By contrast, most cyclical sectors typically perform poorly in the initial three months after the first rate cut, particularly when the rate cut occurs during a US recession. But a year after the start of the easing cycle, cyclical sectors have historically delivered stronger returns.

Initially, cyclicals sell off on the back of a rate cut, which is likely in response to the weaker growth and inflation backdrop.

Initially, cyclicals sell off on the back of the rate cut, which may be in response to the weaker growth and inflation backdrop. But, at some point, these areas of the market become attractive as the equity valuations of these stocks become cheaper and investors anticipate the rate cuts boosting economic activity and corporate earnings. That said, both financials and consumer-discretionary sectors have been the exceptions, as they have generally done well even in the initial months after the first cut.

Interestingly, the technology sector has historically underperformed the broader market in the first few months after a rate cut. But its performance has been negatively skewed by the big sell-off during the technology-bubble recession in the early 2000s. Without this period, technology stocks usually achieve positive returns when rates are cut.

How Do Equity Styles Perform During Rate-Cutting Cycles?

The momentum style has, on average, been the best-performing area of the market during past rate-cutting cycles (FIGURE 2). These stocks would have been performing very well before the rate-cutting cycle, and we believe the pick-up in investor sentiment following the first cut is only going to boost that performance.

To a slightly lesser extent, quality and growth stocks have historically generated positive returns during rate-cutting cycles. This is consistent with our previous analysis on these equity styles performing well in a low inflationary environment. Growth, quality, and momentum stocks perform worse when the rate-easing cycle occurs in recessions. This might be because investors rotate into the more defensive areas of the market, such as the minimum-volatility style.

Even small caps tend do well after the first rate cut during recessions. It may be that small caps benefit from the more aggressive rate cutting that occurs in recessions. However, it’s worth bearing in mind that our analysis is dependent on the time horizon. For example, analysis of small caps back to the 1920s shows that they have historically outperformed the market a year after the first rate cut (FIGURE 3).

But since the mid-1980s, small caps have historically underperformed the broader market after the first rate cut (this is the starting period of our analysis). The difference is likely due to changes in the composition of sectors in the small-cap universe, which has increased its share of financial and real-estate companies but reduced its exposure of technology and consumer-discretionary sectors. That said, the sector exposures of equity styles are dynamic, and the past investment playbook does not guarantee future performance.

Conclusion

Given our baseline view of no recession in the US and the anticipated rate cut by the Fed in September, momentum, growth, and quality stocks may outperform. This finding is consistent with our analysis of these equity styles within a low inflationary backdrop. At the same time, defensive sectors compared to their cyclical peers may also benefit in an environment where rates are being cut.

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Factor Definitions: Momentum–Stocks that have outperformed in the past tend to exhibit strong returns going forward. A momentum strategy is grounded in relative returns from three months to a one-year time frame. Quality–Defined by low debt, stable earnings, and consistent asset growth. Investors can identify quality stocks by using common financial metrics such as return to equity, debt to equity, and earnings variability. Growth–An investment style and strategy focused on increasing an investor’s capital. Growth investors typically invest in growth stocks, i.e., young or small companies whose earnings are expected to increase at an above-average rate compared to their industry sector or the overall market. Value–Aims to capture excess returns from stocks that have low prices relative to their fundamental value. This is commonly tracked by price to book, price to earnings, dividends, and free cash flow. Size–Historically, portfolios consisting of small-cap stocks exhibit greater returns than portfolios with just large-cap stocks. Investors can capture size by looking at the market capitalization of a stock. Volatility–Research suggests that stocks with low volatility earn greater risk-adjusted returns than highly volatile assets. Measuring standard deviation from a one- to three-year time frame is a common method of capturing volatility.

Index Definitions: MSCI USA Index is designed to measure the performance of the large- and mid-cap segments of the US market. With 601 constituents, the index covers approximately 85% of the free-float-adjusted market capitalization in the US. S&P Small Cap 600 Index seeks to measure the small-cap segment of the US equity market. The index is designed to track companies that meet specific inclusion criteria to ensure that they are liquid and financially viable..

Important Risks: Investing involves risk, including the possible loss of principal. Security prices fluctuate in value depending on general market and economic conditions and the prospects of individual companies. • Different investment styles may go in and out of favor, which may cause the Fund to underperform the broader stock market. • To the extend the Fund focuses on one or more sectors, the Fund may be subject to increased volatility and risk of loss if adverse developments occur.  • Small- and mid-cap securities can have greater risks and volatility than large-cap securities. • Diversification does not ensure a profit or protect against a loss in a declining market.