Post-Fed Rate Cut: What to Buy?

Dongwu Securities released a research report stating that the current economic prosperity is not low and has not shown signs of recession; it is a preemptive interest rate cut cycle. Under a preemptive interest rate cut, the performance of U.S. stocks is generally more prominent, and in the long run, preemptive interest rate cuts are more favorable to equity assets. In the case of a soft landing of the U.S. economy, interest rate cuts can help further reduce corporate financing costs and improve profitability. Looking back at the past three rounds of preemptive interest rate cuts, Dongwu Securities found that before and after the rate cuts, growth stocks such as information technology and healthcare, as well as cyclical sectors represented by finance, often perform better, are more sensitive to interest rate changes, and benefit more from the liquidity easing brought about by interest rate cuts.

Global investment trends observed:

In September, the Federal Reserve officially cut interest rates by 50 basis points, signaling that the U.S. has begun to enter an easing cycle. After the interest rate cut is implemented, how will subsequent assets evolve?

Learning from history: Dongwu Securities believes that this round is closer to a preemptive interest rate cut.

Reviewing the interest rate cut cycles since 1980, they can be roughly divided into preemptive interest rate cuts and recessionary interest rate cuts. Recessionary interest rate cuts usually occur when the economy shows a clear recession, aimed at stimulating the economy, and the interest rate cut is often higher; while preemptive interest rate cuts often occur when the economic fundamentals are weakening and there are risks of downward trends, to prevent a large-scale economic recession, the interest rate cut and duration are usually lighter.

Reasons for this interest rate cut being preemptive: 1) In terms of inflation, this round of disinflation has been relatively smooth, with CPI year-on-year being lower than the historical average, and core inflation is also close to the average reading of previous preemptive interest rate cuts; 2) In terms of employment, the job market shows a high level of prosperity, with the unemployment rate far below the historical average, and the number of new non-farm jobs also remains at a medium level; 3) On the economic front, before this round of interest rate cuts, the actual GDP growth rate on an annualized basis was maintained at around 3%, which is close to the average growth rate of 4.3% for preemptive interest rate cuts, far higher than the average growth rate for recessionary interest rate cuts.

In summary, the current economic prosperity is not low and has not shown signs of recession, which can be considered a preemptive interest rate cut cycle.

Under preemptive interest rate cuts, U.S. stocks generally perform more prominently:

U.S. stocks: Usually, one month after the interest rate cut is an important window for U.S. stock market gains, benefiting from the liquidity easing and valuation lift brought about by the interest rate cut. However, different types of interest rate cut cycles diverge thereafter, and in the long run, preemptive interest rate cuts are more favorable to equity assets, with U.S. stocks leading in gains during each preemptive interest rate cut. In the case of a soft landing of the U.S. economy, interest rate cuts can help further reduce corporate financing costs and improve profitability.

U.S. Treasury bonds, U.S. dollar: 1) U.S. Treasury bonds usually run ahead of the interest rate cut cycle, as the expectation of economic and interest rate declines tends to cause Treasury bond prices to rise rapidly before the interest rate cut, and the increase in the 1-2 months after the interest rate cut is opened is somewhat narrowed, especially during the preemptive interest rate cut phase, due to the relatively stronger economic fundamentals, which will suppress the performance of the bond market to a certain extent. In contrast, during the recessionary interest rate cut background, U.S. Treasury bonds perform "in a class of their own". 2) The U.S. dollar often falls with the decline of U.S. Treasury bond yields, but the trend of economic fundamentals may also support the U.S. dollar trend, such as in 2014, when the interest rate cut was initiated, the U.S. economy had a soft landing, and the economic performance was strong, the U.S. dollar index trend was relatively stable.Commodities: 1) Copper: Generally declines during most of the interest rate reduction cycles; 2) Gold: Tends to rise in price during interest rate reduction cycles as interest rates and the US dollar decline, with more significant increases during periods of recession and rapid escalation of risk aversion, such as during the 2008 financial crisis. However, gold is not the best choice during periods of economic stabilization. 3) Crude Oil: Does not show a clear pattern and is largely dependent on changes in supply and demand dynamics and geopolitical conflicts.

