Rate Cuts on the Horizon: Bank of America Predicts Rally for Rate-Sensitive Cyclical Stocks
The Federal Reserve’s expected pivot towards lower interest rates, fueled by recent benign inflation data, has sparked optimism for a significant rally in rate-sensitive cyclical stocks according to a new report by Bank of America. The bank anticipates these stocks will outperform the broader market as investors embrace a more favorable interest rate environment.
Key Takeaways:
- Inflation Surprise: The June inflation reading, which saw the most substantial downside surprise compared to analyst estimates since 1998, provides strong evidence for the Fed’s potential rate cuts.
- Path to "Goldilocks" in 2024: Bank of America forecasts a scenario with moderating yet stable macroeconomic conditions, and a cooling Consumer Price Index (CPI), creating an environment ripe for growth.
- Earnings Recession Recovery: Although the broader market has exhibited low volatility, Bank of America cautions against complacency, suggesting the potential for sharp rotations. The report highlights the importance of small-cap outperformance compared to large caps, as evidenced by the recent rally in the iShares Russell 2000 ETF (IWM).
- Q2 Earnings Crucial: The upcoming second-quarter earnings season will be pivotal for equities, with the market’s focus shifting from multiples to earnings. While some concerns persist regarding disinflation’s potential impact on pricing power, Bank of America anticipates a typical 2% EPS beat.
- Positive Macro Environment: Historically, a combination of slowing GDP and accelerating EPS has proven to be the best macro environment for stocks, fostering strong fundamentals and a benign rate environment.
A New Era for Cyclical Stocks
The prospect of easing rate pressure, coupled with Fed-supported growth and an anticipated recovery in earnings for the "Other 493" companies (excluding the Magnificent 7) from their earnings recession, creates a compelling case for rotation into rate-sensitive cyclical stocks. These companies are often heavily reliant on borrowing costs and tend to benefit strongly from lower interest rates.
Small Cap Momentum
The recent CPI miss triggered a surge in small-cap stocks, with the iShares Russell 2000 ETF (IWM) experiencing its strongest weekly gain since October 2023. This outperformance contrasts sharply with the modest rally in the S&P 500, as tracked by the SPDR S&P 500 ETF Trust (SPY).
While the S&P 500 has displayed low volatility, Bank of America suggests this tranquility may mask underlying vulnerabilities. The bank advises investors to hedge against potential sharp rotations, whether the recent post-CPI moves continue or reverse, through outperformance option calls, such as Russell 2000 vs. Nasdaq 100 or equal- vs. market-weight S&P 500 strategies.
Earnings Season: A Critical Test
The upcoming Q2 earnings season will play a crucial role in shaping the broader market landscape. As investors shift their focus to earnings, the performance of companies will be under intense scrutiny.
While some analysts express concerns that disinflation could pose a challenge to earnings by weakening pricing power, Bank of America remains optimistic, projecting a typical 2% EPS beat. The firm believes that despite the slowing economy, earnings are accelerating, setting the stage for continued strong performance.
Accelerating Earnings, Positive Outlook
The bank anticipates continued earnings acceleration into the second half of the year, with the "Other 493" companies leading the recovery from their earnings recession. This positive earnings outlook, paired with a more favorable interest rate environment, creates a strong foundation for rate-sensitive cyclical stocks to outperform in the coming months.
Historically, a backdrop of slowing GDP and accelerating EPS has been highly beneficial for stocks. This combination provides the optimal macro environment for growth, as it reflects a healthy economy with strong fundamentals. With Bank of America predicting this scenario to play out, the stage is set for rate-sensitive cyclical stocks to shine.
While the report paints a positive picture for rate-sensitive cyclical stocks, investors are advised to remain cautious. The market landscape can be volatile, and sudden shifts in sentiment can occur. Thorough due diligence and a balanced approach to investment strategies are essential to navigating the evolving market conditions.
