For nearly two years, stock investors have faced the challenges of navigating the Federal Reserve’s tightening campaign.
In an effort to rein in record-high inflation, the central bank raised policy rates to levels unseen in over two decades. Despite the conventional wisdom that high interest rates dampen enthusiasm for risk assets, including equities, the US stock market has defied expectations.
Fueled by the relentless momentum of the tech revolution, particularly in artificial intelligence (AI), the S&P 500 is poised to conclude 2023 near two-year highs.
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Further, a fresh wave of optimism swept the market last week as Fed policymakers unveiled plans to initiate rate cuts. Investors, buoyed by this news, are now optimistic that the ongoing rally will extend into 2024 within a less restrictive macroeconomic environment.
Barclays analysts’ views
As noted by Barclays equity strategists, the Fed’s rate cuts have served as bullish signals for a number of decades.
However, although the ongoing economic growth cycle is vigorous, analysts warned that the positive effects of declining inflation may be overshadowed by a slower growth pace in the US economy.
Notably, the strategists said that a dovish pivot typically bodes well for tech and defensive sectors, large-cap stocks, favoring “growth over value.”
“That said, we think the ‘too high, too fast’ rally is ripe for a breather in 1Q24,” strategists added.
Even so, the expected rate reductions should still act as a catalyst. Citi analysts noted that historically, the S&P 500 gained more than 10% on average in the year following the first cut.
When it comes to specific sectors, healthcare, consumer, and tech were among the biggest beneficiaries in the wake of a dovish pivot. However, the movement within sectors became more focused and less diverse compared to the period leading up to the rate cut, Citi strategists noted.
Small cap stocks – an overlooked opportunity?
The rally in US stocks this year has been nothing short of impressive. Yet, it is important to note that the vast majority of its gains came from the biggest companies thriving in the ongoing AI frenzy.
Meanwhile, small-cap stocks – companies valued between $300 million and several billion – have been underperforming. The primary reason is that these stocks are notably more impacted by higher rates.
But, with the Fed expected to cut rates at least three times next year, less-known equities may be allowed to catch up.
Tom Lee, Fundstrat Global Advisors cofounder and former JPMorgan equity strategist, believes small caps are poised for a rebound.
“In the next 12 months it seems like small-caps can be up 50%,” the analyst said in an interview with CNBC. The Russell 2000 index, which tracks US stocks with an average market cap of about $2.8 billion, could rise from 1,996 to 3,000 by the end of 2024, Lee added.
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