Investing Ideas For Lower Interest Rates - 9/10/24 | Market Sense | Fidelity Investments

Intro HEATHER HEGEDUS: Hi there, everybody. Thank you so much for joining us for Market Sense today. I'm Heather Hegedus with fidelity. So the market has been enduring some volatility since we last met, digesting a couple of data points that indicate a cooling labor market, plus a mega-cap tech stock sell-off, which also led to some jitters. But right now, we are looking ahead now to next week when the Fed's next policy meeting happens. And, of course, we are expecting that highly-anticipated rate cut to happen, which will be announced the afternoon of September 18. So we're looking ahead to that. But to talk about what the previous week's developments all might mean for investors is Jurrien Timmer. He's back with us today. And, of course, he is Fidelity's Director of Global Macro. We're also pleased to be joined today by Denise Chisholm. She is Fidelity's Director of Quantitative Market Strategy. And Denise's research focuses on analyzing market history to uncover patterns and probabilities that may be able to help inform the current outlook. Thank you to both of you for making the time today. And, Jurrien, my friend, it is so good to see your face again. Welcome back. I know you just came back from the desert, from feeding the artists at Burning Man. So I want to hear all about that. How was it? JURRIEN TIMMER: It was great. After two kind of challenging years weather wise, we had pretty good weather. We did have some dust. I still have some dust in my lungs. But the camp that I run, we make food for the artists there, and we made about 6,000 to 7,000 meals in that two-week time. So I would consider that a success. HEATHER HEGEDUS: 6,000 to 7,000 meals-- and that was for your vacation. Sounds like a relaxing vacation, Jurrien. Denise, also always good to see you. How have you been? DENISE CHISHOLM: Yeah, great to be back. I want to hear about Burning Man as well. So I'm glad you had better weather this year, Jurrien. HEATHER HEGEDUS: Yeah, any highlights you can share quickly, Jurrien? JURRIEN TIMMER: You know, we did have a little bit of rain, so we got a little PTSD there. And at the end, we got a massive dust storm. But it was nice. It was a more mellow vibe this year. There were a lot of kids there, actually. So it's becoming a little bit more of a family event, which may not be the first thing that people think of. But it was good. We had 90 different people from all walks of life and different places all coming together in our camp to produce fabulous gourmet meals for the community. HEATHER HEGEDUS: What a interesting study in culture, all living together for that short amount of time. Well, welcome back. We've missed you. Today is Tuesday, September 10. We surely have a lot to talk about today, so we should jump right in. Seasonal Volatility or More to Come? So historically, it is well-documented that markets tend to underperform from the month of September through the middle of October. And it's a phenomenon known as the September effect. And we have seen some volatility already, as I mentioned, similar to what played out in early August. So, first of all, Jurrien, let's talk about what caused this volatility. Is there a chance that the choppy market could just be part of this seasonal trend, the September effect? Or could this be a sign that something, perhaps, deeper is going on with the markets and the economy? And could we expect more ups and downs moving forward from here on out now, Jurrien? JURRIEN TIMMER: So there definitely is a seasonal pattern where the returns tend to be strongest from, let's say, mid October till April, May. And they tend to be the weakest, or at least below average, in August to the beginning of October. And so we're obviously in that little wobbly period. And for long-term investors, it's not really anything to worry about because over the long-term, the market still will do what it does. But we're at a point where, obviously, it's an election year. And the market has sort of transitioned from, first, worrying about inflation not coming down, then to sort of declaring victory a little bit that inflation is improving, and that the Fed, therefore, can be allowed to start normalizing rates. And we're going to obviously talk about that. But now, after a few jobs reports that were not terrible by any means, but they were not as strong as anticipated, market's starting to worry about the other side of the Fed's mandate, right? The Fed has a dual mandate-- price stability, 2% inflation, and full employment. And so now that, at least in the eyes of the market, the inflation problem is being resolved, the market's now worrying about the jobs side and whether the weakness or the less strong data on the jobs front tells us anything about whether or not a recession is coming. And I think that's kind of what the market is grappling with here. And also, of course, there is this sort of index effect of the math of the market sort of rotating between these really big companies that you mentioned in your opening remarks and the rest of the market. HEATHER HEGEDUS: Yeah, that's a good segue there, Jurrien, because I know you have been noting that so much of the recent volatility Tech Stocks’ Role in Volatility has been driven by just a few stocks due to the market concentration that you were talking about. So walk us through why the market is more concentrated right now, why that can lead to volatility, like we saw last week-- and maybe a question that investors out there might be watching and wondering is, what does that mean for an investor who, perhaps, put all of their eggs in the tech basket? Where do they go from here? JURRIEN TIMMER: Yeah. Well, we should never put all of our eggs in one basket. So there's the fundamental component, right? You have earnings. You have interest rates. Earnings have been good. Interest rates are now starting to fall. But markets, again, worried about the