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, with the Russell 2000 index of smaller firms climbing 2.4%. 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 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 0.5%, up for a fifth consecutive day. Its equal-weighted version gained 0.9%. The Dow Jones Industrial Average advanced 0.7%. The Nasdaq 100 added 0.3%. A gauge of the “Magnificent Seven” megacaps was little changed.

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.”

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.

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.

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.

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