4 Undervalued Stocks to Buy Before the Fed Cuts Interest Rates

Susan Dziubinski: I’m Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar Research Services’ chief U.S. market strategist Dave Sekera to discuss one thing that’s on his radar this week, one new piece of Morningstar Research, and a few stock picks or pans for the week ahead.

On your radar this week, Dave, is the potential United Auto Workers strike. Both actors and screenwriters are currently on strike and UPS UPS and the Teamsters narrowly averted a strike earlier this summer. What are the larger implications here?

Dave Sekera: Well, good morning, first of all, Susan, on this dreary day here in Chicago. For the past two years, real wage growth has been negative as inflation has outpaced pay raises, and it’s only been within the past couple of months, this has reversed as we’re now starting to see wage growth go up faster than inflation. So, again, certainly great news for workers, but the concern for the market is now twofold. First, if wages rise faster than productivity and inflation, that of course could weigh on margins and limit earning growth. And second, if real wage growth stays too high for too long, the question there would be could that start a wage-price inflation spiral and lead inflation higher over time?

I did speak with Preston Caldwell, [Morningstar’s] head of U.S. economics, and I know he’s not concerned about this reigniting inflation at this point in time. He doesn’t think this is an indication that these strikes are the beginning of really a substantial wage increase across the entire workforce. At this point, his forecast is still that inflation will continue to keep moderating over the course of this year. In fact, we’re looking for inflation to decline to about 2% on average in 2024.

Dziubinski: Also on your radar this week is the upcoming blockbuster IPO for Arm. The chip designer plans to raise about $4.5 billion in the year’s largest IPO with Apple AAPL, Nvidia NVDA, Alphabet GOOG, and other cornerstone investors on board, and then SoftBank will retain a 90% stake. That puts the company’s valuation at around $54 billion to $55 billion. What are your thoughts about this IPO in particular and the IPO market in general?

Sekera: This IPO is going to be very closely watched for a number of reasons. As you mentioned, to start off with, this is a big deal. So they’re looking for about $4.5 billion of proceeds on a $54 billion valuation. Now that valuation does appear to be pretty high. I mean, that’s a fully priced deal for this company, and I think what Arm is going to do is they’re going to try and portray themselves as being a play on artificial intelligence. I think that if they are successful in doing so and they get that high valuation, then I do think we could see a rush to the market for any other AI or related company that’s been looking to IPO.

And then more broadly, I think people are looking at if this is showing that the window to the IPO market is ready to open back up. So, in general, the IPO market, there was a huge wave of IPOs back in 2021, but really since then with the market selling off in 2022, the window to the IPO market has been pretty close to being shut. At this point, there appears to be a pretty large background of potential IPOs out there. I looked through some of the research from PitchBook. According to them, there are 220 IPOs that should have gone public since then.

So, I do think we are seeing a number of indications that the IPO market is starting to open back up. For example, the equity market in general is just well up off of its 2022 lows. We are just seeing valuations up more broadly. I think investors are also just getting more comfortable with the soft-landing scenario. Of course, no one wants to buy an IPO immediately ahead of a recession. So, as people get more concerned, I’m sorry, more comfortable with the economic outlook, that certainly helps. A lot of these venture capital funds are looking to go public to try and cash out some of these portfolio investments and realize some gains for their portfolios. And then there are also some of these companies that are now starting to run out of cash. They need the capital and the capital availability in the VC area right now, my understanding is it’s relatively limited and pretty tight.

I think the big takeaway here for investors even in the public markets is, if this IPO is successful, I do think that opens up the floodgate for a wave of new IPOs, and I think that would actually provide a positive market sentiment for the overall stock market.

Dziubinski: Let’s move on to some new research from Morningstar. This week we’re talking about the new economic outlook from Morningstar Research Services, which includes forecasts for interest rates, inflation, and GDP growth. Let’s start with GDP growth, Dave. What’s our forecast for the next several quarters and then longer term?

Sekera: The U.S. economy has been just defiant of the Federal Reserve. It’s been much stronger for the past couple quarters I think than anybody, ourselves included, really thought that it was going to be in the face of tight monetary policy and high interest rates. So, we did boost our GDP forecast for the third quarter up to 3.2%. However, I’d still caution people that we do expect that tight monetary policy, the highest interest rates that we’ve seen since the global financial crisis, reduced bank lending availability—it’s all going to take a toll on the economy. So while we are still in the no-recession camp, we are still looking for that soft landing, but we do believe that the rate of economic growth will start slowing later this year in the fourth quarter. And then we’re looking for that rate of economic growth to slow sequentially for the next three quarters, bottoming out in the second quarter of 2024, and then only beginning relatively slow expansion thereafter. Our GDP forecast for 2024 is only 1.4% right now.

Dziubinski: What about inflation? What are we expecting for the rest of this year and then longer term?

Sekera: We’re pretty much unchanged on that. We do expect inflation will continue to keep moderating over the course of this year. And, in fact, we’re looking for inflation to moderate further in 2024. So, our forecast for inflation next year is just below the Fed’s 2% target.