economic growth. And then there's a more technical side, right? And typically, the market is pretty well-distributed between large caps, and mid caps, and small caps. But at times in history, you've had a very sort of concentrated market. And the original Nifty 50 in the 1970s was one period, the late-'90s was another one, and, of course, over the last couple of years, we all know about the magnificent seven, the AI story. And that has produced some very, very large concentration in the market. And as the market now starts to kind of rotate towards maybe stocks that benefit from lower rates-- and I know Denise is going to talk about that-- the mathematics of a few really big companies losing some weight in the index, and even though the rest of the market starts to add weight, can the market really go up when that happens because the market is so concentrated? And I think, really, since July, we've seen some wobbles and some churn in the market as that rotation happens. So it's technical, but sometimes you can feel it. HEATHER HEGEDUS: Yeah. As you mentioned, Jurrien, Denise How Much Might the Fed Cut? has done some research, some extensive research, on the impact of market concentration on performance. So what did your research find about that, Denise? DENISE CHISHOLM: Yeah. It's interesting. I think Jurrien sees the same data I do. We have data going back to the 1930s on top stock, top five stocks, top 10 stocks as a percentage of market cap, all the way back to 1927. And you can see that we are in a unique period in the sense that the market, by this measure, has not been this concentrated since the '80s. That said, Jurrien identified a couple of periods in the '70s that were even more concentrated than we're seeing now. And in fact, the market has stayed concentrated to that level in the '40s and '50s for quite some time. So as much as we're describing the market and say most of the gains have come from these seven stocks, when you look back historically and say, as an investor, should I really be concerned about the long-term trends of the market? It's really less evident in the data. It doesn't tend to be a negative signal, one way or the other, about the market. So as much as it's descriptive, it's not really identifying, at least clearly from the historical trends, a risk in the equity market. HEATHER HEGEDUS: OK. All right. Let's switch gears and talk about our topic of the day-- rate cuts. So investors are all but certain that a rate cut is coming, right, when the Fed meets next week. So the question isn't necessarily if, but how much, right? Jurrien, I'll put you on the spot here-- how aggressive do you think the Fed will be? Do you think it's going to be a 25 basis point cut, a 50 basis point cut? How much could that extra 25 basis points matter if we're talking about 25 versus 50? What do you think? JURRIEN TIMMER: Yeah, the market sure likes to obsess over how much, how soon. And, obviously, these things do matter. For me, the main thing, really, is, obviously, the Fed's going to start next week. Everyone knows that. The Fed itself has signaled that. And that is entirely the correct thing to do, because the Fed is quite restrictive here, right? Inflation is currently at around 2.5%, 3%. The Fed is at 5 and 3/8. So that's several hundred basis points above what we could consider a neutral rate. And the clear and present danger of inflation not only being high, but accelerating, seems to be over for now. And the growth side is slowing. So it makes perfect sense for the Fed to start an easing cycle. And then it's really a matter of, how quickly does it go and where does it end up? And whether the Fed goes 25 basis points or 50, I don't think it really matters. My guess is they're going to go 25, because you would only do 50 if you really have a lot of lost ground to make up for. And I don't think the Fed feels that there is that urgency. And I don't think the market feels it either. So my guess is they go 25. And they're going to go several times in a row this year. The market's expecting about 100 basis points this year and another 100 basis points-plus next year into 2026. But ultimately, for me, what matters is, how far above the neutral zone is it now? And where does it end up? And to me, a full easing cycle isn't really warranted because the economy remains relatively sound. But, certainly, a return to neutral makes a lot of sense. And neutral, in my view, is around 3.5%, 4%. So that's at least 150 basis points of rate cuts coming in the next year or so. HEATHER HEGEDUS: OK. Thanks for letting me put you on the spot, my friend. Why Is the Fed Cutting? Historically, the Fed has often cut rates at times when the economy is slowing to try to help reduce the risk of recession. But cuts certainly aren't exclusive to those kinds of events either. So that's why it is important to understand why the Fed is cutting, particularly right now. Is it cutting because, as you just mentioned, Jurrien, inflation is much closer now to its 2% target? Or, could the reason that the Fed is getting ready to cut be a sign that the economy is softening? I know that's sort of something that I think investors have had in the back of their minds. Denise, what do you think? Based on historical patterns that you've studied, do you think it's because the economy is softening or just because they can? DENISE CHISHOLM: Right. There's not a lot of signal in the Fed itself. Meaning that if you look back historically, half the time, the Fed's cutting because they have to-- to your point, the economy is slowing aggressively and dramatically. But half the time, they've been cutting historically because they can recalibrate monetary policy. We saw that happen in the mid-'90s. We saw it happen in the mid-'80s. We saw it, really, happen in 2018. And I think that the differentiating factor that investors should focus on is not the Fed cutting, but it's around other factors, and I'll name two that do sort of bisect your odds and improve