Which Stocks Would Benefit From Fed Rate Cuts? Watch the 2-Year Yield.

Fed rate cuts might not lift all stocks equally. A lot will depend on how the bond market reacts. (NYSE)

Stocks should extend their record-setting rally deep into next year, fueled by a series of Fed rate cuts that—by most accounts—will begin this week.

The central bank, if economists are right, will begin a series of cuts that could lower its benchmark borrowing cost by as much as 1.5 percentage points by this time next year.

Investors are betting that lower Fed rates in tandem with stimulative tax policies and steady economic growth will most certainly drive markets higher into next year.

Still, there are contrarians.

Citigroup analysts, led by Scott Chronert, argue that Fed rate cuts won’t have a uniform impact on stocks because cuts generally signal economic weakness over the near term. And the consensus outlook, they wrote, is for slow growth, but not recession.

Instead, Chronert’s team suggests that only certain stocks—growth names—will break out big because of the rate cuts.

“Our high-level takeaway is that the expected Fed Funds path with a slow, but persistently positive economic trajectory should reinforce our longstanding call to overweight growth,” the team wrote on Monday.

Still, there are a lot of growth stocks to choose from. For Citigroup analysts, the best indicators of what will pop are Treasury bond yields.

Chronert’s team studied a detailed set of historic data—stock performance tied to Fed rate cuts accompanied by strong economic numbers and a steepening Treasury curve, where 2-year note yields fell faster than 10-year note yields.

Real estate, consumer discretionary, and information technology stocks were the standouts, he said. Communications services, energy, and healthcare stocks turned in mixed performances.

Small and mid-cap stocks also benefited from the combination of lower Fed rates and a modestly expanding economy.

That trade pivots in the other direction, however, once growth prospects weaken.

The Fed would, of course, maintain its rate-cutting strategy to stimulate the economy, but that would also probably trigger a bigger decline in two-year Treasury yields.

In this scenario, Chronert’s team predicts defensive stocks would do well. Leading the outperformers, again, would be real estate names. Other smart picks: healthcare, utilities, and consumer staples.

“The takeaway here is that the data underscores our view that the underlying economic condition will matter as to how markets respond to a next wave of Fed rate cuts,” Chronertsaid. “The better the economic backdrop, the more attractive cyclicality and/or longer-duration risk assets become.”

Something else to take into consideration, as Adam Parker of Trivariate Research points out, is the length of the pause since the Fed’s last month in December—nine months.

Parker, Trivariate’s CEO and founder, and a team of analysts found nine times when the Fed cut rates, then waited three to 12 months to cut again.

The S&P 500 lost an average of 2.6% in the first month after another rate cut, according to the Trivariate teamParker and his team said. The index was down by an average of 1.2% over the next three months.

“The best performing sectors in the past were financials, consumer discretionary, and technology,” Parker wrote. “The worst were real estate, communication services, and healthcare.”

Longer term, however, the S&P 500 ultimately benefits, gaining 15.1% over the next 12 months.

“A year later, financials were also the best performing on average, but the median 12- month forward performance was best in technology,” Parker said.

One caveat to this data-based outlook that Parker points out: President Donald Trump’s effort to remake the Fed probably will lead to much lower benchmark rates.

“That isn’t something history dictates an investor should fight, even if the historical cut-pause-cut playbook says we could have some near-term pullback before a 12-month recovery,” Parker added.

In that case, he and his team would point investors to healthcare, financial and technology stocks.

So the big takeaway from Wall Street heading into this week’s Fed meeting: All interest rate cuts aren’t created equal.

And if the economy slows sharply over the next few months, the bullish tenor of a dovish central bank could quickly turn into a defensive one.

Write to Martin Baccardax at martin.baccardax@barrons.com