With the Federal Reserve shifting gears and cutting interest rates by a half point, it’s time for investors, households and businesses to take a long hard look at where their money is.
The Fed on Wednesday lowered interest rates, marking the first rate cut since March 2020. That comes after the central bank aggressively raised rates to a 23-year high to tamp down wayward inflation spurred by near-zero borrowing levels during the Covid pandemic.
A decline in interest rates should, theoretically, mean good news for the stock market. Lower borrowing costs free up cash for companies to reinvest in themselves and return to shareholders. But it also has broader implications about the state of the economy and where it could be headed.
The Dow rose 1.6% for the week, while the S&P 500 gained 1.4%. Both indexes notched new record highs this week. The Nasdaq Composite jumped 1.5%.
The S&P 500 has gained 5.5% on average during the 12 months following a rate cut, according to LPL Financial data based on nine rate hiking cycles since the 1970s. But some investors say the market could see more volatility in the coming months as Wall Street contends with a number of uncertainties.
The labor market, while strong by historical measures, has weakened in recent months. While inflation has cooled considerably since the Fed began hiking rates in 2022, Fed Chair Jerome Powell acknowledged that it is still not at the central bank’s 2% target. It’s unclear whether the US economy will avoid a recession.
“While a soft landing is still viable, concerns that the Fed may still be behind the curve, coupled with policy uncertainty surrounding the upcoming presidential election, set stocks up for a potentially volatile fall,” wrote Jeff Buchbinder, chief equity strategist at LPL Financial, in a Wednesday note.
The Fed likely won’t take rates lower as aggressively as they were raised, unless the economy takes a downturn and necessitates loose economic conditions. Powell warned Wednesday that half-point cuts won’t be the pace at which the central bank lowers rates going forward. Fed officials penciled in a half-point more of cuts in 2024 and cuts amounting to a full percentage point next year.
Plus, it takes time for cuts to take hold on the economy. While mortgage rates and bond yields have begun drifting lower, companies and consumers still might not feel the effects of lower rates right away.
Defensive sectors such as health care, utilities and consumer staples stocks tend to outperform during those first six months of a rate-cutting cycle, according to Buchbinder. While Chair Powell stressed that the economy is still healthy and that this rate cut was specifically delivered to “support the labor market,” the Fed tends to lower rates when the economy is weakening. That means it would make sense for investors to rush into traditionally safer stocks during a rate-cutting cycle.
Eric Diton, managing director of the Wealth Alliance, said he recommends that investors own growth stocks with explosive earnings growth. Tech stocks have seen a boost after the Fed cut rates. Tesla shares have jumped 3.5% this week, Meta Platforms shares gained 7% and Apple shares added 2.6%.
But investors with outsized positions in Big Tech stocks should eye beaten-down areas of the market that benefit from lower interest rates, says Diton.
Small-cap stocks, for example, tend to benefit from lower rates because they tend to have large amounts of floating-rate debt that moves up and down depending on the state of economic and financial conditions. The S&P SmallCap 600 index gained 2.2% this week.
“Take some money off the table and diversify,” said Diton.
