Capital Ideas^TM

What direction could equity markets take from here? Will they continue on a narrow path - led by large-cap tech stocks - or is there potential for a wider range of opportunities?

The US Federal Reserve (Fed) cut rates at its September meeting and history tells us that when a subsequent recession does not materialise, it is a good time to invest in equities.

Our analysis of historical periods suggests it is not uncommon for technology stocks to outpace other areas of the equity market in environments similar to the one we are experiencing; specifically, the period before the first Fed rate cut. Following that, in a soft-landing scenario, there is evidence that markets tend to broaden. However, central to that analysis is that the US avoids recession.

Can the US avoid a recession?

While forecasting recessions is notoriously difficult, we think there are multiple factors supporting a more optimistic outcome over the next 12-months. A robust labour market, stimulus from the IRA/CHIPS Acts¹, and signs that US consumers and borrowers have already borne the brunt of higher rates are just some of the indicators that point to the US avoiding a recession. Capital Group economist Jared Franz sees the potential for a ‘Benjamin Button’ scenario for the US economy, where instead of moving from late-cycle into recessionary territory, it returns to the mid-cycle stage.

Of course, there remain reasons to be cautious. The excess savings created during the pandemic are now dwindling across advanced economies, which could contribute to weakening consumer expectations.

Equity market leadership could broaden out following a Fed rate cut

We looked at rate-cutting cycles since 1982, in recessionary and non-recessionary periods, and tracked how different sectors reacted.

In the previous seven Fed-induced rate cutting cycles, three easing cycles occurred in non-recessionary periods and four took place during recessions.

We analysed both situations, splitting the cutting-cycle into two parts; the peak to first rate cut, and the first rate cut to the last rate cut.

What can we deduce from this analysis? In the event of a soft landing, there is the potential for a broader range of companies and sectors to do well, and potentially outpace technology stocks.

What are the investment implications?

Longer-term trends in the global energy transition, health care developments such as obesity drugs, and the realignment of global supply chains suggest interesting opportunities remain outside of Big Tech.

That’s not to say that technology stocks or US companies should be avoided. There remain a range of technology companies where our portfolio managers and analysts believe in their potential to deliver strong returns. There is also the longer-term potential for AI to profoundly impact a wide range of companies from various industries. Active investors can stand to benefit by identifying the future winners across the AI stack, while being mindful of valuation and concentration risks within their portfolios.

A strategy that is not overly exposed to a particular sector or theme, but constructed with a broader mindset may fare well as it has the potential to benefit from a wider range of economic drivers.

Overall, while it will not be one-way traffic, the road ahead for equities appears to be veering closer towards an open highway than a narrow lane.

1. IRA: Inflation Reduction Act, CHIPS and Science Act: Creating Helpful Incentives to Produce Semiconductors and Science Act