(Bloomberg) — Wall Street traders revived expectations of a half-point interest rate cut by the Federal Reserve next week, prompting a shift in funds into stocks that would benefit most from easier policy.
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Economically sensitive stocks outperformed the big tech companies that have driven the bull market, with the Russell 2000 index of smaller companies rising 2.5%. An equal-weighted version of the S&P 500, which has a weighting equal to Dollar Tree’s, including Nvidia Inc., outperformed the benchmark U.S. stocks. The index is less influenced by larger companies, signaling the rally could be extended.
As the S&P 500 continued to hit new records earlier this year, some investors grew concerned that only a handful of companies were participating in the rally. The market outside of big tech is now surging higher as investors become more confident that the start of a cycle of Fed rate cuts will provide further stimulus to U.S. companies.
“The biggest news in the last 24 hours is the increased likelihood of a 50 basis point rate cut at the Fed meeting next week,” said Jonathan Krinsky at BTIG. “Small caps offer a better balance of risk and reward in the near term, and large tech stocks will probably take another breather, but will certainly participate if the S&P 500 makes new highs.”
The S&P 500 rose 0.7%, its fifth straight day of gains. The index’s equal-weighted average rose 1.1%. The Dow Jones Industrial Average rose 0.9%. The Nasdaq 100 rose 0.7%. The index of the “Magnificent Seven” rose 0.5%.
The yield on the two-year Treasury note fell 7 basis points to 3.57%. The likelihood of a 50-basis-point move rose to 40% on Friday, from 4% at the start of the week. The dollar fell. Gold hit a new record high.
Neil Datta of Renaissance Macro Research says there is a strong case for the Fed to cut rates more aggressively next week.
“The general reason for not doing 50% is that it sends the message that ‘the Fed must know something that we don’t,’ which I don’t believe for a second,” Dutta said. “My own feeling is that the market would welcome this move. It’s good that the Fed is trying to get cooperation quickly.”
JPMorgan Chase’s Michael Feroli said he stood by his view that regulators would do “the right thing” and cut rates by half a percentage point.
Andrew Brenner of NatAlliance Securities said he thought a 50 basis point cut was “the right move,” but added, “it’s hard to imagine the Fed, with its fixation on backward-looking numbers, will cut rates by 50 basis points.”
“It’s not what we want, it’s what we think,” Brenner concluded.
Elias Haddad and Win Thin of Brown Brothers Harriman also believe the Fed is unlikely to cut interest rates as aggressively as financial markets suggest.
“First, the U.S. labor market is not deteriorating. Second, U.S. consumer spending is resilient. Third, underlying inflation is solid. Fourth, financial conditions are accommodative,” they said.
Cantor Fitzgerald’s Eric Johnston said small caps would “have a big rally” if the Fed decides to raise rates, even the “very dovish 25” would rally.
Valuations still appear to favor small-cap stocks, and performance has had little impact on those levels, according to Simeon Hyman of ProShares.
“An expected Fed rate cut this month could be the catalyst for realizing this valuation-driven opportunity,” he said. “Interest rate sensitivity in small-cap stocks is one of the most widely accepted investment principles, and the Fed rate-cutting cycle may bring more ‘oomph’ to small-cap stocks this time around.”
Hyman said small-cap stocks’ interest-rate sensitivity is due in large part to the group’s greater leverage compared to larger companies, which typically have more borrowed capital.
“This is clearly true today, with the Russell 2000 index being nearly three times more leveraged than the S&P 500,” he says. “That difference alone is more than enough to show that small caps are a big beneficiary of lower interest rates, because reducing debt burdens has a bigger impact on small caps than usual.”
Beneath the market’s surface there’s a broad rotation out of tech and communications into more defensive sectors, according to Strategas’ Ryan Grabinski, but the only problem is that earnings growth at the top of the market is still expected to outpace the rest of the index.
“As growth stocks become scarce and investors flock to growth stocks, it wouldn’t be surprising to see the largest, most liquid names rally again,” Grabinski said. “Of course, these stocks are facing legal and regulatory challenges, but in fairness, this is nothing new. Pricing the Magnificent Seven too low could pose a big risk to a portfolio.”
Essentially speaking, the expected growth of the “Mag Seven” will make it “hard to fade,” he concluded.
