Analysis — Prospects for interest rate cuts could boost US stocks as investors await earnings and elections

By Lewis Krauskopf

NEW YORK (Reuters) – The prospect of interest rate cuts in the near term is strengthening investors’ case for staying optimistic after a rally in U.S. stocks that could soon be tested by upcoming corporate earnings reports and growing political uncertainty.

Expectations that the Federal Reserve will begin its long-awaited cycle of interest rate cuts in September remained strong Tuesday after Federal Reserve Chairman Jerome Powell told Congress that the United States is “no longer an overheated economy,” suggesting the case for easing monetary policy is growing stronger.

Rate-cutting bets have fluctuated wildly throughout the year and were just one of several factors — along with strong earnings and excitement about artificial intelligence — that have helped the S&P 500 rise about 17% year to date. Still, many investors believe that greater clarity about when the Fed will start easing monetary policy and by how much in 2024 could provide a buffer for stocks if markets become turbulent in the coming months.

The start of rate cuts will signal that “the Fed has the market’s support,” said Yung-Yu Ma, chief investment officer at BMO Wealth Management. He expects the central bank to cut rates about six times over the next year. “We think that’s definitely positive for both markets and the economy,” he said.

Investors late Tuesday were giving the Fed a better than 70% chance of cutting rates in September, up from about 50% a month ago, according to CME FedWatch. Fund-of-funds futures are pricing in about 50 basis points of easing in 2024 overall, according to LSEG data.

“The Fed is getting closer to cutting interest rates,” said Peter Cardillo, chief market economist at Spartan Capital Securities. “I think we’ll see a rate cut in September and another in December.”

UPCOMING CHALLENGES

Powell told the Senate Banking Committee that inflation had improved in recent months and that “more good data would strengthen” the case for looser monetary policy.

One of the first tests will come on Thursday with the release of U.S. consumer price data for June. While recent reports have shown inflation starting to cool, a stronger-than-expected number could undermine the case for easing in the coming months.

On the other hand, expectations of monetary easing coupled with falling inflation and still resilient economic growth could boost investor confidence amid a range of potential risks in the coming weeks.

Corporate earnings will begin in earnest on Friday with reports from major banks and could weigh on the high-flying U.S. stock market if companies fail to meet lofty expectations. S&P 500 companies are expected to increase profits by 10.6% this year and 14.5% in 2025, according to LSEG IBES.

Investors are also bracing for twists and turns in the U.S. presidential nomination race, after President Joe Biden’s volatile debate with former President Donald Trump late last month prompted calls for the incumbent to step down.

Keith Lerner, co-chief investment officer at Truist Advisory Services, wrote in a recent half-year report that he remains positive on U.S. stocks, although he expects markets to trade “in a more volatile manner” after a strong first half of the year.

“U.S. growth is cooling off from the post-pandemic stimulus boom, but it’s not weak,” he said. Stocks typically rise in the six- to 12-month period following the Fed’s first rate cut, as long as the economy avoids recession, Truist research has shown.

Lower interest rates could also help extend a rally in stocks that has been led by a handful of large-cap stocks like Nvidia. Just 24% of stocks in the S&P 500 outperformed the index in the first half of the year, the third-narrowest six-month period since 1986, according to strategists at BofA Global Research.

Matt Miskin, co-chief investment strategist at John Hancock Investment Management, said lower interest rates could help areas of the market that have been hurt by higher interest rates as big tech surged. That includes small-cap stocks, which are more sensitive to interest rates because they rely more on financing. The small-cap-focused Russell 2000 is up just 0.1% year to date.

“Smaller-cap companies need capital to survive in many cases, and this higher cost of capital really makes it harder for them to operate,” he said. “A lower cost of capital would certainly help these companies.”

Of course, interest rate cuts are not always a sign of an easy future and often occur when the Federal Reserve is forced to quickly ease monetary policy due to worsening economic conditions.

A Wells Fargo Investment Institute study released last month found that the S&P 500 fell an average of 20% in the 250 days following the first downturn in the cycle.

The firm’s strategists write that if the Fed cuts interest rates because of falling inflation, the stock will likely do well over the next six to 18 months.

However, “if the Fed is forced to cut aggressively in response to macroeconomic or market disruptions, we could see equity performance decline,” they wrote.

(Reporting by Lewis Krauskopf in New York; Additional reporting by Stephen Culp; Editing by Ira Iosebashvili and Matthew Lewis)