iCapital Market Pulse: Market Consolidation and the Great Rotation

July 17, 2024 marked the worst down day for the S&P 500 and Nasdaq since April 30, 2024 and December 15, 2022.¹ Semiconductors in particular came under pressure with the  semiconductor (SOX) index down 7% due to the potential Biden administration rule under consideration to further tighten export controls on chips, and former President Trump’s comments on how Taiwan should pay for U.S. defense, given “Taiwan took our chip business from us.”² This is a continuation of the rotation trade that started earlier this month.

The Nasdaq and semis are now posting negative performance month-to-date, while the names more sensitive to interest rate cuts have been solidly outperforming – with regional banks, non-profitable tech, homebuilders, small caps and REITs all posting gains well above the S&P 500 and the Nasdaq. And even with the recent pressure on much of tech and the broader indices, the rotation trades of regional banks, real estate, utilities were still in the green.

What caused this rotation? The apparent certainty that the Fed is very close to cutting rates. June’s cooler than expected consumer price index (CPI) report gave way to a large repricing of the Federal Reserve (Fed) rate expectations – with the September rate cut fully priced.³ Indeed, Chair Powell acknowledged at a recent speech at the Washington D.C. economics club that the “last three inflation readings have added confidence.”⁴

We think this rotation has more room to go in the coming months, despite the sharp moves this month. Yes, regional banks, small caps and REITS may have all run too far, too fast this past week and are looking near-term stretched, but the higher confidence in an upcoming rate cut should keep investors firmly interested in the rate cut beneficiaries in the coming weeks, especially as they find reasons to re-allocate away from tech. Indeed, we did flag earlier the risks to the tech sector from the potential elections rhetoric here, and believe that lofty valuations and buoyant earnings expectations could keep tech under additional pressure for now.

In this week’s commentary we take a closer look at how the markets behaved around the past starts of the rate cutting cycles and share the observations, as well as our thoughts on how to position portfolios going into and around the first rate cut.

Using rate-cutting history as a guide

A look at how the markets have performed around the first rate cut offers several observations.

First, stocks typically rallied into the first rate cut, consolidated in the one to three months after the first cut, and then resumed the upward move – when there was no recession.⁵ This is why we have suggested here and here to retain exposure to stocks in 2024, in anticipation of this first rate cut. Today, however, given the first rate cut should be in September, we are likely approaching a period of consolidation, especially given the extent of the recent upward moves in broad indices. Additionally, this time around, the first rate cut may also coincide with the run-up to the U.S. Presidential election, when volatility typically picks up.

Despite this near-term election uncertainty, we recognize that the volatility tends to subside after the election. And over time, synchronized central bank easing should continue to support stocks. Indeed, 27 of 34 global central banks, or 80% are projected to ease by the end of 2024, up from roughly 40% today.⁶ And historically, stocks advanced by 9.2% in the six months following the first rate cut, according to the median of observations, which includes even recessionary readings (see Exhibit 2).⁷

While the markets may consolidate near-term, they should ultimately move higher. To us, the cumulative rate cuts and the likely post-election relief into year-end is the reason to add to equities on weakness over the next few months.

Second, stocks tended to outperform in the six to 12 months after the rate cuts in non-recessionary scenarios.⁸ Although median market returns tended to be positive following the start of a Fed rate cutting cycle, we find that market returns improved when the Fed cut rates and the economy avoided a recession (see Exhibit 3).⁹ Conversely, during periods when the Fed was cutting in response to a weakening economy or financial market event, markets did not perform as well. Indeed, during the 2001 and 2007 recessionary rate cutting cycles, virtually every sector in the S&P 500 traded lower.¹⁰

Thus, if the Fed is cutting rates in a preemptive fashion, to stick the soft landing, this should be supportive of a continued move to the upside for stocks. But, if this changes and we shift to a no landing, similar to what we saw in the first quarter of this year, or a hard landing scenario, then this would likely weigh negatively on stocks. We are still in the soft-landing camp.

Third, defensive sectors outperformed cyclicals in the three to six months following a rate cut. Consumer staples, health care and utilities posted the best results, while cyclicals like consumer discretionary, energy and materials suffered. Notably, this was the case regardless of whether there was a recession or not.

