Stock Rotation Is Back on Bets Fed Will ‘Go Big’: Markets Wrap

(Bloomberg) — Wall Street traders revived prospects for a half-point Federal Reserve rate cut next week, spurring a rotation into stocks that would benefit the most from policy easing.

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Economically sensitive shares outperformed the group of tech megacaps that have led the bull-market rally, with the Russell 2000 index of smaller firms climbing 2%. An equal-weighted version of the S&P 500 — where the likes of Nvidia Corp. carry the same heft as Dollar Tree Inc. — beat the US equity benchmark. That gauge is less sensitive to gains from the biggest companies — providing a glimpse of hope the rally will broaden out.

As the S&P 500 marched from one record to the next in the first half of the year, some investors grew concerned that only a handful of members outside of technology giants were participating in the rally. Corners of the market outside of big tech are now barreling higher as investors grow more confident that the start of the Fed cutting cycle will keep fueling Corporate America.

“The biggest news in the last 24 hours has been the shift in odds for a 50 basis-point cut at next week’s Fed meeting,” said Jonathan Krinsky at BTIG. “Small-caps offer better risk/reward in the near-term, and think mega-cap tech likely sees another breather, although it will certainly participate if the S&P 500 makes new highs.”

The S&P 500 rose 0.6%, while its equal-weighted version gained 1%. The Nasdaq 100 added 0.4%. The Dow Jones Industrial Average advanced 0.8%. Treasury two-year yields dropped four basis points to 3.6%. The dollar fell. Gold hit another all-time high.

To Eric Johnston at Cantor Fitzgerald, while the consensus is that the Fed will cut by 25 basis points next week, there is “of course” a chance that officials end up going bigger.

His view is that small caps, in particular, would get a “significant rally” if the central bank opt for a 50 basis-point cut — and would still rally with a “very dovish 25.”

Valuation still seems to favor small caps, and performance did little to move that dial, according to Simeon Hyman at ProShares.

“The anticipated Fed rate cut this month could be just the catalyst to realize this valuation-driven opportunity,” he said. “Small-cap interest rate sensitivity is one of the most widely accepted investment tenets, and a Fed rate cut cycle might deliver extra oomph to small-caps this time around.”

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Hyman noted that the rate sensitivity of small-cap stocks is largely attributable to the greater leverage of the cohort versus large firms — smaller companies typically have to borrow more money.

“That is clearly true today, with the Russell 2000 having nearly triple the leverage of the S&P 500, he says. “By itself, that difference is more than sufficient to point to small caps being outsized beneficiaries of rate cuts, as debt burden relief is typically more impactful for them.”

“While cracks are developing in many of the long-time growth leaders, the overall technical picture still shows broader underlying participation than what usually accompanies a cyclical peak,” said Doug Ramsey at The Leuthold Group. “We continue to view this broadening as more likely a sign of a leadership change (from growth to value) than a harbinger of yet another leg higher in the blue-chip averages.”

While there’s been a broader rotation under the surface of the market away from tech and communications and into more defensive corners, the one issue is that earnings growth at the top end of the market are still expected to exceed the rest of the index, according to Ryan Grabinski at Strategas Securities.

“If growth becomes scarce and investors flock to growth, it wouldn’t surprise me to see the largest most liquid names get bid up again,” Grabinski said. “Certainly, they are facing court and regulatory challenges but to be fair this is nothing new. Getting too down on the ‘Magnificent Seven’ could pose a major risk to one’s portfolio.”

Basically put, with the growth expected from the ‘Mag seven’, it makes them “difficult to fade,” he concluded.

Countdown to Fed:

Yes, it is an uphill climb, but I think the Federal Reserve will cut its policy rate by 50 basis points at its upcoming meeting. The case for doing more upfront is strong.

A popular reason to not go 50 is the message it would send. “The Fed must know something the rest of us don’t” or so the thinking goes. I don’t buy this for a second.

There are risks to the market if the Fed only goes 25, especially given the unlikely threshold of a “dovish cut” being met. So, a “how-the-market-would-respond” argument does not feel compelling. My own sense is that markets would welcome the move.

