The Federal Reserve’s upcoming meeting could play a crucial role in the direction of tech stocks and small-cap equities. While a rate cut is not anticipated, any indications from the Fed regarding future rate cuts could be significant for small-cap stocks, which have recently been on a winning streak.
The stock market has been volatile, with U.S. equities experiencing heightened uncertainty due to a significant sell-off in big-tech stocks and a shift toward small-cap and value stocks. This shift, dubbed the “great rotation,” has been a prominent market trend in July.
The transition was somewhat expected. The “Magnificent Seven” stocks, including Nvidia Corp. (up nearly 150% in the first half of 2024) and Meta Platforms Inc. (up over 42%), had an impressive start to the year, boosting major stock indexes. However, this led to a narrow market breadth, setting the stage for a correction. The recent sell-off in tech stocks pulled down indexes like the S&P 500 and Nasdaq Composite, which are heavily weighted with technology stocks.
In contrast, the Russell 2000, which tracks small-cap stocks, gained 10.2% over the 12 trading days leading up to July 26. It outperformed the S&P 500 by 13.3%, marking its largest 12-day outperformance ever, and the Nasdaq Composite by 17.1%, its second-largest 12-day outperformance.
The Russell 2000 ended the week with a 3.5% gain, outperforming the major equity indexes. Dave Sekera, chief U.S. market strategist at Morningstar, views this correction as healthy, highlighting a shift from large-cap growth stocks and tech names to value stocks and small-caps.
High valuations for megacap stocks have become harder to justify, as seen when Alphabet’s stock fell 5% despite an earnings beat. Emily Roland, co-chief investment strategist at John Hancock Investment Management, noted that earnings had to be exceptional to justify recent price surges.
The momentum of this rotation could depend on the upcoming July Federal Open Market Committee (FOMC) meeting. While the Fed is not expected to cut rates, investors will seek clues about the timing of future cuts.
Interest rate changes impact different sectors differently. Small-cap companies, more reliant on variable-rate financing, could benefit from rate cuts. Thomas Martin, senior portfolio manager at Globalt Investments, explains that lower rates reduce borrowing costs and stimulate the economy, potentially boosting small-cap earnings.
Investors have already shifted from megacap to small-cap stocks ahead of the first rate cut, suggesting further momentum for small-caps if rates are lowered. Martin believes the “great rotation” may continue but advises maintaining a diversified portfolio.
However, rate cuts can signal economic weaknesses. Investors will scrutinize Fed Chair Powell’s comments on whether rate cuts aim to combat inflation or address economic slowdowns. A slowing economy could pose risks, especially for small-caps less insulated from downturns.
Roland at John Hancock points to emerging cracks in the labor market and economy, which could prompt the Fed to cut rates. The Fed aims for a “soft landing,” but achieving it is challenging.
The FOMC meeting will be closely watched for insights into the Fed’s economic outlook. A soft landing would be ideal, but its likelihood remains uncertain.
Before Monday’s opening bell, futures for major U.S. indexes were up: Dow futures rose about 0.5% to 41,028, S&P futures increased 0.6% to 5,530, and Nasdaq futures climbed 0.9% to 19,340.
source: Market Watch
