History Can Be a Lousy Guide
Dr. JoAnne Feeney, Partner & Portfolio Manager
Now that the Federal Reserve has shifted to a (much anticipated) rate-cutting regime, investors want to know how this is likely to impact different types of stocks, whether those be growth versus value or those in different sectors, such as information technology or consumer staples. History tells us that once the Fed starts cutting its policy interest rate (the Federal Funds rate), value stocks tend to outperform growth stocks and the “run-to-safety” stocks tend to outperform those in more cyclically expansionary sectors. This time is already different, and it’s time to throw out the history books.
The Fed cut rates at a time when the U.S. economy is in pretty good shape. Yes, it’s the case that the market for labor has softened with fewer job openings, but the unemployment rate remains relatively low and real GDP growth is solid. While some segments of the income distribution are struggling, and some industries are seeing weak demand, the aggregate picture remains healthy. We are not in a recession and we do not see a trigger that would lead the U.S. into one anytime soon. So why did the Fed even bother to cut rates? Primarily because the Fed no longer needs to keep rates so high to get inflation back to its 2% target. The latest data shows inflation running below 2% when looking at the annualized rate over just the last three months. And with labor markets beginning to soften, the Fed is turning its attention to the other element of its dual mandate—that of maximizing employment. The unemployment rate has increased from its 3.5% low to 4.3% and the Fed would like to minimize the risk of it moving significantly higher. Because we are not in a recession from which the Fed is attempting to rescue us, the stocks more likely to do well following these cuts will be a very different sort from those which have benefitted in the wake of rate cuts of past cycles. Now, let’s sort out which areas of the market may stand to gain.
By cutting rates now and signaling that further reductions are coming, the Fed is allowing businesses to access financial capital more cheaply, and so enabling them to create expansion plans knowing that the cost of capital will be even lower in the quarters to come. Those firms most reliant on sourcing external financial capital will likely gain the most. Smaller companies fit into this group, but so do those contemplating large projects with payoffs in the distant future. Biotech companies, for instance, are highly reliant on financial capital to fund years of R&D and clinical trials needed to launch new therapeutics into the market. Technology companies, too, disproportionately invest in R&D before seeing payoffs in the future. These firms should see lower costs at the margin and this could make some projects become financially viable. But it is not only the firms launching new projects that should catch investor attention, but also their suppliers. For several quarters, providers of analytical and production equipment for the life sciences and pharma segments, for example, have suffered weak demand. That could now be changing.
On the consumer side, the rate cut brings down short-term financing costs, such as through credit cards, and potentially medium-term financing, such as for auto loans. By reducing rates, the Fed is giving households greater ability to spend on goods and services. Travel and leisure, and discretionary spending more broadly, stand to benefit. Lower rates may serve to reverse the weakness we have been seeing, for example, in spending on durable goods (e.g., home appliances). And the weakness in autos over the last few quarters may begin to abate as auto loans become more affordable. Note, however, that the impact on home sales is likely to be more muted. The Fed controls the overnight lending rate. Long-term rates, including rates on mortgages, are largely impervious to short-term shifts in monetary policy. But those have also fallen, which should help housing in due course.
Notice that the companies positioned to gain are more likely to be growth companies, rather than the value companies that historically benefited at the times when the Fed has cut rates. It isn’t that value companies benefit from rate cuts per se, it is that those companies are less vulnerable in a downturn, so they hold up better. In the current environment, however, investors do not see a downturn as very likely. Instead, companies positioned to do well are found in sectors such as technology, industrials, health care, and consumer discretionary, rather than consumer staples or utilities. And beyond the direct and indirect impact of rate cuts, those companies and sectors likely to do well will also reflect two additional elements of this investing environment: ongoing cyclical recoveries, such as in personal electronics, and secular trends, such as those triggered by demographics or innovation. This time around, the Fed is cutting rates to reinforce a healthy economy, and that makes all the difference when it comes to the opportunities for investors.
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