Dividend and small-cap stocks : Why could they benefit from rate cuts?

The focus of the market will be on whether the Federal Reserve will cut interest rates in the third quarter, as Federal Reserve Chairman Jerome Powell testifies before Congress and important US CPI data for June is released this Thursday(July 11). This has prompted investors to consider how we can prepare and adjust our investment strategies.

Since March 2022, the Federal Reserve has been raising rates to curb inflation. After 11 rate hikes, U.S. Interest rates have risen to 5.25%-5.50%.

Based on the basic background, we can look at two aspects: the Federal Reserve's dot plot and The CME FedWatch Tool.

1. Federal Reserve's Perspective: The signals from the Fed remain hawkish. The latest June dot plot indicates that officials expect only one rate cut in 2024. More precisely, the median expectation for rate cuts this year has been reduced from three in March to just one.

2. Market Perspective: The market holds a more optimistic view on rate cuts. According to the CME FedWatch Tool, by the end of 2024, there's a 31.3% chance of one rate cut, a 43.6% chance of two cuts, and a 17.7% chance of three cuts (each 25 basis points). This indicates that the market leans towards expecting two rate cuts in 2024, with the first cut potentially occurring in September or November.

An interest rate cut by the Federal Reserve may have a positive effect on dividend stocks, small-cap stocks, and other assets in the US stock market. We will analyze each of these assets individually.

Let's start with dividend stocks, which are stocks that primarily generate returns through dividend income. These types of stocks typically have stable cash flows and profitability, and their growth prospects are relatively stable as well.

According to Morningstar, during rate cut periods, dividend-paying stocks generally outperform non-dividend-paying stocks. There are two potential reasons for this:

1. Lower interest rates may enhance the appeal of dividend stocks, as some investors rely on dividends as a primary source of income from their stock investments.

2. Dividend stocks tend to perform better during economic recessions, which are often accompanied by rate cuts.

1. Risk of Dividend Cuts: There's no guarantee that all companies on the Dividend Aristocrats and Dividend Kings lists will continue to increase dividends in the future. If a company’s performance deteriorates, it may cut dividends and be removed from the list.

2. Dividend Taxation: Even if you plan to hold stocks long-term to avoid capital gains tax, annual dividend payments are still taxable, which can impact total investment returns and should be considered in investment decisions.

Moving on to small cap stocks, which represent smaller companies with higher growth potential but also higher risk.

Typically, small-cap stocks tend to benefit more than large-cap stocks in a rate-cut environment due to their higher sensitivity to interest rate changes.

Small companies tend to rely more heavily on debt than larger enterprises. In a rate-cut environment, small companies benefit from reduced borrowing costs, which can lower their financial costs and improve profit margins. This is particularly true for small companies that depend on bank loans and variable-rate debt.

And also, here is a list of ETFs tracking the Russell 2000 Index, including leveraged and inverse ETFs, for reference.

1. High Volatility: Small-cap stocks are generally more volatile than large-cap stocks, and many small-cap companies are still unprofitable. As a result, track small-cap stocks tend to exhibit more significant fluctuations than large-cap indices, making small-cap investments riskier.

2. Low Exposure to Technology Sector: The Russell 2000 Index is diversified across various sectors, primarily industrials, financials, healthcare, and consumer discretionary. The technology sector, one of the hottest in the market, constitutes a smaller portion of the Russell 2000 Index. If future investments continue to focus on technology themes like AI, cloud computing, and semiconductors, the Russell 2000 Index may miss out on the gains from these sectors.

From the current analysis, high dividend and small cap stocks will be solid choices during the rate cut, but of course you can see there are different risks to these two types of stocks, so be careful of your investment.

Overall, while Federal Reserve rate cuts could positively impact different types of U.S. stocks, it does not guarantee that these assets will perform well post-cuts. It's still important for investors to take into account their financial status and risk tolerance before making investment choices. By doing so, they can develop an investment strategy that is tailored to their specific needs.

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What do you think about the next move to the U.S. stock prices after the rate cut? Feel free to leave your comment~