Economy & Markets
How will the rate-cutting cycle impact economic activity and market returns?
In the weeks since the Federal Reserve (Fed) began its rate-cutting cycle, we’ve engaged in analyses, including with artificial intelligence, tested hypotheses, and gained a deeper understanding of where investors are likely to find the best opportunities as interest rates decline.
We’ve examined housing, finding promise in single-family homebuilder stocks. We see reasons for home buyers to seize the moment rather than wait for mortgage rates to come down further—the lower rates during and before the pandemic continue to exert a “lock-in” effect, constraining housing supply and supporting prices.
Beyond housing, we’ve examined market sectors, industries and market cap size to see which could get a relative lift. Commodity beneficiaries may include oil (though many factors could impede that) and copper. Gold is likely to remain attractive, given ongoing elevated geopolitical risk.
What's not in our sights: A sudden economic boom
Let’s say up front what isn’t likely: We don’t see rate cuts spurring an economic boom right now. Interest rates are important, but they’re far from the only influence on economic activity and market returns.
Consider the reverse: Rate hikes in 2022 and 2023 didn’t hurt the economy as much as the consensus expected. Among the variety of reasons: Companies and households extended their debt repayments (“termed out their liabilities”); many turned to savings and fiscal stimulus payments to tide them over; and the workforce helped boost the economy thanks to a surge in immigration.
Now, on the flipside, rate cuts won’t likely lead to a boom. Moreover, the Fed is bringing interest rates down to a neutral level, which will likely have limited effects on the economy. It is not cutting rates to a stimulative level, out of concern dropping rates too far could cause inflation to pick up again.
A lift to durables—especially housing
The backdrop as the rate-cutting cycle gets underway is one of lower mortgage rates—down from a peak of nearly 8% in October 2023 to about 6.85% at present. 1The drop in mortgage rates is not large, but at the margin it should help stimulate more housing activity on a go-forward basis. And while we do not see a surge in housing activity coming, the environment continues to bode well for large-cap homebuilder stocks.
Why? We begin making our case for interest rate cuts’ impact on housing by considering a traditional distinction economists make, between spending on durables (homes as well as cars, household appliances, etc.) vs. nondurable goods. Durables spending is thought to be the more interest rate-sensitive of the two because it’s more likely to be financed by borrowing. Housing is a classic example: durables spending facilitated by leverage.
We built a model to examine housing’s rate-sensitivity and find that housing activity (existing home sales) is statistically related to changes in mortgage rates. Specifically, a 100 basis point (bps) drop in mortgage rates, all else equal, would stimulate existing home sales by about 3.6% at the peak of impact, which is expected to occur three months after the drop in rates.2
Our analysis finds existing home sales respond strongly to a 1% drop in mortgage rates
Response in housing activity to a 1%pt drop in mortgage rates
Sources: Haver Analytics, Bloomberg Finance L.P., Standard & Poor's, J.P. Morgan Private Bank. Data as of September 2024. Notes: Impulse Response Function of a Vector Autoregression Model that utilizes monthly data from 1992 to 2024.
We also expect the Fed to continue to cut its policy interest rate3 and for mortgage rates to keep trending lower4, moving eventually to a range of 5%–6%.
The bottom line is that housing activity should improve over the next year in our baseline outlook.
Home sales may take years to reach pre-Covid levels
Yet the traditional relationship between rates and housing could be complicated today by the low level of housing affordability in the U.S. Home construction never fully recovered from the global financial crisis—we estimate a shortage of between 2.0 and 2.5 million new homes, relative to trend household demand.5 Today’s homeowner vacancy rate remains as low as it’s been since data collection began in 1956.
In short, structural affordability issues lead us to expect that existing home sales will not return to their pre-pandemic norms for quite some time. Instead, we find that to restore affordability to 2019 levels, mortgage rates would need to plummet to 3%, or wages would have to rise at current rates for almost nine consecutive years.6
Those scenarios are not very probable, but some combination of mortgage rates reaching 5% to 6%, and incomes continuing to advance for the next three to five years, seems the most likely way out of the current housing affordability crisis.
Bullish on builders; multifamily faces challenges
When it comes to housing construction, we aren’t expecting lower rates to give much of a lift to multifamily construction starts. The multifamily segment looks somewhat overbuilt, especially in rapidly expanding population centers in the South and Sun Belt, such as Phoenix. The U.S. apartment vacancy rate now exceeds pre-pandemic levels, in contrast to the record-low homeowner vacancy rate.
U.S. apartment vacancy rates have skyrocketed
LHS: Apartment vacancy rate (%), RHS: Homeowner vacancy rate (%); Apartment vacancy rate (% difference from 2019 average)
Sources (LHS): Apartment List, U.S. Census Bureau, Haver Analytics. Data as of June 2024.
