The Fed's interest rate cut cycle kicks off! The "big to small" trend in the market is becoming more apparent, with small-cap stocks gaining momentum

According to the financial news app Zhitong Finance, the Federal Reserve unexpectedly announced its first rate cut since 2020 on Wednesday, Eastern Time. Following a surprise 50 basis point rate cut, small-cap stocks in the US surged to their highest level in over a month. The small-cap benchmark, the Russell 2000 Index, rose by 2.4% to 2259.70 points at one point, although the gain later narrowed to just 0.2%. This performance was significantly stronger than the collective decline of the three major US stock indices—the Dow Jones Industrial Average, the NASDAQ Composite Index, and the S&P 500 Index, all of which closed lower on Wednesday. The Russell 2000 Index hit its highest level since August 1st during the US trading session and is expected to continue to benefit from the rate cut cycle.

Typically, when the Federal Reserve announces the start of a rate cut cycle, small-cap stocks tend to outperform large-cap stocks in the short to medium term. This is because small businesses, due to their smaller balance sheet size and limited operating scale, are more sensitive to floating interest rates compared to large enterprises. The S&P 500 Index, the benchmark for large-cap stocks, touched a historic high of 5689.75 points earlier but saw its gains narrow after Fed Chair Jerome Powell's speech with a mix of hawkish and dovish tones, ultimately closing with a decline of about 0.3%.

"We have had a good start to this (rate cut cycle), which is a sign of our increased confidence in policy," said Federal Reserve Chair Jerome Powell at a press conference following the Fed's rate decision on Wednesday. Powell also noted that the main purpose of this significant rate cut is to stabilize the US labor market, emphasizing, "We are confident in the current monetary policy adjustment, believing that this appropriate readjustment will help maintain a strong labor market, achieve moderate economic growth, and bring inflation back to a stable 2%."

Powell also pointed out during the press conference that the decision to cut rates by 50 basis points does not mean that Fed policymakers expect the US economy to enter a recession. He stated, "There are currently no signs that the risk of an economic recession is rising. Our policy adjustment is mainly to recalibrate to adapt to the current economic conditions."

In summary, Powell stated that the Fed's monetary policy will be adjusted based on the future development of the economy, whether to accelerate, slow down, or pause the easing policy, will depend on the economic situation. He indicated that the future rate cut path will depend on changes in the labor market and inflation, but currently, the US economy remains strong.

The unexpected 50 basis point rate cut by the Federal Reserve, along with Powell's confident speech about a "soft landing" for the US economy, signifies that the rate cut cycle initiated in September is still ongoing and the US economy remains resilient. This is a significant positive for small-cap stocks in the US, which have been suppressed since the Fed's rate hike cycle in 2022.

Jonathan Krinsky, Chief Market Technician at BTIG, believes that small-cap stocks in the US can provide a better risk/return profile in the short term compared to large-cap stocks. Krinsky previously stated in a report, "If the market's expectation of a 50 basis point rate cut by the Fed is confirmed, the rise in small-cap stocks should accelerate."

Lori Calvasina, Global Head of Equity Strategy Research at RBC Capital Markets, recently stated that funds flowing into US small-cap stocks have not stopped despite the continuous outflow of funds from large-cap stocks. This indicates that more and more investors are looking to switch funds to the small-cap sector As the Fed's rate-cutting cycle begins, the investment style shift from "big to small" becomes more apparent

The seven major US technology giants, known as the "Magnificent 7" with significant weight in the S&P 500 index, including Apple, Microsoft, Google, Tesla, NVIDIA, Amazon, and Meta Platforms, have been the core driving force behind the continuous record highs of the S&P 500 index. Global investors have been flocking to these seven tech giants throughout the whole of 2023 and the first half of 2024, betting on the frenzy of global enterprises investing heavily in generative AI. Due to the massive market size and financial strength of tech giants like Apple and Google, they are in the best position to leverage artificial intelligence technology to expand their revenue.

Looking at the entire US stock market, the core logic behind the comprehensive outperformance of the seven tech giants over value stocks and broad small-cap stocks since 2023 lies in the global AI boom, the uncertain Fed rate-cut expectations, occasional waves of rate-cut expectations, the not-too-strong growth trend of the US economy, and the absence of excessive weakness leading to an economic recession. In such trading conditions, the seven tech giants, with their unparalleled AI revenue generation scale, rock-solid fundamentals, incredibly strong free cash flow reserves, and continuously expanding stock buyback programs, have become a "safe haven" for global funds in the face of uncertain rate-cut expectations and slowing economic growth.

If the Fed's rate-cutting cycle officially begins and the US economy remains resilient without falling into an economic recession, the upward trend of US stocks is very likely to rotate to those small and mid-cap stocks that have suffered significant price declines since 2022. These stock targets are extremely sensitive to interest rate expectations from an investment theory perspective, and even a slight rate cut is expected to boost their depressed stock prices and valuations.

Some Wall Street strategists suggest that under the macro backdrop of the Fed's rate-cutting, the performance of small and mid-cap stocks may far exceed the seven tech giants and broad large-cap stocks in the US stock market. The main logic is that small and mid-cap stocks are often very sensitive to the benchmark interest rates set by the Fed, as they heavily rely on floating rate loans. Therefore, in the context of the Fed's rate-cutting, it means that the long-standing debt pressure on them is significantly reduced, potentially increasing profit margins and stock valuations.

Therefore, with interest rate futures markets pricing in nearly a 100% chance of a 100 basis point rate cut by the Fed before the year-end, the classic rotation rally of small and mid-cap stocks or the trend of profit recovery in small and mid-cap stocks may fully emerge, driving funds towards some small and mid-cap stocks that benefit from the rate-cutting cycle and have very cheap stock prices and valuations, rather than the tech giants whose valuations are at historical highs. Investors will become "comparative shoppers" in the general sense, also known as "comparing three products"