Rate-Cut Rotation August has a reputation as a sleepy time in global stock markets, and the U.S. is no exception. Particularly in the second half of the month, investors head off to the mountains or the beach; trading desks are lightly staffed; and phone calls tend to dwindle. Little surprise that August on balance is an inconclusive month: since 1980, the S&P 500 has averaged a flat performance for the eighth month. There are outliers in both directions, of course, with big gains in 1982, 2002, and 2020; and big losses in 1990, 1998, and 2011. A Frantic August 2024 With one trading week remaining as we prepared this article, the S&P 500 was up about 2% for August 2024. While that number or something like it will be put in the ledger sheet, this August was uncommonly tumultuous. On the final trading day of July, the S&P 500 closed at 5,522. A deeply below-consensus July nonfarm payrolls number sent stocks tumbling, and by 8/5/24, the index was 6% below that level at 5,196. The suddenly popular perception was that the Fed, after badly missing the onset of inflation two-plus years earlier, had held rates too high for too long and was now allowing the economy to slip into recession. The panicky selling in the market belied other evidence that the economy was okay, if not exactly roaring. Second-quarter 2024 GDP grew 2.8%, double the growth rate reported for the first quarter. In addition, second-quarter S&P 500 earnings from continuing operations increased year-over-year in low double-digits, for the strongest growth in nine quarters. Simultaneously, there are rifts in the consumer and business economies, because goods and services have been too expensive for too long. As of the beginning of August's final trading week, the S&P 500 had climbed back to within a percentage point of its all-time high. Fed Chair Jay Powell used the forum of this year's Jackson Hole Economic Symposium to allay recession fears. In his calm and reassuring speech, the Fed Chair stated that the 'time has come' to cut interest rates in response to cooler inflation and slowing economic growth. Inflation has 'declined significantly,' he added, and the labor market 'is no longer overheated.' Perhaps most notably, Fed Chair Powell acknowledged, 'the balance of risks to our two mandates has changed.' Inflation is receding, and the mandate to return inflation to 2% has nearly been met. At the same time, the economy has softened from recent peaks, and the mandate to maintain maximum sustainable employment is now at risk. Reversals in Fed policy, and particularly the move from raising rates to cutting rates, inevitably come at a fraught time for the economy. In those periods, the economy is seen as vulnerable to too little stimulus, while inflation is at risk of returning from too much stimulus. The Fed Chair's calm tone in addressing the dual mandate, in our view, was a necessary lubricant in the shift from restrictive to accommodative monetary policy. The market response - an 8.4% rally in the S&P 500 off the 8/5/24 lows, to 5,635 at the 8/23/24 close - suggests that investors broadly feel that the Fed in this cycle has successfully navigated the transition from fighting inflation to sustaining employment and economic growth. New Favored Sectors Emerge The August gain in the S&P 500 will go in the books as a single number: the markets recovered, good job, and on we go. Beneath the surface, the market in August - and in an equally tumultuous July - has been undergoing a meaningful transition at the sector level. Investors' nearly two-year fascination with AI stocks has not gone away, but it has moderated somewhat. And AI stock winnings may now be a vital source of funds for investing in other areas perceived as timely in the currently unfolding interest-rate environment. During the third quarter to date, the two best-performing sectors have been Utilities and Real Estate. With one trading week left in August, the iShares Real Estate ETF IYR is up 14% for 3Q24; and iShares Dow Jones US Utility ETF is up 10%. Both sectors are perceived as sensitive to interest rates, and both have historically moved into favor when market rates of interest are declining. When Treasury and fixed-income yields begin to decline, some portion of bond investors rotate into stocks in pursuit of income provided by high-yield equity sectors. The rotation into Utilities and Real Estate stocks sends prices higher, causing yields to come down (assuming no change in dividend policy) as stock prices come up. Yields on Utilities and REIT, whether rising or falling, thus maintain a floating but relatively consistent differential with bond yields. We looked at Utilities sector performance across an approximately 20-year span dating back to the turn of the millennium. In an 11-sector index, we differentiate between a top-five finish (top-five performing sectors in any year) and a bottom-five finish (worst performing five sectors in any year). Utilities had top-five sector performances in 2007, 2008, 2011, 2014, and 2018, when interest rates were declining. Utilities had bottom-five performances in 2020, 2021, and 2023, when interest rates were rising. Digging into the details from some of those years, Utilities were the third-best sector in the S&P 500 in both 2007 and 2008. The 10-year Treasury yield went from 4.8% on January 1, 2007, to 2.4% by December 31, 2008. Arguably, investors had other things on their minds in 2008, such as the Great Recession. Nevertheless, rotation into defensive sectors in troubled times is also a persistent theme. In 2011, which was not a particularly volatile time in the economy, Utilities were the best sector in the S&P 500. In that year, the 10-year year Treasury yield went from 3.4% on January 1, 2011, to 2.0% on December 31. Utilities were the second-best sector in 2014, as the 10-year year Treasury yield went from 2.8% on January 1, 2014, to 2.1% on December 31. Finally, Utilities were the second-best sector in 2018. Over a two-year span, the 10-year Treasury yield went from 2.5% on January 1, 2018, to 1.7% on December 31, 2019. We do not have the same clear signal from Real Estate, given that the stocks were not broken out from the S&P Financial Sector until 2016. Additionally, whereas Utilities are monopolistic and regulated, Real Estate stocks operate in multiple industries spanning retail shopping, commercial real estate, doctors' offices, rental apartments, and more. Still, the performance of the two leading sectors in 3Q24 signals that the financial markets have fully embraced the reality and immanence of Fed rate cuts. Other sectors that are top-5 in 3Q24 include Financials Healthcare, and Industrial; all are up in the 7%-8% range for the quarter to date. Financial stocks such as banks would seem vulnerable to compression in net interest margins as rates come down. But the bigger outcomes from lower rates are the expected revival in commercial & consumer loans, including mortgages, and strengthening in fee-based businesses such as credit financing, IPOs, and M&A. Healthcare stocks are expected to benefit as lower interest rates take some of the strain off consumer finances, enabling more discretionary and high-return medica