your odds of a good equity market when the Fed is cutting. And one is earnings growth. The stronger earnings growth has been historically, the more likely it is that the "why" behind that is that recalibration of policy. Because the stronger earnings growth has been, the more likely the labor market is to continue to grow. Again, there's never 100% odds, but there is a clear relationship there. The other thing that I'm watching is the exact thing Jurrien highlighted, which is, look, some of this is a level issue. And we saw that the Fed hiked dramatically and aggressively to a very high nominal rate relative to the level of inflation. And if that sounds like a bad outcome for the equity markets, historically speaking, it's the opposite. And that's partly around the fact that it points to the fact that the Fed can recalibrate because it's so elevated relative to inflation. And it partly points to the fact that, to the extent that the economy is hit with a shock, the Fed finally has the ability to do something about it. So, actually, a lot of the data around our situation currently still points to constructive on equities. HEATHER HEGEDUS: OK. All right, let's talk about positioning your portfolio Which Sectors Historically Perform Best Before Rate-Cutting Cycles? for a rate-cutting cycle. Falling interest rates have historically been a boon for a variety of types of investments. And after a first rate cut, stocks, in particular, have typically outperformed over the following 12 months. And that's whether we're in a recession or not. You're kind of shaking your head a little bit here, Denise. So correct me if I'm wrong on that. And the thing that I really wanted to ask you about, Denise, was we've been talking about a September rate cut for so long now. I feel like, isn't it already priced into the market at this point? So for investors who are looking to actively position their portfolios in anticipation of a rate cutting cycle, could opportunities because of that be too late, be beyond us now? Or do you still see some opportunities that investors might want to consider in advance of this happening? DENISE CHISHOLM: Now, look, that is always the right question to ask because the market is a discounting mechanism. By the time it hits the tape, it's usually priced into the stocks. But I do think this time is different. And when you look at the sectors, specifically the 11 gig sectors and you look at the correlations to bond yields, the negative correlations to bond yields, you do see historically, 70% of the time, by the time the Fed starts cutting interest rates, those interest rate-sensitive sectors outperform by about 1,000 basis points. That is not our situation currently. Those interest rate-sensitive sectors almost look, to me, in the data, like they discounted a Fed hike. They've underperformed over the last 12 months by about 1,000 basis points, which is what we usually see in a rate hike before a rate hike happens. And that's the interest rate sensitives-- they change every cycle. But this time, it's financials, real estate, and industrials. So I do see that as an opportunity, because I don't think, in the equity market, at least, that all stocks have discounted a rate cut. HEATHER HEGEDUS: OK. So you like financials, real estate, industrials-- any other opportunities that you can help identify, in your view, Denise? And also, I think it would be helpful to level set here for everybody-- are we talking about short or long-term What’s the Time Frame to Make a Move? opportunities here? Do investors need to take action and make a move before the cuts come next week? Or what's the time frame for investors to do something here? DENISE CHISHOLM: Right. So I do have a data-driven approach, and it is looking at those historical patterns, as you said. And anything below three to six month is looking like a coin flip in my data. So I always say that my best guess in terms of the probabilities and the patterns I'm seeing in the market is really around a one year to 18-month time horizon. So that's the time horizon that I'm really talking about. And I do think that there are other opportunities in the market other than technology stocks and other than financials and real estate. And it's really around down the cap spectrum. We have a pretty unique setup, and I call it kind of a trifecta that I'm looking for in the data, in the sense that the backdrop is changing in the sense that interest rates are falling and earnings growth is accelerating-- and this is true even on an equal weighted basis-- and that tends to be a pretty sweet spot for small and mid-cap stocks relative to their large cap peers. 70% odds that they outperform, and it's one of the only scenarios of that permutations and combinations of earnings growth and interest rates where that is the case. This is happening at the same time where you do see very elevated valuations between large caps, and mid caps, and small caps. And that, historically, biases your odds in favor of a small and mid cap rotation. So the more expensive large caps have been relative to mid and small caps, the less likely they are to continue to outperform. And if you add on one more sort of pulled rubber band, we have very wide valuation spreads down in that small cap and mid cap area, which is just, I like to call it, an expression of fear, which is when investors sell anything they think is risky, they buy anything they think is safe. And that level of fear, especially when you look at it relative to credit spreads that are more benign right now, is usually an opportunity for investors. The more fear there is, the more likely average returns are to be higher. So that's a long-winded, probabilistic way to say, look, I think that there are still areas of the market that are actually discounting a hard landing, and they're down the cap spectrum. HEATHER HEGEDUS: The more fear there is, the more opportunity for returns. Is that what you said? DENISE CHISHOLM: The higher the returns