Dziubinski: And then lastly, Dave, let’s talk about our interest-rate forecast. Let’s start with where do we expect to end 2023?

Sekera: Taking a look at interest rates, let’s break it into two, let’s talk about the short end and then the long end. In the short end of the curve, we do think the Fed is done hiking rates. We’re not looking for any more interest-rate hikes out of the Fed. I do think that short rates are either going to be at or really close to their peak. And, in fact, I think they probably start coming down later this year, certainly by the beginning of next year, as the market starts to price in the Fed cutting rates next year. I think the market is pricing in a total of four or five price cuts or interest-rate cuts from the Fed in the second half of next year.

Then taking a look at long-term rates, I think those are also probably pretty close to their peak and should start coming down later this year as well. And a lot of that is just due to our economic outlook. Again, we are forecasting for the rate of economic growth to start slowing later this year and continue to slow next year. And I think once the market really starts seeing that and starts pricing that in, that’s going to boost the demand for Treasuries. And so our forecast right now for the yield on average next year for the 10-year is about 3%.

Dziubinski: Now, we expect the Fed to begin to cut interest rates pretty early in 2024. When and why?

Sekera: Well, the Fed, of course, wants that soft landing. And to do that, they want the economy to slow just enough to lower inflation but not so much that they end up causing a recession. So our expectation is based on that combination of the economic forecast and the inflation forecast. So, with the economy beginning to slow in the fourth quarter, continuing to slow in the beginning of next year with inflation moderating and declining toward the Fed’s target, I think the combination of both of those is what we’re looking at that provides the Fed the room that they would need to start cutting rates sometime in the first quarter of next year.

Dziubinski: Our outlook has actually differentiated a bit from what others in the market are saying. Why is our view different?

Sekera: At this point, when I take a look at the fed funds, it looks like the market’s not pricing in a fed-fund rate until like a 50/50 probability next summer. So, well after our expectation of when we start expecting the Fed to start cutting rates. And I think we’re also more aggressive in our expectation for how much long-term interest rates will come down next year.

Dziubinski: Got it. Well, it’s time to move on to the picks portion of our program. This week, you’ve brought along four undervalued stocks for a falling interest-rate environment. Your first two picks are from the real estate sector. Before we get to them, talk first about why real estate stocks should do well as rates fall.

Sekera: Falling interest rates are positive for all assets, but the real estate area is one that we do think would do especially well. So, I spoke with our REIT analyst last week, Kevin Brown, and he highlighted a number of those, specifically those with long-leased assets with long-term financing are the ones that would benefit the most. Essentially, like a bond, you’re now discounting a future free cash flow stream at a lower interest rate, which of course increases your present value today. Now, having said all that, in the real estate space, my own personal opinion would be still to steer clear of urban office space.

Dziubinski: Then tell us about your two picks, which are Realty Income O and Healthpeak Properties PEAK.

Sekera: Realty Income is a 5-star-rated stock, trades at a 28% discount to our fair value, and currently pays a 5.1% dividend yield. Now it’s a triple net lease provider. What that means is that the tenant ends up paying for all of the property expense, all the real estate tax, the insurance, the maintenance, and so forth. Essentially, that takes a lot of the risk out for the lessor for just how fast those expenses can rise over time. In this case, it makes it a much less risky play for Realty Income.

The other one is Healthpeak, also a 5-star-rated stock, trades at a 39% discount and pays about a 6% dividend yield. Now, I would note that as are most REITs, it does not have an economic moat, but it does have a Medium uncertainty. And they have a diversified healthcare portfolio, mainly consisting of medical offices and life science assets, but they also have some senior housing, some hospital, and some skilled nursing assets as well.

Dziubinski: Now your next two picks for a falling-interest-rate environment are utility stocks. So why should utilities benefit from falling interest rates?

Sekera: Well, and especially regulated utilities will benefit as essentially they’re able to lock in the return on equity based on the regulatory environment that they operate under. I spoke with our utilities analyst Travis Miller, and he points out that the ones that he thinks will do the best in a falling-interest-rate environment are the ones that have the most growth-investment prospects. Those would be the ones that benefit the most, just as they’re going to be able to lock in additional lower-cost funding to build out those assets over time and still capture that regulatory rate of return.

Dziubinski: Your two picks here are Entergy ETR and American Electric Power AEP. Why do you like them?

Sekera: In this case, both of these have a pretty similar setup. These are two of the utilities that our analyst team forecasts have the best prospects for growth investment. Both are currently rated 4 stars. Both have some of the lowest price-to-fair values in our utilities coverage. Both have a narrow moat with a Low uncertainty and then higher-than-average dividend yields paying 4.5% and 4.1%, respectively.

Dziubinski: Well, thanks for your time this morning, Dave. Dave and I will be back live next Monday at 9 a.m. Eastern, 8 a.m. Central. In the meantime, please like this video and subscribe to Morningstar’s channel. Have a great week.