Source (RHS): Apartment List. Data as of August 2024.
Homebuilders, homeowners, may profit
Large homebuilders seem well positioned to continue to capture market share. Their profit margins have already increased by nearly 500bps (from 21% to 26%) from pre-pandemic levels, and their earnings per share have nearly tripled. We see even more room for growth.
One potential customer base: millennials (people in their 30s or early 40s) dissatisfied with the lack of housing inventory. Survey evidence suggests that as Americans age, they strongly prefer owning a single-family home over renting an apartment.7
The Millennials are the largest generation in American history, and the structural demand for single-family homes they are producing looks set to continue for years. The current backdrop also bodes well for single-family housing renovations since, along with being in short supply, America’s housing stock is also significantly aged, as we’ve written previously.8
Could home prices plummet as supply improves?
Some observers argue that as mortgage rates fall, supply will outpace demand and home prices will fall significantly. We’re skeptical of this thesis.
Nearly 60% of U.S. homeowners already have a mortgage rate below 4%, according to a recent report using Federal Housing Finance Agency data.9 This “lock-in effect” is likely to limit any surge in housing supply as mortgage rates fall. To be sure, supply is likely to improve as rates come down, but likely not enough—or quickly enough—to drive home prices meaningfully lower nationally.10
Non-essential industries are more rate-sensitive
Looking beyond durables, new research in macroeconomics shines an even more precise light on the question of which sectors are more sensitive to changing interest rates by considering the distinct impacts on essential vs. non-essential industries.
In a paper published this June, “Non-Essential Business Cycles,” authors Michele Andreolli, Natalie Rickard and Paolo Surico make a compelling case that tight monetary policy (high interest rates) hurts non-essential industries more than essential industries.11
Essential sectors are where consumers tend to spend their money, whether their income changes or not. Gassing up the car, paying rent, covering food at home, utilities and children’s clothing are essential because they’re less likely to decline when a worker receives a pay cut. Non-essential sectors show a stronger relation to income: after a bigger than expected bonus, a worker is more likely to splurge on non-essentials like a vacation or entertainment, for example.
We build on these authors’ work and map their innovative approach to markets utilizing artificial intelligence. We feed their paper’s detailed descriptions of essential vs. non-essential industries into a large language model (LLM) trained and maintained by J.P. Morgan Investment Bank, and then we ask the LLM to select baskets of company stocks that best align with the essential and non-essential industrial classifications.
The chart below shows the results: namely, which 50 S&P 500 stocks the AI chose as essential and which 50 are non-essential. We then weight the two baskets equally and overlay the 2-year real interest rate for visualization purposes.
Relationship between interest rates and essential vs. non-essential stock performance
Ratio of essential to non-essential stock baskets’ performance; RHS: Real 2-year rates
Sources: Haver Analytics, Bloomberg Finance L.P., Standard & Poor's, J.P. Morgan Private Bank. Data as of September 2024.
How do the LLM-chosen stocks match up with traditional equity sector classifications? Essential stocks fall primarily into Utilities, Healthcare and Energy. Non-essential stocks fall into other sectors, such as Consumer Discretionary (including leisure, hotels, luxuries, restaurants and furniture) and Information Technology. The chart plots the sector weights within the essential and non-essential baskets the LLM chose.
Opportunities as rates fall may include discretionary tech, travel, restaurants
Sector weights of essential/non-essential stock baskets
Sources: Haver Analytics, Bloomberg Finance L.P., Standard & Poor's, J.P. Morgan. Data as of September 30, 2024.
Our main result comes from quantifying the size and timing of how essential and non-essential stocks respond to changes in interest rates. We build a similar model to the housing activity model but here we assess the impact of a 100bps decrease in real two-year interest rates on essentials stocks’ performance relative to non-essentials’.
We find that all else equal, essentials stocks underperform by more than 3ppts, an impact that peaks two months after the drop in interest rates.
We find after a 1% rate decline, essential stocks underperform non-essential
Response of essential to non-essential to a 1%pt drop in real interest rates
Sources: Haver Analytics, Bloomberg Finance L.P., Standard & Poor’s, J.P. Morgan Private Bank. Data as of September 2024. Impulse Response Function of a Vector Autoregression Model that utilizes monthly data from 2004 to 2024, controlling for real GDP and real S&P 500 returns. All data is inputted as monthly percent changes. The lag structure of the model is chosen according to the Akaike information criterion. The gray range is the 95% confidence interval.