have been historically on average, with that one-year time horizon. HEATHER HEGEDUS: OK. All right. Thanks, Denise. More Rate-Cutting Cycle Potential Opportunities Jurrien, how about you? Where do you see opportunities right now? JURRIEN TIMMER: Yeah. So I agree with what Denise said. And it's sort of the everything else trade, if you will, right-- the Mag Seven, the FAANGs, as they used to be called, those have been the port in the storm over the past couple of years while the Fed was raising rates. And, of course, the AI story has been part of that as well. But they were considered safe havens because these companies have so much cash that they don't really necessarily care what the fed is doing with rates because they're somewhat immune from interest rates, et cetera. And the rest of the market, like everyone else, is affected by the level of interest rates. They have debt to refinance, et cetera. And now that interest rates are coming down, the everything else part of the market can sort of breathe again. And as Denise mentioned, earnings growth is positive. It's accelerating. If you look at the equal weighted S&P instead of the cap weighted S&P, the equal weight is trading at an 18 times PE, the cap weighted at a 23 times. So you look at the average stock, it's trading at a reasonable valuation, has rising earnings, and interest rates are now falling. What's not to like about that? And it's just a matter of overcoming kind of that index effect of these very large companies sort of passing the baton to the rest of the market. So that, I totally agree. And I would just add sort of bonds to that. Bonds didn't perform the way they sort of were supposed to during the rate-tightening cycle. But now, they are again. They're providing an offset to any kind of economic growth jitters. And in the case that maybe Denise and I are wrong and earnings growth does not keep going, having some bonds in your portfolio is a nice cushion just in case the growth story does not pan out. HEATHER HEGEDUS: OK. And another topic I want to quickly get to, but we're getting tight on time now-- Where Should You Consider Moving Cash To? another topic, when you see a rate-cutting cycle, starting, is think about how much money you have parked in cash, because, of course, that 5% that we've gotten spoiled with, and just about everything-- treasuries, money markets-- is about to go down. Denise, what other options might be up for consideration? And you've got to compare that to what's already been priced into the market, I'm sure, Denise. But what do you see out there as potential options? DENISE CHISHOLM: Look, in some ways, the research I just talked about highlights the opportunity I see in equities, especially on that, depending on your risk tolerance, equal weighted, mid-cap, or small cap indices. I still think that there's a positive risk-reward there. But, look, equities are volatile. So when you say "when the Fed cuts," does that mean that you should put them in immediately? I think that to the extent that you have a one-year time horizon, I think equities still offer a positive risk-reward. As it relates to the next one month or three months, I think sometimes that stuff's anybody's guess. HEATHER HEGEDUS: OK. Jurrien, anything you'd add to that? JURRIEN TIMMER: I would just add the bond market, of course-- so if you take cash has no duration, right? And it's currently above 5%, but that's going to change as the Fed cuts rates. So your reinvestment risk on cash is significant, right, because a year from now that might be 3% or 4%. And going a little bit out the curve for the bond market is a way to kind of lock in a little bit more of the capital appreciation potential that, if rates cut, the two-year yield or the five-year yield will benefit, and then you've at least locked in a couple of years worth of that. But, again, to your earlier point, a lot of that is already priced in. So the two-year yield is already trading at 3.6%. So maybe the opportunity has passed there. But, certainly, on the equity side-- again, stocks that benefit from lower rates that haven't already reflected what's about to happen with rates-- that is still a potential opportunity. HEATHER HEGEDUS: OK. And, finally, as we're about at the 20-minute mark now, before we go, let's do Timmer's Take. It's been a while since we've gotten your take, Jurrien. Timmer’s Take So I'm really excited to hear about what's on your radar for this week besides next week's Fed meeting. JURRIEN TIMMER: Well, we're in a quiet phase for earnings, so there's not really a lot to look at there. Like I said, the baton is kind of being passed from worrying about inflation to worrying about growth. And we just had the jobs report last week. So we kind of know where the growth is. We do have the CPI and PPI coming out this week. And so that will be an ongoing check to make sure that we actually can stop worrying about inflation. And so that will be probably the next important sort of data point to check off. HEATHER HEGEDUS: Check off the box. All right, Jurrien and Denise, thank you so much for all the great insights today. And we get that it's sometimes helpful to talk through your financial concerns. Just a reminder, you can always call, go to our website, or download our app. Just a reminder before we go, too, we have an email address now where you can reach out to our Market Sense team. I read those emails. Jurrien reads those emails. And we would love for you to use it for the next couple of weeks to suggest questions you might have about the upcoming election. Maybe you'll be listening to the presidential debate tonight. Well, shoot us an email, and we might use some of your questions for our election Q&A episode coming up the first week in October. So that email address is marketsense@fidelity.com. On behalf of Jurrien Timmer and Denise Chisholm, I'm Heather Hegedus. We will see you back here next week, Tuesday at our regular time, 2 o'clock Eastern. Take care, everybody. N/A