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Here is How Wall Street Reacts to Fed's Easing Cycle

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The Fed is widely expected to trim interest rates when it issues its policy statement on Sep 18 at the end of the two-day meeting. If the speculation materializes, it will mark the central bank second rate cut this year, and many are of the opinion that it will be an “insurance cut.” Here is a rundown on how the stock market reacts to Fed rate-cutting cycles.

Why the Fed is Expected to Cut Rates This September?

The ECB has launched fresh stimulus packages in an attempt to prevent further slowing down of Eurozone economy. The ECB confirmed that it would trim its deposit rate (the interest paid to commercial banks when they place funds with the central bank) by 0.1 percentage points to an all-time low of -0.5%. At the same time, the ECB has announced a massive new-bond buying program. The central bank’s quantitative easing (QE) program will involve 20 billion euros ($21.9 billion) per month of net asset purchases for as long as required.

However, with the ECB ramping up its efforts to stimulate the Eurozone economy, the pressure is mounting on the Fed to do the same. President Trump has already called for the Fed to cut rates to boost the U.S. economy. In fact, an overwhelming majority of observers are anticipating a rate cut on August’s soft employment report.

Slowdown in the U.S. private sector job scenario in August will no doubt keep the Fed on under pressure to lower its benchmark rate by at least a quarter-percentage again later this month. The U.S. economy added just 130,000 jobs this month, almost 28,000 less than analysts’ expectations and 29,000 lower than July levels. By the way, August’s job addition was the lowest in three months giving enough indications of the toll that the intensifying U.S.-China trade dispute has had on the nation’s economic expansion.

The trade war has seriously affected the manufacturing sector. Only 3,000 factory jobs were added in August, less than expectations of 8,000 job additions and down from July’s job increase of 4,000. Jobs at transportations and warehousing jobs were the worst hit witnessing a decline of 0.5%.

Retail jobs also bore the brunt, declining for the seventh straight month, indicating more trouble ahead. Some may argue that Federal jobs increased by 34,000, propelled mostly by 25,000 new temporary jobs related to the U.S. 2020 Census. Then again it’s a temporary boost.

The Goldman Sachs Group, Inc. (GS - Free Report) also acknowledged that many analysts have started to price in “insurance cuts,” which means it is expecting the Fed to cut rates right before a downturn in order to save the economy. According to CME FedWatch tool, the Fed funds futures market now points to a 90% chance of at least a quarter-point rate cut at the Fed’s September meeting.

How the Stock Market Reacts to Rate-Cutting Cycles?

Since we are expecting “insurance cuts”, where problems of a slowdown are imminent but the economy isn’t in a recession, the benchmark S&P 500 is poised to come up with healthy gains in the near term. As pointed out by Allianz Global Investors, the S&P 500 on average tends to jump 20.4% after a year following “insurance cuts.”

What’s more, small-caps generally tend to outperform large caps during such easing cycles, according to Jefferies research. The firm added that small-caps tend to surge 28% in the 12 months, following a rate cut as compared to 15% for large caps.

If we dig into sectors, then healthcare stocks generally outperform after a rate cut. Barclays has compiled data that shows that healthcare stocks generally rise nearly 7% in the nine months following a rate cut. And what makes this set of stocks stand out is that they tend to rise consistently.

We all know that rate cuts mainly take place when the economy goes through a rough patch or is in recession. And healthcare stocks have time and again thrived in such scenarios. This is because they are mostly defensive in nature as their products are not directly related to the developments in the stock market.

Moreover, healthcare stocks are known for paying hefty dividends, which makes them more alluring when rates decline in uneasy economic conditions. Needless to say, lower interest rates mostly tend to raise prices of high-yielding stocks.

One top healthcare stock one may consider now is Molina Healthcare, Inc. (MOH - Free Report) . The Zacks Rank #2 (Buy) company has consistently provided solid dividend yield over the past five-year period.

Rate-sensitive utilities also gain. This is because utilities are capital-intensive businesses and the funds generated from internal sources are not always sufficient to meet their requirements. Consequently, these companies have high levels of debt. Consequently, low interest rates will help them pay off debts and book profits.

However, higher interest rates and an increase in the debt level, for that matter a steep debt/equity ratio, impacts the credit ratings of these utility operators. If the credit ratings go down, a company will find it difficult to borrow funds from the markets at reasonable rates, leading to a rise in cost of operations.

Given the buoyancy among rate-sensitive stocks, investors can bet on NRG Energy, Inc. (NRG - Free Report) . The stock currently carries a Zacks Rank 2.

Thanks to the dovish expectations, gold prices are also expected to rise. This is because lower interest rates generally tend to make bonds and other fixed-income investments less attractive. Money will flow out of bonds and money market funds as they can’t provide higher yields, and in turn may flow into gold. It’s worth pointing out though that the yellow metal offers no yield at all.

With gold prices set to rise, investing in Kinross Gold Corporation (KGC - Free Report) and AngloGold Ashanti Limited (AU - Free Report) seems a prudent decision at the moment. After all, these stocks boast a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

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