How will various assets trade after this interest rate cut?

1. US Stocks: Looking back at the past three rounds of preemptive interest rate cuts, Dongwu Securities found that before and after the rate cuts, growth stocks such as information technology and healthcare, as well as cyclical sectors represented by finance, often perform better. They are more sensitive to interest rate changes and benefit more from the liquidity easing brought about by rate cuts.

Based on this, Dongwu Securities believes that in the future, the relatively certain investment themes in US stocks are:

1) Interest Rate Sensitive: Small-cap growth & biotechnology, finance, real estate.

In terms of style, small-cap growth may outperform large-cap. On one hand, interest rate cuts reduce the short-term debt pressure on small and medium-sized enterprises, improving profit expectations and valuations. On the other hand, against the backdrop of interest rate cuts, a "soft landing" of the US economy boosts the sentiment for small and medium caps. Therefore, through historical analysis, small-cap growth, mainly represented by the Russell 2000 Growth Index, has seen increases of 1.8%, 12.1%, and 47.7% three, six, and twelve months after the start of rate cuts, respectively, all of which are generally higher than the large-cap (S&P 500) increases of 2.3%, 7.3%, and 7.8%.

In terms of industry, the biggest "winner" may be biotechnology stocks. First, the high certainty brought about by interest rate cuts, combined with the current position structure, shows that biotechnology is still at a relatively low level, thus biotechnology has a favorable position structure and may be the most elastic trade in interest rate cut transactions. Second, with the rise of AI, biotech has become an important direction for global investment.

Additionally, finance and real estate are directly and significantly affected by interest rates, with profit support, and both industries may still see good gains in the future.

2) Defensive: Utilities. The utility industry benefits from increased power investment due to the downward pressure on interest rates and can also hedge against the risk of economic slowdown.

The technology industry is relatively more concerning, with the biggest worry being deleveraging. Although from a discounting perspective, the Federal Reserve's interest rate cuts are beneficial for lifting US stock valuations. However: 1) Technology companies currently have a large amount of cash on hand, and the impact of interest rate cuts on their refinancing is relatively small. 2) Technology stocks, led by Nvidia, may experience deleveraging again. 3) From an emotional perspective, although over the past quarter, the "US stock market's seven sisters" have been the most crowded trade, the bullish sentiment has been continuously weakening, dropping from 70% in July to less than 50% in September.2. U.S. Treasury Bonds: Expected to decline first, then rise. U.S. Treasury bond yields are typically the most sensitive to the "perception" of a rate-cutting cycle. Looking back at each rate-cutting cycle since 1994, the yields on 10-year U.S. Treasury bonds have all shown a significant decline. However, after the rate cut is implemented, considering that the rate cut expectations have been overly fulfilled beforehand, the downward momentum of U.S. Treasury yields will be clearly insufficient, and a rebound may occur instead.

3. U.S. Dollar: Central tendency to fall, but the extent is limited. During a rate-cutting cycle, the U.S. dollar usually falls. However, considering the relatively resilient fundamentals of the U.S. economy, which still perform stronger compared to the economies of China and Europe, this will support the central tendency of the U.S. dollar to a certain extent, and the degree of decline may be limited.

4. Gold: Cautious in stages. 1) Considering that this rate cut is intended to be a preemptive measure, if the U.S. economy achieves a "soft landing" in 2024, the upside potential for gold may be lower than market expectations. Historically, in the context of preemptive rate cuts, the increase in gold prices is significantly lower than during recessionary rate cuts. 2) Inflation may cool down faster than policy rates, and real interest rates will remain relatively high, which will also drag on the rise in gold prices to some extent. 3) Bitcoin may continue to divert gold allocations. Spot Bitcoin ETFs have become an important asset allocation category, and institutional investors are gradually including "digital gold" (Bitcoin) in their investment portfolios, which will also divert some demand for gold allocations.