Uncovering likely winners and losers from the Fed’s pivot
Discovering the outperformance of non-essential stocks is a useful result because it allows us to more precisely bet on a question many strategists are struggling with: the likely (relative) winners and losers from the Fed’s pivot to an easier monetary policy stance.
One common consideration is that investors move down in cap size to find companies that will benefit from lower interest rates. Many strategists say this because smaller companies are more debt leveraged than larger companies. We do not disagree at a high level. The chart shows leverage metrics for large, mid and small-cap stocks.12
Smaller-caps carry more debt, so are more rate-sensitive, at a high level
Debt-to-market capitalization ratio, average over the last 4 quarters
Sources: Standard & Poor’s, Haver Analytics. Data as of June 30, 2024.
However, we can add useful precision to this high level point, applying our LLM framework to zero in on the interest rate sensitivity of small and mid-cap equities.
We build analogous equal-weighted portfolio stock baskets using the LLM on the S&P 1000 Index (the “smid-cap” index that combines the S&P600 and the S&P400). The model’s results are again statistically significant: Essential smid-cap stocks underperform non-essential in the context of falling interest rates. A 100bps drop in real two-year interest rates results in a 2.5ppt under-performance at the peak of impact, which again occurs two months after the drop in interest rates.13
Essential “smid”-cap stocks underperform non-essential two months after rates drop
Response of the ratio of essential to non-essential to a 1%pt drop in real interest rates
Sources: Haver Analytics, Bloomberg Finance L.P., Standard & Poor's, J.P. Morgan Private Bank. Data as of September 2024. Notes: Impulse Response Function of a Vector Autoregression Model that utilizes monthly data from 2004 to 2024, controlling for real GDP and real S&P500 returns. All data is inputted as monthly percent changes. The lag structure of the model is chosen according to the Akaike information criterion. The gray range is the 95% confidence interval.
The bottom line here: What the academics found in their paper seems to offer an important market insight. In a rate-cutting regime, investors will likely do well by owning non-essential stock risk, especially relative to essential stock risk.
Will commodities benefit from Fed easing?
We end this article by examining the interest rate sensitivity of commodities. Recent research has found a statistically significant relationship between U.S. monetary policy surprises and commodity prices.14 The mechanisms at work are at least fourfold. Interest rate changes affect:
- The opportunity cost of commodity storage
- The real-economy channel: Rate changes have effects on current and future commodity consumption
- The liquidity-portfolio channel: Rate changes affect financial conditions and thus trading liquidity in physical and derivative markets related to commodities
- The exchange-rate channel: Most commodities are traded in dollars
We quantify these effects with a model similar to those shown throughout this article, examining the impact a 100bps drop in real two-year interest rates has on commodity prices. The result: Commodity prices in aggregate increase by about 3.5% at the peak impact, which occurs four months after the drop in interest rates.
We find commodity prices rise 3.5% at peak, four months after a rate drop
Response of the aggregate commodity spot index to a 1%pt drop in real interest rates
Sources: Haver Analytics, Bloomberg Finance L.P., Standard & Poor's, J.P. Morgan Private Bank. Data as of September 2024. Impulse Response Function of a Vector Autoregression Model that utilizes monthly data from 2004 to 2024, controlling for real GDP and real S&P500 returns. All data is inputted as monthly percent changes. The lag structure of the model is chosen according to the Akaike information criterion. The gray range is the 95% confidence interval.
The commodity index we chose allows us to run the analysis for commodity subsectors, and we especially examine crude oil, copper, agricultural commodities and gold. We find statistically significant interest rate sensitivity for crude oil and copper, but not for agricultural commodities and gold.15
It must be noted that the model works in isolation from many real world factors, and our current investment outlook is not bullish on the price of oil due to supply issues specifically related to OPEC cuts that are set to expire. However, we are bullish on the price of copper relative to the price of oil, because we see copper supply dynamics as far less of a headwind.
The upshot for commodities investors
As rates fall, we should expect commodity prices to increase but not across all commodity markets equally.
The gold result may be surprising since many strategists assume gold responds to interest rates (especially if lower interest rates act, in some ways, to undermine the U.S. dollar). We think this conventional wisdom is misplaced and have argued previously that gold looks much more like a geopolitical hedge than a hedge against the Fed or inflation.16
Yet, to be sure, geopolitical risks remain high and concerning. Although gold may not benefit directly from the Fed’s rate cutting cycle, we still think it makes sense for investors to hold a structural allocation to the precious metal within a diversified portfolio. Our previously bullish view on gold has moderated as prices have risen to historic highs, but in the event of an adverse unexpected geopolitical shock, gold would likely head even higher—potentially significantly higher, depending on the nature of the shock.
