Here are the sectors poised to gain from September's potential Fed rate cuts and the "Trump Trade"

US small-cap stocks are outshining large caps
Investors are favouring small caps amid expectations of an imminent Fed rate cut
The “Trump Trade” is also gaining traction

US small-cap stocks have quietly seized the spotlight in recent days, taking over from the mega-cap tech giants.

Small caps now lead the charge in the recent bullish market, fuelled by optimism that the Fed’s interest rate cuts, now expected in September, will broaden the economic recovery, playing squarely into their favour.

Over the past week, the small-cap Russell 2000 index has outperformed the Nasdaq 100 by approximately 12% – a feat not seen since 2011 – beating the returns of the S&P 500 by over 3x.

Investors are starting to shift their focus to overlooked sectors of the market, buoyed by recent easing inflation figures that suggest imminent interest rate cuts by the Fed.

According to the latest CME FedWatch data, traders are now fully confident, with a 100% probability, that the Fed will begin cutting rates in September.

Small-cap stocks, known for their responsiveness to sentiment, stand to gain disproportionately from these anticipated cuts.

“Rotation is the name of the game,” Andrew Brenner at NatAlliance Securities told Bloomberg. “This is consistent with the increased perception of cutting rates.”

Why small caps are sensitive to interest rates

Small-cap stocks are particularly sensitive to interest rates because they often rely on external financing to fuel their growth.

When interest rates are high, the cost of borrowing increases, making it more expensive for these companies to finance new projects and growth initiatives.

And when interest rates decline, these small caps benefit from lower borrowing costs, pushing up their valuations.

Another reason small caps are sensitive to interest rates is that growth stocks are valued based on their future earnings potential.

Higher interest rates increase the discount rate used in valuation models, which reduces the present value of those future earnings, and in turn, the share price.

On the other hand, when interest rates decline, the discount rate decreases, increasing the present value of their future earnings and hence the share price.

The Fed Reserve’s decisions on interest rates therefore can have a disproportionate impact on small-cap companies compared to larger stocks.

For small caps to rally strongly, there needs to be a clear confirmation that the anticipated Fed Reserve rate cuts are indeed underway, which we basically have right now.

The “Trump trade”

Along with the potential rate cuts, the “Trump trade” is gaining momentum, driven by expectations of Trump’s election win after Saturday’s unsuccessful assassination attempt.

In a research note released on Monday morning, Dubai-based financial advisory firm deVere Group pointed out three market sectors poised to benefit from a Trump victory: energy, manufacturing, and banking stocks.

Energy

Nigel Green, CEO and founder of deVere, says Trump’s administration has historically prioritised energy independence and economic growth over environmental regulations.

“His past actions, such as rolling back Obama-era climate policies and exiting the Paris Agreement, reflect a preference for less stringent environmental oversight,” Green said.

“Should Trump win the presidency again, a similar approach is expected, which would benefit the energy sector, particularly fossil fuels.”

Manufacturing

Green believes Trump’s flagship ‘America First’ policy will push domestic manufacturing and reduce the US’ dependence on foreign imports.

“A return to this policy is likely to include tariffs on foreign goods and incentives for American companies to bring manufacturing back to the US,” says Green.

Banking stocks

Green added that Trump’s administration has historically favoured deregulation, aiming to reduce the regulatory burden on financial institutions.

“With less stringent regulations, banks and financial institutions can expect reduced compliance costs and increased profit margins,” Green said.

“Deregulation could also facilitate increased lending activities, boosting the revenues of financial services companies.”

Gold, crypto could also benefit

Trump’s policies may also be supportive of the gold market.

Traders have noted that the combined ‘rate cut trade’ and ‘Trump trade’ have propelled gold prices to new highs this week, reinforcing its status as a safe haven.

Also, Trump’s choice of Senator JD Vance as his running mate for the 2024 presidential election is seen as a “masterstroke” for the crypto market, given Vance’s strong support for cryptocurrency.

“Vance, an outspoken supporter of Bitcoin and other digital currencies, represents a significant and strategic move in the evolving political landscape where crypto has become a major issue,” said Green.

“This decision is not only smart but also a potentially transformative masterstroke.”