Unraveling the Impact on Stocks, Sectors, and the Dollar

The Federal Reserve's Jackson Hole meeting signaled a potential shift in the economic winds, with interest rate cuts looming on the horizon and the yield curve finally un-inverting after two years. What does this mean for your portfolio? Could this be the dawn of a new market cycle, or are hidden risks lurking beneath the surface?

In this issue, we'll delve into the implications of the yield curve uninversion, exploring its historical impact on stocks, sectors, and the US dollar. We'll uncover which industries will likely thrive and which may falter as the interest rate landscape transforms.

Join us as we navigate this pivotal market moment, providing insights to help you adapt your investment strategy and seize emerging opportunities. The time to prepare is now – don't miss out!

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During the recent Jackson Hole meeting of the Federal Reserve, Powell communicated that it was time for the Fed to reduce interest rates. Post-meeting, the market has fully factored in a high probability of at least 69.3% for interest rates being lowered at least four times before the end of the year. As the policy interest rate of the U.S. Federal Reserve impacts short-term rates, the latest interest rate quotes indicate that the inversion of U.S. Treasuries, which has lasted for more than two years, is finally ending.

What does an inverted interest rate mean, and what does the end of an inversion signify?

An inversion of the U.S. Treasury curve, or yield curve inversion, occurs when short-term interest rates (such as those on 2-year Treasury notes) become higher than long-term interest rates (like those on 10-year Treasury bonds).

Typically, long-term bonds have higher yields than short-term notes, reflecting the risks and uncertainties associated with the longer time horizon. However, investors might turn to long-term bonds as a safe investment if they expect economic growth to slow down or a recession to occur. Meanwhile, short-term interest rates might rise due to actions by the central bank, like the Federal Reserve, aiming to control inflation or economic overheating.

On the other hand, the end of the U.S. Treasury yield curve inversion may indicate an improvement in the economic outlook and adjustments in monetary policy. However, this doesn't necessarily mean that the risk has vanished. The economic context and the reasons behind the change in the yield curve's shape should be carefully considered, as they could also signal other underlying economic shifts.

How is the market performing after the end of an interest rate inversion?

After studying the one-year performance following the yield curve uninversion, it was observed that value stocks tend to underperform growth stocks during these periods. This trend was evident in the years 1998, 2007, and 2019. However, there was an exception in 2001 when growth stocks significantly underperformed value stocks during the burst of the internet bubble. Therefore, whether growth or value stocks will outperform following a yield curve uninversion also depends mainly on the valuation of growth stocks.

Which industries will perform better after the yield curve uninverts?

In historical terms, when the yield curve goes from being inverted to uninverted, its impact on different sectors has been variable. However, defensive value stocks, such as the S&P 500's consumer discretionary sector and the Russell 2000's health care sector, have consistently shown strong performance after the yield curve uninverts.

Looking at data since the mid-1990s and comparing across the 11 Global Industry Classification Standard (GICS) sectors, large-cap consumer discretionary stocks in the S&P 500 have, on average, achieved the best performance relative to other sectors in the year following a yield curve inversion.

The technology and materials sectors have also performed well, with technology stocks reliably outperforming the broader index, beating it in three out of four uninversions. On the other hand, the financials and real estate sectors have generally performed the worst following a yield curve uninversion.

In the Russell 2000, the communications and discretionary sectors were the strongest performers, while real estate and energy were the weakest. Consequently, defensive sectors have typically performed better than cyclical ones.

What impact will the downward interest rate cycle and a weak dollar have on the markets?

1. The decrease in interest rates in the United States will affect specific industries. Sectors with high debt levels, such as utilities or telecommunications, may benefit from reduced interest expenses due to lower rates.

2. The decline in U.S. interest rates will impact global exchange rates and the value of the U.S. dollar. A weaker dollar can make U.S. exports more competitive, benefiting companies with significant international sales. On the other hand, it can increase the cost of imports and reduce the net income of companies that heavily rely on raw materials imports.

3. Bloomberg's analyst Michael Casper pointed out in his recent report that the US Dollar Index has a more negative correlation with the large-cap value style than with growth, and the consumer discretionary sector shows the most negative correlation with the US dollar. This suggests that consumer discretionary stocks are likely to rise when the dollar weakens.

4. Falling interest rates often correspond to economic contraction. Merrill Lynch's investment clock suggests that in times of potential recession, investors should focus on defensive industries.

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That’s it for this episode!

Sources: Moomoo news.

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