Conclusion
Fed easing is likely to benefit single-family homebuilders, non-essential stocks (especially small and mid caps) and copper relative to other non-precious metal commodities. Gold is likely to remain attractive at a time of continued elevated geopolitical risks.
The start of the U.S. rate-cutting cycle should lead investors to think about their portfolios differently. The research and modeling we’ve done help us understand several ways to identify potential beneficiaries of lower interest rates—sectors, markets and stocks that investors might want to own as the Fed easing cycle continues.
Speak to your J.P. Morgan team about how to take advantage of our findings and whether your portfolio is positioned to benefit from the Fed’s rate-cutting cycle.
1Source: Average of Bankrate 30-year fixed rate and the Freddie Mac 30-year fixed rate. Data is as of October 2024.
2A lag of only three months seems short, but it fits with our view that the lag in monetary policy’s impact on the economy has shortened, a point that Fed Chair Jerome Powell has previously acknowledged. “Transcript of Chair Powell’s Press Conference,” Federal Reserve Board, November 2, 2022. https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20221102.pdf
3As we’ve written, our baseline view is two more 25bps rate cuts this year, one each in November and December, and four in 2025, one per quarter, which would bring policy rates to 3.5% by the end of next year. There are upside and downside risks to this base-case view, and it may also be impacted by the upcoming U.S. presidential election.
4Longer-term Treasury yields are based on expectations of Fed interest rate policy, and mortgage rates are priced at a spread above Treasury yields. Thus, a Fed cutting cycle flows through to mortgage rates. We note that the mortgage spread is currently wide, due to elevated interest rate volatility, which we expect to decline as the Fed’s moves further towards a neutral monetary policy stance.
5Joe Seydl and Jonathan Linden, “Investing in a changed world of shortages and oversupply,” J.P. Morgan Private Bank, July 18, 2023. https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/investing-in-a-changed-world-of-shortages-and-oversupply
6We have previously taken a deep dive into the U.S. housing affordability crisis. Joe Seydl, “When will the crisis in U.S. housing affordability end—and how? J.P. Morgan Private Bank, November 14, 2023. https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/ideas-and-insights/when-will-the-crisis-in-US-housing-affordability-end-and-how
7“National Community and Transportation Preferences Survey,” National Association of Realtors, April 2023. https://www.nar.realtor/sites/default/files/documents/2023-community-and-transportation-preferences-survey-slides-06-20-2023.pdf
8Joe Seydl and Jonathan Linden, “Investing in a changed world of shortages and oversupply,” J.P. Morgan Private Bank, July 18, 2023. https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/investing-in-a-changed-world-of-shortages-and-oversupply
9LilLily Katz, “6 of every 7 people with mortgages have an interest rate below 6%, but the lock-in effect is starting to ease,” Redfin News, August 27, 2024. https://www.redfin.com/news/mortgage-rate-lock-in-housing-2024/
10Although this does appear to have happened in certain isolated metros with high supply elasticity, such as Austin, Texas, Phoenix, Arizona, and in the condo market in South Florida.
11Michele Andreolli, Natalie Richard and Paolo Surico, “Non-Essential Business Cycles,” National Bureau of Economic Research, June 2024. https://conference.nber.org/conf_papers/f202255.pdf
12Furthermore, smaller companies also tend to have a greater share of liabilities that are floating rate rather than fixed rate. Michael Cembalest, “Eye on the Market: The Lion in Winter,” J.P. Morgan Asset & Wealth Management, July 23, 2024. https://am.jpmorgan.com/us/en/asset-management/institutional/insights/market-insights/eye-on-the-market/the-lion-in-winter/
13We also ran the same exercise on the small (S&P 600) and mid-cap (S&P 400) equity indexes separately. While we did find a statistically significant and similar result for mid cap, we did not find statistical significance when examining small cap on its own. Results available on request.
14Jorge Miranda-Pinto, Andrea Pescatori, Ervin Prifti, et al., “The commodity transmission channel of monetary policy and inflation dynamics,” Vox EU, Centre for Economic Policy Research, May 28, 2024. https://cepr.org/voxeu/columns/commodity-transmission-channel-monetary-policy-and-inflation-dynamics
15For crude oil, the result is a peak impact of +5.4% five months after the drop in interest rates, while the result for copper is a peak impact of +3.8% three months after the drop in interest rates. Results available on request.
16Joe Seydl, “How do geopolitical shocks impact markets?” J.P. Morgan Private Bank, May 24, 2024. https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/how-do-geopolitical-shocks-impact-markets
Our latest thinking identifies the likely relative winners (and losers) from the Fed’s pivot toward an easier monetary policy stance.
Joe Seydl
Senior Markets Economist
Published Oct 28, 2024
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