Rate Cuts Coming! What's Next for Stocks & Bonds?

Key Concepts

• Fed Funds Rate: The target short-term interest rate set by the US Federal Reserve.
• Inflation: A general increase in prices and decrease in the purchasing value of money.
• Recessionary Cut: Interest rate cuts made by the Fed in response to an existing or imminent recession.
• Maintenance Cut: Interest rate cuts made by the Fed to prevent an economic slowdown or stall, rather than in response to a full-blown recession.
• Discounted Cash Flow (DCF) Valuation: A method of valuing a company based on its expected future cash flows.
• VIX (Volatility Index): A measure of the expected volatility of the S&P 500 index.
• REITs (Real Estate Investment Trusts): Companies that own, operate, or finance income-generating real estate.
• Consumer Discretionary Stocks: Stocks of companies that sell non-essential goods and services.
• Small to Midcap Stocks: Stocks of companies with smaller market capitalizations.
• Speculative Growth Stocks: Stocks of companies, often unprofitable, with high revenue growth potential.

Federal Reserve Interest Rate Policy and Market Implications

Current Fed Stance and Future Outlook

The Federal Reserve (Fed) is poised to cut interest rates this week, following a nine-month period of holding them steady at 4.5%. Projections indicate at least two to three rate cuts this year and a significant number more next year, with the target Fed Funds Rate aiming to reach 3% or less by the end of next year. This shift is driven by recent data suggesting potential economic slowdowns, prompting the Fed to act preemptively.

Historical Context of Fed Policy

• Post-COVID Stimulus: The Fed funds rate was near 0% after the COVID-19 pandemic to stimulate the economy.
• Inflationary Surge: This led to high inflation by 2022, forcing the Fed to aggressively raise rates from near 0% to over 5%.
• 2022 Market Crash: The aggressive rate hikes caused a stock market crash and a bear market in 2022.
• Rate Hold and Recent Cuts: The Fed maintained rates above 5% for approximately one year. In September 2024, with inflation under control, they began cutting rates, implementing three cuts totaling about 1% (100 basis points), bringing the target rate down to the current 4.25%-4.5% range (average 4.33%). This rate has been held for the past nine months.

Rationale for Current Rate Cuts: Economic "Cracks"

The primary driver for the upcoming rate cuts is not political pressure but rather emerging signs of weakness in the US economy. The analogy used is that of a car:

• Raising Rates: Stepping on the brakes to slow down an overheating economy (high inflation). This led to the 2022 market crash due to fears of an economic stall.
• Cutting Rates: Stepping on the accelerator to speed up a slowing economy.

While Q2 GDP was strong at 3.3% and Q3 real-time tracking by the Atlanta Fed is at 3.1%, recent employment data indicates Americans are finding it harder to secure jobs. This suggests the "driver" (economy) might be falling asleep, risking a slowdown or stall.

Employment Data Concerns

• June Job Losses: Revised data shows the US economy lost 13,000 jobs in June, the first monthly job loss in five years (since December 2020).
• August Job Creation: Only 22,000 jobs were added in August, significantly below the expected 75,000.
• Unemployment Rate: The unemployment rate rose to 4.3%. While not alarming in isolation, a continued upward trend coupled with job losses could signal a recession.

Impact of Rate Cuts on the Stock Market

The effect of Fed rate cuts on the stock market depends crucially on why the cuts are being made and when.

General Impact of Lowering Interest Rates

• Lower Borrowing Costs: Consumers and businesses can borrow money more cheaply, leading to increased spending and investment.
• Increased Consumer Spending: Lower borrowing costs for consumers boost spending.
• Business Investment: Cheaper borrowing encourages businesses to invest and expand.
• Higher Corporate Profits: Increased spending and investment generally lead to higher corporate profits.
• Increased Intrinsic Value: Lower interest rates reduce the discount rate used in discounted cash flow (DCF) models, increasing the intrinsic value of companies.

Recessionary Cuts vs. Maintenance Cuts

• Recessionary Cut: Occurs when the Fed cuts rates because a recession is already present or imminent. These are generally not bullish for the stock market. Historically, after such cuts, the market has entered a bear market for 6-18 months (e.g., the 2000 dot-com crash, the 2008 financial crisis). The market collapses before or during these cuts because the underlying economic issues are severe, and the cuts are too late to prevent a downturn.
• Maintenance Cut: Occurs when the Fed cuts rates as the economy is slowing down but has not yet stalled. These are generally bullish. The Fed aims to accelerate the economy before it falters. The 1995 period is cited as an example where maintenance cuts coincided with a bullish market, driven by reaccelerating job growth.

The current situation is characterized as more of a "maintenance cut" due to strong GDP and industrial production, despite weakening employment data.

Market Behavior When Fed Cuts Rates Near All-Time Highs

The Fed is cutting rates while the market is near all-time highs. This has occurred 22 times since the 1950s.

• Next 30 Days: The market has a 50% chance of going up and a 50% chance of going down. The speaker anticipates a short-term dip due to seasonality (September tends to be bearish) and the market appearing overextended in the short term.
• Next 3 Months: The market has been up 77% of the time.
• Next 1 Year: The market has been up 100% of the time, with an average return of 13.9% and a median return of 9.8%.