However, the experience in 1995 – the last often-cited soft landing scenario – was somewhat different – financials were among the top performers, along with more defensive sectors like health care and communication services (which at the time obviously did not include any of today’s Mag 7). And notably, the Russell 2000 small caps outperformed large caps in the one to three months after the first rate cut and kept up pace in the six to 12 months period delivering in-line or close to the S&P 500 returns. Also notably, broad info tech consolidated in the months after the rate cut.

This experience is one of the reasons why we believe the rotation into small caps, financials and real estate can continue. Additionally, when we have seen large relative moves in markets, they tended to persist. When we examine the forward returns for small caps after sharp moves (99th percentile), returns show an average outperformance of 2% relative to large cap equities over a one-year timeframe.¹¹

Finally, and perhaps most importantly, the benefits of rate cuts should be more than just a boost to sentiment – they could be a boost to the bottom line. For example, the two and a half rate cuts priced in for this year could deliver a tangible benefit to small-caps. One-third of the Russell 2000 index is not profitable, and 40% of the debt these companies have on their balance sheets is floating rate.¹² Thus, a reset lower in the floating rate benchmark like SOFR – which has already started – could soon provide much needed relief to these companies’ financials.

Likewise, we think regional banks stand to breathe a huge sigh of relief with the upcoming rate cuts. For example, unrealized losses on held-to-maturity assets that are now massive for regional banks (which we discussed here) should reverse with rate cuts and lower yields. Net income margins should improve with steeper yields curves and deposit costs and betas should be lower as the Fed cuts rates.

Finally, rate cuts should also alleviate pressure on commercial real estate (CRE). The cost of capital for developers and cost of servicing for operators should decline, while lower yields should also support lower cap rates overtime, and therefore, higher CRE prices. Indeed, we have already seen an inflection higher in CRE prices across most sectors. All of this in turn would reduce the CRE risk that regional banks have been facing.

How to position portfolios for the ongoing rotation

We believe there are a few ways to position portfolios to navigate the current market dynamics including consolidation and rotation. Specifically, we would look to trim positions in the technology and communication services sectors and rotate them into a barbell of rate sensitive sectors such as regional banks, real estate and small caps, and defensive sectors such as utilities.

Trimming Tech

Given the S&P 500 has become very tech focused for much of 2024, the technology sector may need to work off its overbought condition and excess bullish sentiment. Tech valuations are now lofty as P/E multiples have expanded sharply since the start of the year and earnings expectations are high. Indeed, communication services and technology upwards earnings revisions are what is keeping the overall S&P 500 earnings season expectations relatively high.

Additionally, we believe market participants are going to be very focused on how companies are monetizing AI this quarter. Indeed, with the hyperscalers spending an additional $27 billion and $38 billion on capex and R&D in 2024 and 2025, we have not seen as large of a rise in sales and earnings estimates.¹³ Thus investors may start to worry about the return on invested capital.

And of course, the ramp-up in election rhetoric and potential for more stringent export controls from both sides of the aisle or talk of tariffs could also weigh on the sector, as we have seen today.

Adding to a barbell of defensives and rotation trades

We remain in the soft-landing camp, but still think that adding some defensive posture in portfolios is warranted near-term. As we have seen above, defensive sectors perform well around the time of the first rate cut in both a recessionary and non-recessionary scenario — most likely given their favorable sensitivity to lower rates and economic resilience.¹⁴ And given some of the recent disappointments in economic data, these sectors should act as a hedge if we get any further downside surprises in growth.

We would also balance this with the rotation trades, or rate cut beneficiaries, with a preference towards regional banks, commercial real estate and small-caps. In our 2024 outlook, we discussed how the realization of rate cuts could lead to catch-up opportunities for some of these groups. We saw this in the last major equity market rotation, from the November 2023 CPI print into year-end (when rate cuts were being aggressively priced into markets), as regional banks, REITs, non-profitable tech and small caps outperformed the S&P 500 by 12.5%, 6.3%, 19.1%, and 6.7% respectively.¹⁵ And although the recent outperformance has been large, given the right catalyst(s) of rate cuts and the economy seemingly heading towards a soft landing, we believe it can continue.