Wall Street is preparing for a significant Federal Reserve interest rate cut announcement this Wednesday, with uncertainty remaining about how aggressive the central bank will be.
As of Monday morning, the CME FedWatch tool indicates a 59% probability of a 50-basis-point cut. Morgan Stanley's latest research suggests this would be the most favorable outcome for the stock market, provided the Fed manages to calm concerns about economic growth.
“In the very short term, the best scenario for equities this week is for the Fed to deliver a 50-basis-point cut without sparking concerns about economic growth or triggering the unwinding of the yen carry trade. This would represent a pure 'insurance cut' ahead of macro data expected to stabilize,” writes Mike Wilson, Morgan Stanley’s Chief Investment Officer, in a note published Monday.
Labor market deterioration in the months leading up to this policy meeting has increased investor pressure on the Fed to lower borrowing costs in an effort to prevent an economic slowdown.
According to Morgan Stanley, the bond market suggests that monetary policy is lagging behind current conditions. Holding rates higher for too long could risk damaging key areas of the economy. As a result, the bank sees a 50-basis-point cut as the most prudent move.
However, some analysts warn that an aggressive cut may signal deeper economic issues that the Fed is attempting to address.
Morgan Stanley is advising investors to shift their portfolios toward two stock categories that have historically outperformed in similar rate-cutting environments: defensive and high-quality stocks.
This strategy is driven by increasing concerns about economic growth. While the S&P 500 reflects confidence in the Fed’s ability to engineer a soft landing and achieve 15% earnings-per-share growth into 2025, market internals reveal a more cautious sentiment, with investors flocking to defensive stocks in anticipation of a potential slowdown.
Wilson highlights that the performance gap between defensive stocks and cyclicals has been the most pronounced since the last recession. Defensive sectors, such as utilities and consumer staples, tend to perform well regardless of broader macroeconomic conditions, making them attractive in uncertain times.
"Defensives typically outperform cyclicals both before and after a rate cut. Large caps also tend to outperform small caps during these periods. These factors align with our current defensive and large-cap bias, as rate cuts often occur later in the economic cycle," Morgan Stanley notes.
