Fed rate cuts are coming. Get ready for the next phase of the stock market.

Here’s what’s happening and what to do about it.

After a “long period of weakness, the defense is starting to behave better,” JP Morgan equity strategists said in a report on Tuesday. And “if bond yields decline as economic growth weakens, sector leadership will likely become more defensive.”

As if on cue, the yield on the 10-year Treasury has fallen from just north of 4.7% at the end of April to about 4.53% today. Gross domestic product growth for the first quarter on an annualized basis was just 1.6%, compared with 3.4% in the last three months of 2023 (the government will release revised figures on Thursday).

With this in mind, J.P. Morgan strategists said they now recommend “overweight” stocks in utilities, real estate, healthcare and consumer staples globally.

All four sectors are known for high dividend yields, so they tend to benefit from falling interest rates, making their payouts relatively more attractive. While utilities have recently emerged as market darlings as potential beneficiaries of massive AI demand for electricity, the other three sectors are lagging behind this year’s growth in the broader market. Real estate stocks fell 7%, while the S&P 500 increased by 11%

Once there is more clarity about when the Fed will cut interest rates, these sectors may finally catch the offer. Signs of economic weakness may also be helpful and may in themselves influence the decision to ease monetary policy.

The Fed is now expected to begin cutting interest rates before there is any significant evidence of weakness. However, if the Fed proves too late to prevent a recession, defensive sectors could shine again. Keep in mind that the Federal Reserve raised interest rates 11 times from March 2022 to July 2023 and that it may take many months for such increases to take full effect.

“Yield replacement sectors continue to have defensive properties, which makes them attractive as recession protection,” Ross Mayfield, investment strategy analyst at Baird Private Wealth Management, said in a recent report.

Defensive sectors are not the only investments that can thrive during a downturn.

JP Morgan strategists also said they like commodities in the so-called barbell approach, in which more economically sensitive commodities balance more defensive and less cyclical stocks. Precious metals, especially gold and silver, have been rising in price recently. So does copper due to AI mania and hope for an economic rebound in China. Copper wires are the main conductor of electricity, making them a key component of public facilities and data centers.

Small-cap stocks could also be compelling buys once the Fed and other central banks begin to ease. JP Morgan strategists are a bit more bullish on European small-caps, arguing that “the turnaround could be coming our way given the upcoming price cuts by the ECB and BoE.” The rebound for U.S. small-cap stocks may take longer given that it is unclear when the Fed will begin cutting interest rates.

But some fund managers are still betting that rate cuts will happen sooner rather than later, saying small-cap stocks should gain, perhaps outperforming larger companies, as borrowing costs start to fall.

Bob Scott, portfolio manager at Next Century Growth, said Fed rate hikes hurt small-cap stocks more than large-cap stocks, lowering earnings estimates and stock prices. Rate cuts should allow them to achieve higher earnings growth, he said.

“Small caps have digested the rise in interest rates over the last few years and are now trading at more reasonable valuations,” Scott said. “Typically, small-cap stocks are expected to grow faster than average large-cap stocks and have historically performed better when the Fed lowers interest rates.”

While Scott and his team of managers hold a variety of small-cap stocks with strong growth prospects, Scott’s RiverPark/Next Century Growth fund remains somewhat defensive with an emphasis on healthcare. The most important holdings include RXSight, a manufacturer of adjustable intraocular lens implants for patients after cataract surgery, and Tandem Diabetes
,

manufacturer of insulin pumps.

These companies and other defensive stocks may lack the sex appeal of Nvidia and other AI plays, but investors need to start positioning their portfolios for lower interest rates and slower growth before it’s too late.

Write to Paul R. La Monica at [email protected]