“While many long-time growth leaders are showing cracks, overall technical analysis indicates that underlying participation remains broader than typically accompanies cyclical peaks,” said Doug Ramsey of The Leuthold Group. “We continue to view this widening as more likely a sign of a change in leadership (from growth to value) than a harbinger of further gains for the blue-chip average.”
Technology stocks have driven the market for the past few years, but investors have shown interest in other sectors in the past two months. As a result, money has flowed into other parts of the market, including utilities, real estate, industrials and small caps. The risk is that what looks like a rotation out of technology and artificial intelligence may not be all that much after all.
“This rotation has actually caused the demise of diversification,” said Michael Landsberg, chief investment officer at Landsberg Bennett Private Wealth Management. “Many investors have added artificial intelligence-centric stocks to the utilities, industrials and real estate sectors, mistakenly thinking they are properly diversified when in fact they are still overly reliant on technology themes.”
According to Bank of America strategists led by Michael Hartnett, stocks are likely to remain sideways until U.S. employment data shows clear signs of weakening or strengthening.
A clearer direction in employment “will clear up the ambiguity of the fall,” Hartnett wrote in a note after nonfarm payrolls rose 142,000 in August, less than economists had expected. “Until then, risks remain cyclical, rather than sharply shifting or reversing.”
Wall Street prepares for the Fed:
Judging by the price action, investors are definitely expecting a dovish interest rate decision, which could take the form of a surprise 50 basis point cut or even a 25 basis point cut, with at least one 50 basis point cut likely in the remaining two meetings later this year.
And here’s the thing: the market is currently pricing in a 50 basis point cut as likely as a 25 basis point cut, and anything other than 50 will disappoint market prices.
While we maintain that a 0.25 percentage point cut would be the path of least resistance, it is clear that a 50 basis point cut is on the table and will be part of the Fed’s discussions. We recognize that CPI and PPI will likely lead to more moderate movements in core PCE. As they are the Fed’s preferred measures, the overall inflation profile will be less of a concern to policymakers, allowing the FOMC to focus on the labor market.
With expectations of a 25bp Fed cut at the start of the cycle while remaining generally dovish, rates may continue to rise and the yield curve may continue to bull steepen. We would recommend buying duration dips.
Markets are currently oscillating between a 25bp cut and a 50bp cut next week. We expect a 25bp cut and will be watching the outline of the new economic outlook. As long as inflation remains on a sustainable trajectory towards 2%, the labor market will determine future Fed policy decisions.
Company Highlights:
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U.S. Steel shares surged after The Washington Post reported that President Joe Biden is unlikely to immediately block Nippon Steel’s takeover bid.
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Embattled aircraft maker Boeing is facing the possibility of a long-term worker strike, putting it at risk of losing its investment-grade rating as production and cash flow are further disrupted.
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Oracle said its annual revenue will grow to at least $104 billion in fiscal 2029, signaling optimism about the growth prospects for its cloud infrastructure business.
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Cloud-computing provider CoreWeave, one of the hottest new companies in the artificial intelligence (AI) field, is in talks to sell its existing shares for $23 billion, according to people familiar with the matter.
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Adobe Inc. offered a forecast that did little to assuage investors’ impatience for its new artificial intelligence tools to start generating revenue.
Some of the key market developments:
stock
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The S&P 500 was up 0.7% as of 1:48 p.m. New York time.
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The Nasdaq 100 rose 0.7%.
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The Dow Jones Industrial Average rose 0.9%.
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The MSCI World Index rose 0.7%.
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The S&P 500 equal-weighted index rose 1.1%.
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The Russell 2000 Index rose 2.5%.
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The Bloomberg Magnificent 7 Total Return Index rose 0.5%.
currency
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The Bloomberg Dollar Spot Index fell 0.3%.
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The euro was little changed at $1.1082
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The British pound was little changed at 1.3126 to the dollar
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The Japanese yen rose 0.6% to 140.94 yen to the dollar.
Cryptocurrency
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Bitcoin rose 3% to $59,941.59
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Ether rose 3.1% to $2,424.69.
Bonds
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The yield on the 10-year Treasury note fell 3 basis points to 3.64%.
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German 10-year government bond yields were little changed at 2.15%
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UK 10-year government bond yields fell 1 basis point to 3.77%.
merchandise
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West Texas Intermediate crude fell 0.3% to $68.73 a barrel.
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Spot gold rose 1% to $2,582.75 an ounce.
This story was produced with assistance from Bloomberg Automation.
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