Great stock rotation hinges on Powell signaling rate cuts soon

The continuing broadening of this year’s powerful stock market rally hangs on what the Federal Reserve does and says about interest rates after its two-day meeting wraps up on Wednesday.

Since the July 11 consumer price index print showed signs of cooling inflation, traders have stepped up their rotation out of Big Technology shares and into everything from small-capitalization stocks to value plays. Meanwhile, investors have poured nearly $6 billion into non-tech sector US exchange-traded funds, compared with just $1.4 billion that has flowed into tech ETFs, Bloomberg Intelligence data show.

For the trend to continue, Fed Chair Jerome Powell will have to lay the groundwork for cutting interest rates in September following the most disruptive monetary policy tightening campaign in recent memory at his press conference on Wednesday.

“This equity rally that’s broadened may be turned upside down if the Fed doesn’t signal it’s cutting rates very soon,” said Jimmy Lee, chief executive of the Wealth Consulting Group, whose snapping up tech and small-cap shares in anticipation of a September cut. “If Powell doesn’t stay stubborn, this bull market has more room to run.”

Some have even argued for a cut at this week’s meeting after the Fed’s preferred inflation gauge - the core personal consumption expenditures price index - climbed by just 2.6% in June from a year ago, near the central bank’s 2% target. But Wall Street isn’t betting on it.

A year has come and gone since the Fed last raised rates, keeping borrowing costs stable while central bankers wait for signs that inflation is being tamed. If the Fed is about to begin a rate reduction cycle, stock bulls have history on their side. In the six prior hiking cycles, the S&P 500 Index has risen an average 5% a year after the first cut, according to calculations by the financial research firm CFRA. What’s more, the gains also broadened, with the small-cap Russell 2000 Index climbing 3.2% 12 months later, CFRA’s data show.

It’s been a wild ride since the Fed began its tightening campaign to tame inflation in March 2022, with the S&P 500 climbing 29% since then. But it was hardly a straight climb. After a brutal stretch two years ago that plunged the equities benchmark into a bear market, it has rebounded to all-time highs and traded above 5,600 for the first time ever, fueled by the frenzy surrounding artificial-intelligence.

Price pressures appear mostly contained at this point. Traders now fear that if the Fed doesn’t reduce borrowing costs it risks stoking turmoil in the banking sector while curtailing credit in crucial corners of the US economy. In the 1970s and again during the dot-com bubble, overly restrictive monetary policy, among other things, hurt the economy.

During the last seven tightening cycles, the average time from the final rate hike to the first cut was 9.2 months, per Sam Stovall, chief investment strategist at CFRA. At 12 months since the Fed’s last hike in July 2023, this span is already longer.

All of which makes the road tougher for traders trying to game the rotation out of Big Tech with August and September, historically the worst months for stock returns, coming up. The Fed meeting arrives during the same week earnings are expected from Microsoft Corp., Meta Platforms Inc., Apple Inc. and Amazon.com Inc., with analysts projecting their profit growth is poised to slow.

While another $1.2 billion was funneled into US small caps last week, according to EPFR Global, not everyone is buying that its rally - or the rotation theme - has legs. To Jeff Rubin at Birinyi Associates Inc., the moves look like a typical correction, with the Nasdaq 100 Index down 7.4% from its July 10 high.

“Rate cuts would need to be aggressive for those smaller companies to benefit,” said Nancy Tengler, chief executive officer at Laffer Tengler Investments. “And we just don’t see that happening with the economy strong.”

History shows that buying stocks at the end of hiking cycles is a winning strategy in relatively low-inflationary environments, like the 1990s. But when monetary easing comes in the wake of inflationary pressures, like the 1970s, stocks fall in the three months after the last hike, according to Bank of America Corp.

That’s why Powell’s commentary this week is critical to the tug-of-war between bulls and bears, who are expecting him to at least hint at when to expect lower rates.

“Traders are pricing in action by the Fed very soon,” said Eric Beiley, executive managing director of wealth management at Steward Partners Global Advisory, who is pulling money out of growth shares and pouring it into large-cap value and small-cap stocks that trade at attractive valuations. “It’s important officials act, or else stocks will be vulnerable in a seasonally weak and volatile time.”