are also at the centre of the artificial intelligence theme that has been exciting investors this year, said Rick Meckler, partner at Cherry Lane Investments.

“You could see... a broadening of stock buying,” Meckler said. “But I think as long as the AI thesis is dominating the market, it’s going to be difficult for these stocks to drop significantly.” Any sustained move away from megacaps could spell trouble due to their heavy weightings in indexes.

The S&P 500’s year-to-date gains have been concentrated in stocks like Nvidia and Microsoft, and analysts have warned that any weakness in them could hurt the major indexes.

If large cap tech stocks keep falling, “at some point, that will cause the entire market to decline,” Matthew Maley, chief market strategist at Miller Tabak, said in a note on Friday.

Reuters