How will the rate-cutting cycle impact economic activity and market returns?

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.

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.

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. 

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

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

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:

1.  The opportunity cost of commodity storage
2.  The real-economy channel: Rate changes have effects on current and future commodity consumption
3.  The liquidity-portfolio channel: Rate changes affect financial conditions and thus trading liquidity in physical and derivative markets related to commodities
4.  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.

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.