Forecasts from the Federal Reserve and comments from central bankers couldn’t be more clear. Investors are being warned that interest rates will stay high for longer than they expect, with the median forecast from Fed officials calling for one rate cut this year.
And yet cash is flowing into stocks that benefit from low borrowing costs. The technology sector saw $2.1 billion in inflows this week, the most since March, according to data compiled by EPFR Global and Bank of America.
“The market remains unconvinced that inflation expectations and labor market data do not give the Fed room for multiple rate cuts this year,” said Keith Buchanan, senior portfolio manager at Global Investments. “This stubbornness is keeping the environment in place that is benefiting risk assets.”
The central bank’s projections for fewer rate cuts this year and Fed Chairman Jerome Powell’s hawkish comments in his press conference on Wednesday did not prevent the S&P 500 index from surpassing 5,400 for the first time, which also happened on Wednesday and remained there through at least Friday. The benchmark is up more than 50% since it bottomed in October 2022, which was during a bear market driven by the Fed’s massive interest rate hikes that began in March 2022 and were aimed at taming runaway inflation.
The question for investors now is: What will the market do when the Fed finally decides to cut interest rates?
Historically, rate cuts have marked a turning point that has ushered in strong equity returns — but only for cycles that aren’t driven by recessions, such as this one. This explains why the latest flow data from Bank of America and EPFR Global show a rotation into financials, materials and utilities — three important groups closely linked to the economy, which historically benefit from rate cuts as long as there is strong economic growth.
The consensus is that economic growth will remain strong, with the Atlanta Fed’s GDP Now model predicting real GDP growth will rise to 3.1% annualized in the second quarter, up from 1.3% in the first quarter.
“There’s very little indication that you’ll see any kind of real volatility,” said Carol Schleff, chief investment officer at BMO Family Office.
Tech Boost
Fund managers are also increasing exposure to tech stocks. The Nasdaq 100 index has gained 17% through 2024. Shares of the seven largest companies in the S&P 500 are priced at an average of 36 times projected earnings, compared with 22 times for the benchmark, according to data compiled by Bloomberg.
Data for the week ended June 14 compiled by Deutsche Bank AG showed overall equity positions have now reached their highest level since November 2021, when the Nasdaq 100 was at its peak.
Rules-based and discretionary investors — who rely on predefined guidelines and algorithms to make decisions — led the surge this week, with the technology sector rising sharply, along with rate-sensitive groups such as utilities, staples and real estate.
If the Fed takes a firm dovish stance, defensive sectors of the market that pay steady dividends, such as consumer goods and real estate, will also become more attractive, said Terry Sandven, chief equity strategist at U.S. Bank Wealth Management.
June is typically a quiet period in the markets, with trading volumes lower than they were in summer. But next week is a wild card: “triple witching.” Contracts linked to stocks and indexes expire on Friday, which coincides with the quarterly rebalancing of indexes, a confluence that produces a burst of volatility and high trading volume. It can therefore disrupt the situation in a very short period of time.
“Next week could prove to be quite eventful for equities,” said Frank Moncalm, senior portfolio manager at Entimo.
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