Fresh uncertainty around Fed rate cuts exposes the stock market's winners and losers

By Vivien Lou Chen

5% 10-year Treasury yield no longer considered a level that might trigger a stock-market correction, portfolio manager says

Higher U.S. inflation is dashing investors' hopes for multiple Federal Reserve interest rate cuts this year, while opening the door to 5% Treasury yields across the board and cleaving the stock market into distinct categories of winners and losers. Winners are being identified as those companies with ample cash and little debt, sheltering them from the need to borrow or refinance at higher interest rates.

Before Middle East tensions came to the fore on Friday, technology stocks were driving the equity market to a mostly higher finish only a day after Wednesday's hotter-than-expected consumer-price inflation report for March. By contrast, small-cap companies, as reflected in the Russell 2000 index RUT, suffered some of the worst post-CPI reaction, ending the week down by 2.9%.See: Small-cap stocks 'challenged' as inflation pushes out Fed rate-cut expectations, warns BofAThe prospect of either no 2024 Fed rate cuts, or fewer than the three quarter-point reductions projected by policymakers, has lead to relatively sharp and rapid increases in Treasury yields - moves that typically produce problems for the stock market as a whole.

Something a bit different might be going on this time around, however. Higher market-based interest rates are impacting sectors differently, extending the survival-of-the-fittest theme that began with the onset of the 2020 Covid-19 pandemic. "Anything sensitive to interest rates would be the losers, like cryptocurrency, small-cap companies, and the industrial sector, which had been driven earlier this year by a lot of hope and expectations for rate cuts," said Ben Emons, senior portfolio manager and head of fixed income for NewEdge Wealth in New York, which manages more than $45 billion in assets.It's difficult to say what levels the benchmark S&P 500 SPX or U.S. stocks overall should be trading at, considering the continued strength of the economy, Emons said via phone. Meanwhile, the risk of war in the Middle East threatens to unleash further inflationary pressures with oil prices likely to rise, followed by Treasury yields, he said. Fears about escalating Iran-Israel tensions shook financial markets on Friday, with the Dow Jones Industrial Average DJIA posting its biggest weekly loss since March 2023. Nonetheless, the Dow Jones is still up by 0.8%, or 293.70 points, for all of 2024 at 37,983.24. And so far this year, the S&P 500 is up 7.4%, or 353.58 points, at 5,123.41 and the Nasdaq Composite Index COMP is up 7.8%, or 1,163.74 points, at 16,175.09.See also: Iran-Israel fears sink stocks as traders rush to gold, Treasury bonds

"Yields closer to 5% across the Treasury curve are one thing to expect" - a prospect that's less likely to trigger a stock-market correction than in 2022, when the Fed was behind the curve on inflation, according to Emons. "It would take yields closer to 6% for something like that to happen," he said.The bottom line is that U.S. economic growth isn't being curtailed as much as many had expected - despite the highest interest rates in more than 20 years, at between 5.25% to 5.5%. Jamie Dimon, chief executive of JPMorgan Chase & Co. (JPM), and former U.S. Treasury Secretary Larry Summers are a few of the big names that have suggested over the past week that interest rates might need to go higher from here. Read: 'Serious possibility' that Fed's next rate move is a hike, warns Larry Summers and Interest rates could hit 8% or more and wars are creating outsize geopolitical risks, Jamie Dimon warnsWednesday's consumer-price index for March showed the annual headline rate of inflation moved up to 3.5% from 3.2% previously, and came less than a week after nonfarm payrolls data revealed the U.S. created a higher-than-expected 303,000 new jobs last month. The midweek CPI report triggered the biggest one-day jumps in the 2- and 10-year Treasury yields in at least a year. Suddenly, 5%-or-higher yields across all U.S. government debt seems feasible. "Right now, the market is thinking the Fed can still lower rates, but whether the central bank will hike is the real question," said Robert Daly, who manages more than $4.5 billion in assets as director of fixed income at Glenmede Investment Management in Philadelphia.

Via phone, Daly said there's a less than 10% chance that Fed policymakers will raise interest rates again, but he sees a high likelihood of no rate cuts - which should push Treasury yields up and weigh on the minds of investors, who will question where risk assets are priced."There's going to be winners and losers and you have to pick your spot accordingly," Daly said. "I prefer high-quality fixed income and I would be in safety. Companies that have strengthened their balance sheets, with limited needs to refinance, can be the winners in this environment."

Senior research analyst Violeta Todorova at London-based Leverage Shares, a provider of exchange-traded products, said her firm is "bullish on financials, energy, materials and selectively on tech, while real estate is still underperforming.""Our base line scenario is for two 25-basis-points cuts in 2024, and we see a good probability U.S. equity markets [will] rise around 10%" from early Friday's levels, Todorova said in an email to MarketWatch. In the event of no Fed rate cuts in 2024, "we are likely to see only a modest increase [in stocks] by year-end," according to the analyst. Under a no-rate-cut scenario, her firm's targets would be 40,400 for the Dow Jones Industrial Average; 5,330 for the S&P 500; and 18,750 for the Nasdaq-100 NDX, she said. However, if inflation continues to rise and forces the Fed to deliver another hike in 2024, "the stock-market rally is likely to stall and a deeper correction is likely to unfold as soon as such probability gains traction," Todorova said. That's the least-probable scenario and one that would likely leave the Dow Jones Industrial Average trading around 37,200; the S&P 500 at roughly 5,000; and the Nasdaq-100 at about 17,200 by year-end.Monday's data docket brings U.S. retail sales for March, along with the New York Empire State manufacturing survey and the home builder confidence index for April.

Tuesday brings March data on housing starts, building permits, and industrial production. On Wednesday, the Fed's Beige Book report is set to be released. Thursday's data includes weekly initial jobless claims and the Philadelphia Fed manufacturing survey for April, as well as March's existing home claims and U.S. leading economic indicators. A number of Fed officials are scheduled to speak throughout the week, starting with Dallas Fed President Lorie Logan in Tokyo on Monday.

-Vivien Lou Chen

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04-14-24 1201ET

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