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Rate-sensitive cyclical stocks could see a significant rally and outperform the broader market as the Federal Reserve prepares to lower interest rates following the latest benign inflation data, according to a report by Bank of America.
“Last week, inflation ticked another box for the Fed,” said economist Stephen Juneau, noting that June’s inflation reading provided the most substantial downside surprise compared to analyst estimates since 1998.
Bank of America suggests we are “on the path to Goldilocks in 2024.” The bank describes a scenario with moderating but stable macroeconomic conditions and a cooling consumer price index (CPI).
In this kind macroeconomic environment, “the stars are aligning for the rotation into rate-sensitive cyclicals,” stated equity analyst Ohsung Kwon.
Kwon highlighted that easing rate pressure, Fed-supported growth, and broadening earnings as the “Other 493” companies emerge from an earnings recession will support this rotation.
Last week’s record CPI miss resulted in a massive outperformance of small caps compared to large caps.
The iShares Russell 2000 ETF (NYSE:IWM) rallied by over 6%, notching its strongest week since October 2023. In contrast, the S&P 500, as tracked by the SPDR S&P 500 ETF Trust (NYSE:SPY), did rally only by 0.9% for the week.
This fragility beneath the surface contrasts sharply with the low volatility in the S&P 500, a risk flagged by Bank of America. The bank recommends mitigating the risk of sharp rotations, whether the post-CPI moves extend or reverse, through outperformance option calls, such as Russell 2000 vs. Nasdaq 100 or equal- vs. market-weight S&P 500.
Chart: Small Caps Showcased Strongest Weekly Performance In 2024 On Rate-Cut Speculations
Image: Benzinga Pro
The second-quarter earnings season is expected to be crucial for equities as the market increasingly focuses on earnings rather than multiples.
Despite some concerns that disinflation could become a headwind to earnings by weakening pricing power, Bank of America anticipates a typical 2% EPS beat.
“We believe the equity cycle is in a different phase than the macrocycle. While the economy is slowing, earnings are accelerating,” the report stated.
Historically, a backdrop of slowing GDP and accelerating EPS has been the best macro environment for stocks, resulting in a benign rate environment and strong fundamentals.
Bank of America expects continued acceleration in earnings in the second half of the year as the “Other 493” companies (excluding the Magnificent 7) recover from their earnings recession.
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Image: Pixabay
