Weekly stock market update | Edward Jones

5) Cuts highlight the opportunities for leadership rotations and the risks of having too much cash  

With rates destined to decline in the coming years, areas of the market that have been punished from the Fed’s aggressive tightening campaign could be the ones that stand to benefit the most. So far in the third quarter we have seen a subtle change in market leadership toward more balance than over the past year. While the shift in Fed policy has helped lift stocks broadly, it is a mix of defensive and cyclical sectors that have led the charge (real estate, utilities, financials, industrials), rather than the usual suspects (tech, communication services and consumer discretionary).¹ In fact, the Nasdaq over the past three months is trailing the market-cap and equal-weighted S&P 500, growth is underperforming value, and semiconductors, a group that has delivered stellar results over the past year, is bucking the market trend and posting modest losses.¹

As long as a recession is avoided, which we expect, the bull market in stocks appears poised to continue, with cyclical and lower-valuation stocks potentially starting to close the gap with mega-cap tech. Lower Fed policy rates and bond yields could also make high-quality dividend-paying stocks, like the S&P 500 Dividend Aristocrats, more attractive to investors. And mid-cap stocks that offer a nice balance among quality, valuations, and cyclical upside in case of an economic reacceleration next year, offer catch-up potential.

In the fixed-income space, the implications from a pivot to rate cuts are wide as well. The 2- and 10-year Treasury yields rose modestly after the Fed’s outsized rate cut, possibly reflecting an easing in recession risks. Yet, bond yields remain near the lows for the year, and the path of least resistance is likely lower ahead. This pattern is reflected in the consistently positive returns for investment-grade bonds 12 months following the start of a Fed rate-cutting.³

Now that the Fed has moved and is promising more cuts, like the BoC, the reinvestment risk of having an oversized allocation to cash investments is more tangible. When a GIC or a short-term bond matures six months or a year out, investors might have to reinvest the returned principal at a lower rate, earning less. This is why we recommend investors consider extending the maturity profile of their fixed-income portfolios by repositioning where appropriate in intermediate- and long-term bonds.