Here's Goldman Sachs playbook for beating the market if the Fed cuts interest rates

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Pedestrians walk past the New York Stock Exchange before the closing bell in New York.

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Goldman Sachs is encouraging their clients to prepare for the possibility that the Federal Reserve cuts interest rates later this year and adjust their stock holdings.

The investment bank’s top stock strategist recommended defensive health care and consumer staples sectors as two key areas that have typically outperformed the broader market following the start of cutting cycles.

“If the Fed does cut rates, the S&P 500 usually rallies afterward, with health care and consumer staples outperforming and information technology consistently lagging,” wrote David Kostin, chief U.S. equity strategist at Goldman Sachs. The “communication services sector has generated the best relative returns and hit rate of outperformance during the subsequent 3 months (+4 pp, 100%), but has underperformed over a 12-month horizon.”

Investors have grown confident in recent weeks that the Fed will reduce interest rates before the end of the year, pressured by weaker economic data, U.S.-China trade tensions and anemic inflation. The S&P 500 rose 4.4% last week, clinching its best week since November amid the rate-cut optimism.

Investors tracked by the CME Group’s FedWatch tool believe the central bank is more likely than not to cut rates at least once by July. The Fed meets next week and again July 30-31.

Goldman also recommended certain investment themes like momentum trades, which are bets that stocks currently in favor will continue to outperform. Momentum investors believe that upward trends can persist for extended periods, despite lofty valuations and steep price tags. Kostin also recommended stocks that trade calmer than others, encouraging clients to look for securities with low volatility.

Excluding two exceptional rate cuts in 1998 and 2001, Kostin’s analysis of the past 35 years showed momentum trades have generated a median 13% return in the 12 months following a rate cut.

“Few precedents exist during the past 30 years where futures discounted an interest rate cut 30 days prior to a scheduled FOMC meeting but the Fed did not cut,” Kostin added.

Easier borrowing costs often give companies with weaker balance sheets an advantage over those with less leverage, Goldman Sachs said. Though companies with strong balance sheets have outperformed their weak balance sheet counterparts by 28 percentage points since the start of 2017, Goldman said that may start to change if Fed Chair Jerome Powell and his colleagues cut the overnight rate.

“We advocated for owning strong balance sheet stocks as the Fed consistently tightened policy during 2017 and 2018. However, the Fed’s dovish pivot this year and the nearly unprecedented valuation premium of strong balance sheet stocks led us to adopt a more neutral posture in February,” Kostin wrote. ” Elevated corporate leverage and slowing economic growth remain long-term tailwinds, but a potential interest rate cut should be a headwind to further outperformance of strong balance sheets.”

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