With analysts expecting interest rates to come down, strategist Tina Fong and economist Ben Read at investment manager Schroders discuss which areas of the US equity market perform best after the first rate cut.

Defensive sectors tend to outperform their cyclical peers when a central bank first decides to cut interest rates, according to Tina Fong and Ben Read at UK-listed investment manager Schroders. The prospect of a rate cut by the US Federal Reserve is an increasingly noisy talking point.

For the analysis of sectors, Schroders has grouped them into cyclicals and defensives based on sensitivity to the state of the overall market. “For instance, the cyclical sectors, such as technology, outperform even more when the market rises, but also decline more when the market falls,” the authors of the Schroders note said.

The defensive outperformance is particularly noticeable. when rates are first cut. “This is especially evident during recessions, which is likely due to investors seeking areas of the market which are most likely to withstand the weaker growth environment and benefit from more aggressive rate cuts,” the authors said.

By contrast, most cyclical sectors perform poorly in the initial three months after the first rate cut, particularly when the rate cut occurs during a US recession. “But a year after the start of the easing cycle, cyclical sectors usually deliver stronger returns,” Fong and Read said.

The Schroders paper cames out a week after global equity sold off sharply amid worries that the US economy – the world's largest – is stuttering. There has also been commentary about high valuations on the "Magnificent Seven" big tech stocks such as Alphabet, Nvidia and Microsoft, encouraging a rapid unwinding of stock market trading positions. Markets have partly recovered, but there appears to be a lingering level of caution. And as the weeks go by ahead of the November 5 US elections, there remains speculation that the Federal Reserve will cut rates. Economists expect a quarter-point reduction in interest rates at the Fed’s September 17 to 18 meeting, Bloomberg has reported.

The pattern
Initially, cyclicals sell off on the back of the rate cut, which is likely in response to the weaker growth and inflation backdrop. But at some point, these areas of the market become attractive as the equity valuations of these stocks become cheaper and investors anticipate the rate cuts boosting economic activity and corporate earnings. That said, both financials and consumer discretionary sectors have been the exceptions, as they have generally done well even in the initial months after the first cut.

Interestingly, the tech sector underperforms the broader market in the first few months after the rate cut. “But its performance has been negatively skewed by the big sell-off during the technology bubble recession in the early 2000s. Without this period, technology stocks usually achieve positive returns when rates are cut,” Fong and Read continued.

Equity styles
The Schrodrers authors highlighted how the momentum style has, on average, been the best performing area of the market during past rate cutting cycles: “These stocks would have been performing very well before the rate cutting cycle, and the pick-up in investor sentiment following the first cut is only going to boost that performance.”

To a slightly lesser extent, quality and growth stocks have typically generated positive returns during rate cutting cycles. This is consistent with their previous analysis of these equity styles performing well in a low inflationary environment. “Growth, quality and momentum stocks perform worse when the rate easing cycle occurs in recessions. This might be because investors rotate into the more defensive areas of the market such as the minimum volatility (min vol) style,” Fong and Read added.

“Even small caps tend to do well after the first rate cut during recessions,” they said. It may be that small caps benefit from the more aggressive rate cutting that occurs in recessions. However, their analysis is dependent on the time horizon. For example, analysis of small caps back in the 1920s shows that they have for most of the time outperformed the market a year after the first rate cut.

But after the mid-1980s, small caps have underperformed the broader market after the first rate cut. The difference is likely due to changes in the composition of sectors in the small-cap universe, which has increased its share of financial and real estate companies but reduced its exposure of technology and consumer discretionary sectors. Clearly, the sector exposures of equity styles are dynamic, and the past investment playbook does not guarantee future performance.

Given their baseline view of no recession in the US and the anticipated rate cut by the Fed in September 2024, Fong and Read believe that it is likely that momentum, growth, and quality stocks will outperform. This finding is consistent with their analysis of these equity styles within a low inflationary backdrop: “At the same time, defensive sectors compared to their cyclical peers are also likely to thrive in an environment where rates are being cut.”