Investment Strategy During Expected Market Volatility

• No Shorting or Selling: The speaker will not short the market or sell existing holdings, as predicting exact tops and bottoms is impossible.
• Buying Opportunities: When the market experiences a "wave down," the speaker will use it to buy more shares of high-quality companies at undervalued prices or support levels.
• Options Strategy: During market downturns, increased volatility (higher VIX) makes premiums attractive. The speaker plans to sell cash-secured put options or put credit spreads to earn premiums, which will become profitable when the market rebounds.

Market Pricing and Potential for Short-Term Sell-off

The market has already priced in the expected rate cut on Wednesday. Therefore, the actual announcement might lead to a short-term sell-off due to profit-taking. However, as the Fed continues cutting rates throughout the year and into next, the market is expected to rebound after any initial dip.

Industries Poised to Benefit from Rate Cuts

1. Bonds

• Inverse Relationship: Bond prices move inversely to interest rates. When rates rise, bond prices fall, and vice versa.
• Expected Rebound: Consistent rate cuts over the next one to two years should lead to a significant rebound in bond prices.
• Examples:
  • Treasury Bond ETFs: IE (3-7 year Treasury bond ETF) shows a recent reversal from a bear market and is entering an uptrend.
  • Corporate Bond ETFs: LQD shows a similar pattern, reversing from a downtrend as rates fall.
  • Closed-End Bond Funds: PTY (PIMCO Corporate Opportunity Closed Fund) offers a ~10% dividend yield and potential upside as rates decrease.

2. REITs (Real Estate Investment Trusts)

• Lower Funding Costs: Reduced interest rates lower the cost of loans for REITs, which use debt to acquire real estate.
• Increased Property Valuation: Lower interest rates lead to lower capitalization rates (cap rates), increasing property valuations.
• Improved Financials: Lower interest expenses boost net property income, adjusted funds from operations (AFFO), and dividends per share, leading to stock price appreciation.
• Examples:
  • Capital Ascenders REIT: Holds both Singapore and overseas properties, showing a rebound as US rates are expected to fall. Offers over 5% yield.
  • Frasers Centrepoint Trust: Holds only Singapore assets, has already rebounded due to falling Singapore rates, with potential for further upside as US rates decrease.
  • Capital Integrated Commercial Trust REIT: Has already surpassed fair value, offering less than 5% yield, suggesting waiting for a pullback.

3. Real Estate and Housing Related Stocks

• Spurred Home Buying: Lower mortgage rates encourage home purchases.
• Beneficiaries: Homebuilders, and companies supplying the housing sector (e.g., Home Depot, Lowe's, Pool Corporation).
• Impact of Long-Term Rates: While the Fed controls short-term rates, long-term rates (like the 10-year Treasury yield) directly influence mortgage rates.
• Examples:
  • Homebuilders ETF (XHB): Shows recovery as the 10-year Treasury yield stabilizes and the Fed signals rate cuts.
  • Individual Companies: Lowe's (owned by the speaker) is already pricing in the rate cut cycle but is currently overvalued. The speaker advises buying on "wave downs" rather than "wave ups."

4. Consumer Discretionary Stocks

• Increased Disposable Income: Lower interest payments free up disposable income for consumers to spend on non-essential items.
• Beneficiaries: Internet retail (Amazon, eBay), auto manufacturers (Tesla), home improvement, apparel, restaurants, travel (Booking.com), specialty retail.
• Quality Focus: Emphasis is placed on buying high-quality companies with strong economic moats, high predictability, profitability, financial strength, and that are undervalued.
• Examples:
  • AutoZone: Owned by the speaker for years, a high-quality stock but currently overvalued.
  • Booking.com: A high-quality stock but currently overvalued, advising to wait for a "wave down."

5. Small to Midcap Stocks and Speculative Growth Stocks

• Higher Risk: These categories are inherently riskier.
• Small to Midcap ETFs: IWM (Russell 2000 ETF) is showing signs of rebound.
• Speculative Growth Stocks: Often unprofitable but with high revenue growth. The speaker tends to avoid these individually but may buy them when they become profitable (e.g., Palantir, Snowflake). These are often considered for short-term trading rather than long-term investment.
• Example: Oscar (a short-term trade for the speaker).

Conclusion

The Federal Reserve's impending interest rate cuts signal a shift from tightening to easing, driven by concerns about economic deceleration, particularly in the labor market. While the market has largely priced in the initial cut, the long-term trend of falling rates is expected to be bullish for the stock market, especially for sectors like bonds, REITs, housing-related stocks, consumer discretionary, and potentially small-cap and speculative growth stocks. The speaker advocates for a strategy of buying high-quality companies on market dips ("wave downs") and utilizing options strategies to capitalize on volatility, rather than chasing short-term market movements. The distinction between "recessionary cuts" and "maintenance cuts" is crucial for understanding the market's reaction, with the current environment leaning towards the latter, suggesting a more positive outlook for equities.