(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, with the Russell 2000 index of smaller firms climbing 2.5%. 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 affected by 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 companies 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 further fuel 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 we 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 0.4%, up for a fifth stright day. Its equal-weighted version gained 0.7%. The Dow Jones Industrial Average advanced 0.6%. The Nasdaq 100 added 0.3%. A gauge of the “Magnificent Seven” megacaps advanced 0.2%.
Treasury two-year yields dropped seven basis points to 3.57%. The likelihood of a 50-basis-point move climbed to 40% on Friday, up from as low as 4% earlier in the week. The dollar fell. Gold rose to another record.
To Neil Dutta at Renaissance Macro Research, the case for the Fed cutting more agressively next week 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.’ I don’t buy this for a second,” Dutta says. “My own sense is that markets would welcome the move. It is a good thing that the Fed is trying to get onsides quickly.”
At JPMorgan Chase & Co., Michael Feroli says he’s sticking with his call that offficials will do the “right thing” and cut a half-point.
Andrew Brenner at NatAlliance Securities says that while he thinks a 50 basis-point cut is the “right call,” he just can’t see “this Fed — who is so entrenched in backward-looking numbers — getting to 50.”
“That is what we think, rather than we want,” Brenner concluded.
Elias Haddad and Win Thin at Brown Brothers Harriman & Co., also believe the Fed is unlikely to slash rates as aggressively as implied by the money market.
“First, the US labor market is not falling out of bed. Second, US consumer spending is resilient. Third, underlying inflation is sticky. Fourth, financial conditions are loose,” they said.
In the event the Fed decides to go bigger, small caps would get a “significant rally” — and would still rally with a “very dovish 25,” said Eric Johnston at Cantor Fitzgerald.
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.”
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 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.
“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.
“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.”
After a couple years of technology stocks leading the market higher, investors in the last two months have shown an appetite for other sectors. As a result, money flew into other corners of the market, including utilities, real estate, industrials and small-cap stocks. The risk is that what seems like a rotation away from tech and artificial intelligence may not be much of one after all.
“This rotation has actually caused the death of diversification,” said Michael Landsberg, chief investment officer at Landsberg Bennett Private Wealth Management. “Many investors are adding artificial intelligence-centric stocks in the utilities, industrials and real estate sectors, and incorrectly thinking that they are properly diversified when they are actually still overly exposed to technology themes.”
Stock markets are likely to trade sideways until US employment data show clear signs of either weakening or strengthening, according to Bank of America Corp. strategists led by Michael Hartnett.
A clear direction for jobs would “resolve the autumn ambiguity,” Hartnett wrote in a note, after non-farm payrolls climbed by 142,000 in August, lower than economists’ expectations. “Until then, risk rotates rather than rips or retreats.”
Wall Street Gears Up for Fed:
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.
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.
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.
Markets are torn right now between a 25bp cut and 50bp cut next week. We expect 25bp and will be focusing on the new Summary of Economic Projections. As long as inflation stays on a sustained path to 2%, the labor market will be what determines upcoming Fed policy decisions.
Corporate Highlights:
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United States Steel Corp. surged after the Washington Post reported President Joe Biden wouldn’t immediately move to block Nippon Steel Corp.’s takeover bid.
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Boeing Co. is at risk of losing its investment-grade credit rating as the embattled planemaker faces the prospect of a drawn-out strike by workers that will further disrupt production and cash flow.
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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.
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CoreWeave, a cloud computing provider that’s among the hottest startups in the artificial intelligence race, is in talks to arrange a sale of existing shares valuing it at $23 billion, according to people with knowledge of the matter.
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Adobe Inc. delivered an outlook that failed to quell investor impatience for new artificial intelligence tools to start generating cash.
Some of the main moves in markets:
Stocks
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The S&P 500 rose 0.4% as of 3:01 p.m. New York time
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The Nasdaq 100 rose 0.3%
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The Dow Jones Industrial Average rose 0.6%
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The MSCI World Index rose 0.5%
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S&P 500 Equal Weighted Index rose 0.7%
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Bloomberg Magnificent 7 Total Return Index rose 0.2%
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The Russell 2000 Index rose 2.1%
Currencies
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The Bloomberg Dollar Spot Index fell 0.3%
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The euro was little changed at $1.1078
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The British pound was little changed at $1.3121
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The Japanese yen rose 0.6% to 140.91 per dollar
Cryptocurrencies
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Bitcoin rose 2.8% to $59,833.73
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Ether rose 3.1% to $2,423.77
Bonds
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The yield on 10-year Treasuries declined three basis points to 3.65%
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Germany’s 10-year yield was little changed at 2.15%
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Britain’s 10-year yield declined one basis point to 3.77%
Commodities
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West Texas Intermediate crude was little changed
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Spot gold rose 0.9% to $2,581.53 an ounce
This story was produced with the assistance of Bloomberg Automation.
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