Hopes of a rate cut could boost U.S. stocks as investors await earnings, elections

Prospects of interest rate cuts in the near future are strengthening the case for investors to remain bullish, even as a rally in U.S. stocks could be tested by upcoming corporate earnings reports and growing political uncertainty.Expectations that the Federal Reserve will begin its long-awaited rate-cutting cycle in September held firm on Tuesday after Fed Chairman Jerome Powell told Congress that the U.S. economy is “no longer overheating,” suggesting the case for easing monetary policy is strengthening.

Rate-cut expectations have fluctuated widely this year and are just one factor, along with strong corporate earnings and hopes for artificial intelligence, that have helped propel the S&P 500 up about 17% this year. Still, many investors believe that greater clarity on when the Fed will start easing monetary policy and how much it will cut rates in 2024 could provide a cushion for stocks if the market churns in the coming months.

The start of rate cuts would signal that “the Fed has the market’s backing,” said Yun Yu Ma, chief investment officer at BMO Wealth Management. He expects the Fed to cut rates about six times over the next 12 months. “I think this is definitely a positive for both the markets and the economy,” he said.

Investors late Tuesday were pricing in more than a 70% chance that the Fed would cut rates in September, according to CME FedWatch, up from about 50% a month ago. Fund futures are pricing in about 50 basis points of easing for all of 2024, according to LSEG data.

“The Fed is close to cutting rates,” said Peter Cardillo, chief market economist at Spartan Capital Securities. “We expect a cut in September and then again in December.”

Future tasks

Powell told the Senate Banking Committee that inflation has improved in recent months and that “further, better data would strengthen the case for further monetary easing.”

An early test will be the release of U.S. consumer price data for June on Thursday. The past few reports have shown that inflation is starting to cool, but a better-than-expected reading could weaken the case for easing in coming months.

Meanwhile, expectations of easier monetary policy, combined with easing inflation and still-resilient growth, could boost investor confidence amid several possible risks over the coming weeks. Corporate earnings begin in earnest on Friday with reports from major banks, which could weigh on an expensive U.S. stock market if companies fail to meet lofty expectations. S&P 500 earnings are expected to grow 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 race after a shaky performance in a debate between President Joe Biden and former President Donald Trump late last month prompted calls for the incumbent president to step down.

Keith Lerner, co-chief investment officer at Truist Advisory Services, said in a recent interim outlook that he remains positive on U.S. stocks but expects the market to be “volatile” after a strong first half of the year.

“U.S. economic growth is now slowing from the post-pandemic stimulus boom, but it’s not weak,” he said. Stocks typically rise six to 12 months after the Fed’s first rate cut, as long as the economy avoids a recession, according to Truist research.

Lower rates could also help extend the stock rally that has been driven by a handful of large companies such as Nvidia. Just 24% of stocks outperformed the S&P 500 in the first half of the year, the third-shortest six-month stretch since 1986, according to strategists at Bank of America Global Research.

As big technology stocks surge, lower rates could help sectors of the market that have been hurt by rising interest rates, said Matt Miskin, co-chief investment strategist at John Hancock Investment Management. That includes small-cap stocks, which tend to be more sensitive to rates because they rely more on financing. The small-cap-weighted Russell 2000 index is up just 0.1% this year.

“Small businesses often need capital to survive, and the rising cost of capital really makes it harder for them to do business,” he said. “A lower cost of capital would definitely help these businesses.”

Of course, rate cuts aren’t always a sign of smooth sailing, and they often come when a weakening economy forces the Fed to ease monetary policy quickly. A study by Wells Fargo Investment Research released last month found that the S&P 500 has fallen an average of 20% in the 250 days following the first rate cut of a cycle.

The firm’s strategists say stocks will likely perform well over the next six to 18 months if falling inflation leads the Fed to cut rates. But “if macroeconomic or market turmoil forces the Fed to cut rates aggressively, we would expect stocks to weaken,” they say.