Optimism on the FED soon commencing a rate easing cycle has driven a rare small cap performance, absolute and relative on the premise that smaller companies benefit more from rate cuts. While this may be so on a relative basis, ultimately it’s growth that drives share prices rather than interest rates or valuations. We focus on the “why” of a FED easing cycle, which inevitably is driven by growth concerns rather than softer inflation alone. History also suggests that equities decline when the FED starts cutting. This is all the more pertinent when the current cycle appears extended on multiple parameters. With the FED expected to start easing in Sep (or a surprise in July?), and equities priced to perfection, delivering on earnings expectations becomes that much more critical to retain a bullish agenda.
Summary
- Economic Growth Is Slowing – While there are clear, early signs of growth pulling back, these are moderate at this stage. However, two of the strongest pillars, consumption and labor are the ones that are weakening. The key question is what tips this cycle over – in our view, its likely to be labor driving consumption, making the jobs market our keenest focus.
- When Will the FED Cut and How Fast - After a near one year pause, the FED appears all set to start easing rates from Sep’24 with a further cut in Dec’24. Given the increasingly dovish statements from the FED Chair, a surprise July rate cut should not be ruled out, even though not priced in.
- Rate Cuts – Good or Not So? - In the run up to the easing cycle, “bad news (economic)” is “good news (markets)” – when the FED starts easing, “bad news (economic)” becomes “bad news” for the markets.
- Small Cap Optimism – Driven by Rate Cuts – Is This Misplaced? - Small Cap absolute performance with need optimism on topline growth rather than just the benefit from easier monetary policy – that said, there does appear to be a case for outperformance vs. large caps, as interest rates decline.
- Market Internals Better Than the Headline - While the 14% decline in Mag-7 and a 20% pt underperformance vs. RUT may add credence to the unwind of exuberance, market internals appear more supportive. As before, valuations for SPX are expensive, mainly due to the Mag-7, but then so is earnings growth.
- Earnings – The Most Critical Variable - With a strong correlation to earnings, the outlook for SPX remains positive, AS LONG AS, companies do not miss.
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