Goldilocks

All eyes are on U.S. Federal Reserve Chairman Jerome Powell ahead of an important Federal Open Market Committee (FOMC) meeting on 18 September. Market participants are now pegging the odds of a rate cut at 100%, according to CME’s FedWatch tool. 

Interest rate traders are betting on a federal funds rate between 4.25% and 4.5% before the end of the year. They’re hardly out of line: Powell himself acknowledged that ‘the time has come’ for policy to adjust, as the economy continues to grow at a ‘solid pace’ and the upside risks to inflation have diminished. 

It’s the ideal scenario for policymakers, and it’s often referred to as a Goldilocks economy. The girl from the tale likes her porridge at just the right temperature, and the U.S. economy appears to be in a similar sweet spot. It’s expanding, with unemployment relatively low and inflation seemingly under control.

With a rate cut all but certain, the question now is how big that cut will be (and how many of them there will be before the end of the year). The Fed has kept its policy rate in the 5.25% to 5.50% range since last July. A Reuters poll from August shows that market participants expect at least three cuts in 2024.

One thing that could dampen the prospect of a sizable rate cut is the labour market. July’s jobs data showed an uncomfortable increase in the unemployment rate to 4.3%, and the stock market had an equally uncomfortable reaction: major Wall Street indices ended the day in red. The U.S. market tumbled again when August jobs came in below expectations, with Broadcom ($AVGO) and Nvidia ($NVDA) weighing the index down significantly.

But how will this all-important event next week impact your portfolio? Schroders research shows an 11% average return for U.S. stocks 12 months after the Fed starts a cutting cycle. That figure is as high as 17% in a ‘no-recession’ scenario. Equities also tend to outperform everything, including corporate bonds and cash. 

Rate-sensitive sectors will likely benefit the most. That means real estate, banks, utilities, consumer discretionary and technology stocks have more to gain from the cheaper borrowing costs that come from lower interest rates.

Constellation Energy ($CEG) is a utility company that managed to rally 67% YoY even as interest rates stayed at their highest levels in nearly 20 years. Lower cost of financing will likely be a boon for a firm as capital-intensive as Constellation.

Another U.S. stock that’s done well despite the circumstances is Welltower Inc ($WELL) – a real estate investment trust that invests in healthcare infrastructure. Its share price is up 50% YoY, and the firm recently increased its dividend payout ratio to 10% and raised guidance for its funds from operations.

A rate-cut-induced boost to consumer spending could also benefit firms like Home Depot ($HD), McDonald’s ($MCD), Lowe’s ($LOW) and TJX ($TJX). But the sector most people will be focused on in this cycle is technology – specifically, how the Nvidias of the world will perform when rates are lower. 

And while large cap tech may well see a rally, it’s worth noting that firms with higher cash reserves – like Alphabet ($GOOG) and Apple ($AAPL) – could see diminishing returns on that cash as interest rates come down. 

Whether or not the market rallies with a rate cut, lower rates mean more disposable income for asset allocation. Ahead of the event, investors might also engage in some Goldilocks’ stock picking. But it isn’t just about finding the right investment; it’s about identifying the ideal balance between risk and reward.