Just when we put the 50 basis-point cut next week on the back burner, the talk of 50 has risen from the dead.

While we originally called for a 50 basis-point cut — and think a 50 cut is the right call — we just can’t see this Fed who is so entrenched in backward-looking numbers, getting to 50. Jerome Powell’s consensus view is that he will not have enough votes to get 50. Hence his strategy will be to go 25 and then be uber dovish, at the presser. That is what we think, rather than we want.

Judging by price action, investors are certainly looking for a dovish rate decision. This could be in the form of a surprise 50 basis-point cut — or 25 basis-point cut, with a strong hint of at least one 50 basis-point reduction in the remaining two meetings later this year.

It is all about the economic growth now and jobs market. You would think that after the hotter inflation data that the implied probability of a 50 basis-point cut would have dropped to zero. In fact, it did fall close to zero, but it has since bounced back and we are back to square one. This implies that there is an equally split chances of a 25 basis-point or 50 basis-point cut next week.

And this is the issue: Now that market is back pricing as much likelihood on the 50 as 25 basis-point cut out of the gates, then anything but 50 will disappointment market pricing.

We maintain that a quarter-point initial cut is the path of least resistance, although it is clear that 50 basis points is on the table and will be part of the Fed’s conversation. We’re cognizant that CPI and PPI are likely to translate into a more benign move in core-PCE. As the Fed’s favored measure, the overall inflation profile will appear less concerning for policymakers and thereby allow the FOMC to focus on the labor market.

The decision to cut between 25 vs 50 basis points could be closer than most people anticipate. In our view, the dot plot will be the most prominent part of the Fed’s guidance next week, along with Chair Jerome Powell’s post-meeting press conference. Our expectation for the Fed’s forward guidance is for it to lean broadly dovish.

Treasuries will focus on the size of the cut, the dot plot, and Powell’s remarks as key guideposts. Given our expectation for the Fed to send a generally dovish tone while delivering a 25bp rate cut to start the cycle, rates can continue to rally and the curve can continue to bull steepen. We favor buying dips in duration.

Corporate Highlights:

• Adobe Inc. delivered an outlook that failed to quell investor impatience for new artificial intelligence tools to start generating cash.

• Oracle Corp. said annual revenue will rise to at least $104 billion in fiscal 2029, an optimistic signal on the growth prospects of the software maker’s cloud infrastructure business. The company’s shares jumped to reach record highs.

• Boeing Co. factory workers walked off the job for the first time in 16 years, halting manufacturing across the planemaker’s Seattle hub after members of its largest union voted overwhelmingly to reject a contract offer and go on strike.

• Energy company Halliburton Co. was downgraded by RBC Capital Markets downgraded to sector perform from outperform.

• Furniture retailer RH reported second-quarter revenue and profit that topped Wall Street expectations. The company touted an improvement in customer demand in recent months, though it cut its sales forecast for the year, saying revenue will lag demand as it adjusts its assortment.

Some of the main moves in markets:

Stocks

• The S&P 500 rose 0.6% as of 11:26 a.m. New York time

• The Nasdaq 100 rose 0.4%

• The Dow Jones Industrial Average rose 0.8%

• The Stoxx Europe 600 rose 0.7%

• The MSCI World Index rose 0.7%

• Bloomberg Magnificent 7 Total Return Index rose 0.4%

• The Russell 2000 Index rose 2%

• S&P 500 Equal Weighted Index rose 1%

Currencies

• The Bloomberg Dollar Spot Index fell 0.4%

• The euro rose 0.1% to $1.1088

• The British pound rose 0.1% to $1.3143

• The Japanese yen rose 1% to 140.38 per dollar

Cryptocurrencies

• Bitcoin rose 1.3% to $58,931.88

• Ether rose 1.5% to $2,386.03

Bonds

• The yield on 10-year Treasuries declined two basis points to 3.66%

• Germany’s 10-year yield was little changed at 2.15%

• Britain’s 10-year yield declined one basis point to 3.77%

Commodities

• West Texas Intermediate crude rose 1% to $69.65 a barrel

• Spot gold rose 0.8% to $2,577.57 an ounce

This story was produced with the assistance of Bloomberg Automation.

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