Rate-cutting playbook: Investment strategies for offense and defense

Last week’s macro data pushed large-cap equities to their best performance streak in over a month.

The S&P 500 posted its best week since last November. But the rally itself was a fairly broad one. Mega caps led the way with a more than +6% rally, but small caps also climbed +3%.

Performance was driven by a weeklong run of favorable data in the U.S. That stretched across producer prices, consumer prices, retail sales and jobless claims. This has helped quell market slowdown fears sparked by the July Jobs Report. Prices were in line with or lower than Street expectations, initial claims (those applying for unemployment insurance) were lower, and the control measure of retail sales (what is used in the GDP calculation) tripled market forecasts.

Earnings also helped to spur the rally. Walmart (+8%), the largest private employer in the U.S., reported second-quarter earnings. The retailer raised its sales growth guidance for the year 4.75% (versus expectations of 4%). Management also gave an upbeat description of the consumer as: “Each part of the business is growing—store and club sales are up, and eCommerce is compounding.” Shares of Starbucks (+26%) got a caffeine kick last week when the coffee chain announced it will replace its CEO with Brian Niccol, the current Chipotle CEO. The news caused some indigestion for shares of Chipotle, which were down -5%. The stir in management comes as activist investors Elliott Investment Management and Starboard Value have amassed stakes in Starbucks.

Inspired by the start of a new Premier League football season, we look ahead and describe below the tactics for a rate-cutting cycle.

The rate-cutting playbook

Last week’s inflation and labor market data should free up the Federal Reserve to cut interest rates in September on its own terms – just as we have seen from the European Central Bank and Bank of England this summer. Futures markets are pricing in 100% probability of a 25-basis-point cut with about a 25% chance of 50 bps. We think investors should dust off their rate-cutting cycle playbooks to position their portfolios. Like a well-balanced playbook, there are two sides to consider: offense and defense.

Defense: Bonds may have your back

Investors will likely start earning less on their dollar-denominated cash in just 30 days. Now may be the time to consider moving out of excess cash and extend duration by buying bonds.

Why buy bonds? When you buy a bond, you capture elevated yields for longer. For example, cash yields on T-bills are still quoted above 5%, but that doesn’t give you the full picture. Rather, that quoted figure represents the annualized yield on a bill that matures in three months. In reality, that 5% yield means you earn 1.2% total over the next three months, and then you have to reinvest at the prevailing rate. In other words, as the Fed cuts rates, yields on T-bills and other short-dated instruments should drop quickly.

Yields have already dropped. Are you too late? We believe the answer is no, even if 10-year yields have already declined by nearly 80 bps from this year’s peak. Historically, buying bonds one month prior to the first cut of a cycle delivers nearly 300 bps of excess return relative to waiting until one month after the Fed has started cutting.

Starting yield doesn’t tell the whole story. Bond prices often rise when interest rates fall, whereas cash yields remain relatively stable. For example, if you invested in a product with little to no duration, like short-term Treasury bills, you would receive the current yield over the investment period. In contrast, investing in a product with duration, like core bonds, offers the potential for both yield and price appreciation if interest rates decrease.

To illustrate, if interest rates were to decrease by 100 basis points, a hypothetical investment in core bonds which has duration would likely result in higher returns compared to cash. 

Bonds can play a key role in a defensive investment strategy by providing capital preservation, income enhancement, and diversification. As a potential rate-cutting cycle approaches, consider incorporating bonds and extending duration in a defensive strategy.

Offense: Recovery in rate-sensitive sectors

Rate-cutting cycles also offer the opportunity to play some offense, particularly in those sectors that have underperformed in part due to higher rates. Below we highlight three areas that could recover with lower rates:

• Refinancing: Over 60% of homeowners in the U.S. own their homes through a mortgage. Through the hiking cycle, mortgage rates climbed to over 8% from ~3%, and have since fallen back to ~7%. The higher rate environment has deterred new homebuyers from entering the market, and existing homeowners from relocating. The move lower in rates could provide a welcome relief to hopeful homeowners and folks who took out a mortgage near the highs. We’re already seeing signs of this. The MBA Refinancing Index had its biggest weekly jump since 2020. Even though refinancing is still dormant relative to 2021’s binge, the tick higher is a positive sign that home equity could act as a source of support for the consumer, spending and residential projects as rates fall.
• Commercial real estate (CRE): Following the fastest hiking cycle since the early 1980s, aggregate CRE property prices across the pond have fallen by 12% since their peak in 2022, marking the third correction in U.S. CRE property prices in the last 30 years. In the UK, reports suggest that offices are now being sold at their biggest discount since the financial crisis.
  

Much of the impairment has been concentrated in the office sector. As Michael Cembalest, Chairman of Market and Investment Strategy for J.P. Morgan Asset & Wealth Management, noted in his latest piece, ~25% of workers are working from home, leading to leasers giving back 10–12% of their rented spaces. As such, developers have been considering taking aging office buildings and turning the properties into housing. Those conversions are picking up in New York and London, as office vacancies have risen since the pandemic. Lower financing rates can encourage developers to take on these conversions, and a lower discount rate should support property values.

• M&A: Just last week, Mars Incorporated, the food manufacturer and packager, agreed to buy Kellanova, maker of Pringles. The deal will total nearly $36 billion composed of debt and a 33% per share premium on Kellanova’s equity. Elsewhere, a Bloomberg article  reported that Skydance’s Paramount deal is now open to competition. M&A activity has been muted this year: Volumes are 20% below the 10-year average. The Mars deal, the second-largest year-to-date, along with investors competing for current deals, may signal green shoots for the industry into the impending rate-cutting cycle.

Whether you want to play offense, defense or a little bit of both, now is the time to prepare for a rate-cutting cycle. Your J.P. Morgan team is here to help.