Broader Tech Rally Hinges on Fed Rate Cuts Amid AI Stock Surge

Key Takeaway

• The Nasdaq 100's equal-weight index has underperformed its cap-weighted counterpart for seven consecutive weeks, highlighting concentrated gains in AI-driven tech stocks.
• Investors are focusing on mega-cap tech stocks like Nvidia amid macroeconomic uncertainty and cyclical concerns, sidelining broader market participation.
• A potential selloff in top-performing tech names could sharply impact the broader market due to their significant weightings.

Tech Sector Divergence

The recent broad equity rally in the U.S. stock market has not extended to the technology sector, where gains remain concentrated among a few artificial intelligence (AI) winners. The equal-weight version of the Nasdaq 100 Index, which treats all companies equally regardless of size, has underperformed its cap-weighted counterpart for seven consecutive weeks through Friday's close. This marks the longest streak of underperformance since February 2020, with similar occurrences only happening a few times in the past decade.

Alec Young, chief investment strategist at Mapsignals, noted, "For the equal weight, in general, to do better, we need to get a sense that the Fed is gonna cut rates." However, Friday's robust jobs report dampened hopes for multiple rate cuts this year, with Fed swaps no longer pricing in a cut before December. Despite this, the S&P 500 Index and Nasdaq 100 managed to end the week higher by 1.3% and 2.5%, respectively.

Investors are gravitating towards the largest technology stocks and AI winners for their perceived safety amid macroeconomic uncertainty. "There’s a lot of macro uncertainty right now. So it’s all about bottom-up earnings visibility. And the reality is that the mega cap, Magnificent Six really provide that," said Young, referring to the top tech stocks excluding Tesla Inc. Chip stocks, particularly Nvidia Corp., are seeing significant momentum as hedge funds and other investors avoid other tech stocks that might not benefit as much from the AI boom.

Fed's Rate-Cut Outlook

The Federal Reserve's upcoming meeting on Wednesday is expected to provide more clarity on its rate-cut plans. The central bank, led by Chair Jerome Powell, is widely anticipated to hold borrowing costs steady for the seventh consecutive meeting. However, there is less certainty about officials' rate projections. According to a Bloomberg survey, 41% of economists expect the Fed to signal two cuts in the closely watched "dot plot," while an equal number expect one or no cuts at all.

Bloomberg Economics' chief U.S. economist, Anna Wong, stated, "The June FOMC meeting will be one of the most pivotal this year as Powell may provide the clearest hint yet to the rate-cut timetable. The new dot plot likely will indicate two 25-basis-point cuts this year, compared with three in the March version." Despite growth indicators consistently surprising to the downside, inflation data has met expectations, leading to a relatively dovish outlook from Powell.

Inflation by the Fed's preferred measure was 2.7% in the year ended April, compared to the central bank's 2% target. Recent data showing a surge in payrolls and accelerating wages have led traders to dial back expectations for rate cuts this year. Thomas Simons, senior U.S. economist at Jefferies, commented, "The Fed will opt to keep rates steady for longer. They will want to see a renewed run of more favorable data in line with an inflation trend closer to 2% before they feel comfortable cutting rates."

Market Risks and Opportunities

RBC Capital Markets strategists, led by Lori Calvasina, warn that investors remain overly optimistic about the timing of a Federal Reserve interest-rate cut. They see the risk of an 8% slump in U.S. stocks if easing fails to materialize this year. The team laid out three year-end scenarios for the S&P 500 Index based on expected corporate earnings, inflation, and interest rates.

In the most bearish scenario, the S&P 500 could drop almost 16% if stubborn inflation results in Fed rate hikes. If the Fed holds rates at current levels and inflation proves stickier than expected, the index could fall to 4,900 points. Conversely, if the central bank cuts rates as expected but earnings fall short of projections, the S&P 500 would trade around 5,100 points, about 5% lower than current levels.

Calvasina noted, "There is some modest downside risk to the U.S. equity market if the Fed does nothing this year and inflation is stickier than expected." Investors are now only pricing in one full rate reduction by December, according to swaps data, but even that projection may be too optimistic given the recent hot labor market data.

Street Views

• Alec Young, Mapsignals (Neutral on the broader market):

  "For the equal weight, in general, to do better, we need to get a sense that the Fed is gonna cut rates."

• Alec Young, Mapsignals (Bullish on mega cap tech stocks and AI winners):

  "There’s a lot of macro uncertainty right now. So it’s all about bottom-up earnings visibility. And the reality is that the mega cap, Magnificent Six really provide that."
  "It’s very difficult to get broad market participation, value participation, equal weight participation when you have cyclical concerns."

• George Ball, Sanders Morris Harris (Bearish on high valuations in top tech stocks):

  "I think in the three to six-month time horizon we may see something of a bubble left that pops... Because those few names so dominate the tech sector, weakness in them will bring down the broader averages, perhaps even quite sharply."

• Ken Mahoney, Mahoney Asset Management (Bullish on leadership stocks):

  "Money’s going to flow to leadership stocks... If that’s what it takes to find and deliver performance, you’ll find us there too."