What Sectors Could Benefit Most From the Fed’s Rate Cut?

Stocks rose slightly on Wednesday in the immediate aftermath of the Federal Reserve‘s first interest-rate cut in more than four years, a half-percentage-point reduction.

The S&P 500 traded near a record high after rebounding from a slump in July and August, when concerns about a slowing labor market and the possibility of recession reached their peak.

Since then, stocks have rallied, assisted by data showing cooling inflation and a resilient economy, as well as comments by Fed officials, who made clear their intention to begin cutting interest rates to support a soft landing. 

Will Rate Cuts Boost the Stock Market?

Wall Street, according to a recent Deutsche Bank analysis, has good reason to be optimistic about the market’s future.

Analysts evaluated the S&P 500’s performance over every Fed easing cycle in the past 70 years and found that rate cuts haven’t prevented the stock market from falling in past recessions. However, when the Fed has cut rates outside of a recession, stocks have tended to soar. The S&P 500’s median two-year return after that kind of cut has been nearly 50%.

Most economists see only a slight chance that the U.S. enters a recession in the next year. Goldman Sachs’ lead economist, Jan Hatzius, in August lowered the firm’s recession prediction to 20% from 25%. That adjustment came after the July jobs report triggered the “Sahm rule,” a historically reliable recession indicator.

Plenty of other economists have discounted recent recession indicators, including the steepening of the yield curve out of inversion, noting the peculiarity of the post-COVID economic recovery. 

Are Rate Cuts Priced Into the Stock Market?

But a post-rate-cut rally isn’t a certainty, and that’s in no small part because of stocks’ recent strength.

The S&P 500 has risen more than 26% in the past year, its best performance in the lead-up to rate cuts on record, according to Deutsche Bank. Usually, the index is flat over that period. 

“So you could argue that some of a potential ‘no recession easing cycle’ gains have been borrowed from the future this time,” the analysts wrote. 

The stock market’s anticipation of rate cuts has been nowhere more visible than in the surging stocks of homebuilders. The S&P Homebuilders Select Industry Index has risen 3.8% this month, in the top three gainers for S&P industry indexes. 

Homebuilder and building products stocks have been buoyed in recent months by the expectation that lower mortgage rates will unleash pent-up demand for new housing and revive the long-dormant housing market. That expectation has been borne out by data showing new home sales increased more than expected in July as mortgage rates fell.

Other early beneficiaries of rate cuts include regional banks (+15% quarter-to-date), whose Treasury and commercial real estate portfolios were hit hard by rising interest rates, and insurance (+13%). 

As with the S&P 500, however, analysts say stocks in these sectors may already have rate cuts priced in, limiting their near-term upside.

Homebuilder stocks, wrote Bank of America analysts on Tuesday, have a history of outperforming in the lead-up to and immediately after the beginning of a Fed easing cycle. However, they said, mortgage rates already have fallen to a two-year low and, as of last week, sat just slightly above the firm’s year-end forecast of 5.75% to 6%, possibly leaving little room for improvement. Plus, their recent rally has homebuilder stocks trading at elevated valuations compared with prior rate-cutting cycles.

Other Sectors That Could Benefit From Cuts

Historically, defensive sectors have tended to perform best in the six months after the Fed’s first rate cut, according to a recent report from Jeff Buchbinder, chief equity strategist at LPL Financial.

In 1995—when the Fed cut rates into a soft landing and the buildout of the internet was in its early phases, making it the cycle that most closely resembles today’s—healthcare and telecoms were the best-performing sectors six months after the first cut. Consumer staples and utilities also outperformed, Buchbinder wrote.

Meanwhile tech stocks, despite the nascent internet buildout and the initial public offering (IPO) of browser pioneer Netscape, slumped nearly 20% in the six months after the first cut in 1995.

To be sure, the Fed has only embarked on four rate-cutting cycles since the introduction of the S&P Global Industry Classification Standard (GICS) in the 1990s, making this an exceptionally short history, as Buchbinder warns.

Still, with substantial economic and political uncertainty likely to hang over markets well into the fall, the “risk-off” lessons of 1995 could be constructive.