Which areas of the US equity market perform best when interest rates start to fall?
With interest rates likely to be headed lower in the coming months, we examine which stock market sectors and styles typically do well after the first rate cut.
We recently published an article on what the expected fall in inflationary pressures means for the performance of different areas of the equity market. Historically, when US inflation approaches the Federal Reserve's (Fed) 2% target, the momentum style and technology stocks have generally shown stronger performance.
However, it is important to note that this is only one aspect of the overall picture. The fall in inflation provides room for the central bank to cut rates. In fact, a year after the first rate cut by the Fed, US stocks have typically delivered double-digit returns. At the same time, the growth environment matters particularly when recessions lead to a more aggressive rate easing cycle. With interest rates likely to be fall in the coming months, which sectors and styles of the stock market typically do well after the first rate cut?
After the first rate cut, defensive sectors tend to outperform their cyclical peers
For the analysis on sectors, we have grouped them into cyclicals and defensives based on their sensitivity to the overall market. For instance, the cyclical sectors, such as technology, typically outperform even more when the market rises, but also decline more when the market falls.
Table 1 shows that defensive sectors have tended to outperform their cyclical peers following the first rate cut by the Fed. This is especially evident during recessions, which is likely due to investors seeking areas of the market which are most likely to withstand the weaker growth environment and benefit from more aggressive rate cuts.
By contrast, most cyclical sectors typically perform poorly in the initial three months after the first rate cut, particularly when the rate cut occurs during an US recession. But a year after the start of the easing cycle, cyclical sectors usually deliver stronger returns.
Initially, cyclicals sell off on the back of the rate cut, which is likely in response to the weaker growth and inflation backdrop. But at some point, these areas of the market become attractive as the equity valuations of these stocks become cheaper and investors anticipate the rate cuts boosting economic activity and corporate earnings. That said, both financials and consumer discretionary sectors have been the exceptions, as they have generally done well even in the initial months after the first cut.
Interestingly, the technology sector underperforms the broader market in the first few months after the rate cut. But its performance has been negatively skewed by the big sell-off during the technology bubble recession in the early 2000s. Without this period, technology stocks usually achieve positive returns when rates are cut.
How do equity styles perform during rate cutting cycles?
The momentum style has, on average, been the best performing area of the market during past rate cutting cycles (table 2). These stocks would have been performing very well before the rate cutting cycle, and the pick-up in investor sentiment following the first cut is only going to boost that performance.
To a slightly lesser extent, quality and growth stocks have typically generated positive returns during rate cutting cycles. This is consistent with our previous analysis on these equity styles performing well in a low inflationary environment. Growth, quality and momentum stocks perform worse when the rate easing cycle occurs in recessions. This might be because investors rotate into the more defensive areas of the market such as the minimum volatility (min. vol.) style.
Even small caps tend do well after the first rate cut during recessions. It may be that small caps benefit from the more aggressive rate cutting that occurs in recessions. However, it is worth bearing in mind that our analysis is dependent on the time horizon. For example, analysis of small caps back to the 1920s shows that they have for most of the time outperformed the market a year after the first rate cut (table 3).
But after the mid-1980s, small caps have typically underperformed the broader market after the first rate cut (this is the starting period of our analysis). The difference is likely due to changes in the composition of sectors in the small cap universe, which has increased its share of financial and real estate companies but reduced its exposure of technology and consumer discretionary sectors. Clearly, the sector exposures of equity styles are dynamic, and the past investment playbook does not guarantee future performance.
Conclusion
Given our baseline view of no recession in the US and the anticipated rate cut by the Fed in September, it is likely that momentum, growth, and quality stocks will outperform. This finding is consistent with our analysis of these equity styles within a low inflationary backdrop. At the same time, defensive sectors compared to their cyclical peers are also likely to thrive in an environment where rates are being cut.
Any reference to regions/ countries/ sectors/ stocks/ securities is for illustrative purposes only and not a recommendation to buy or sell any financial instruments or adopt a specific investment strategy. Past performance is not a guide to future performance and may not be repeated.
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