Cooling Inflation Likely to Aid These ETF Areas

The biggest change in the market's outlook came from the July employment report. U.S. employers unexpectedly cut jobs in July. The weaker labor market reduced pressure on the Fed to raise interest rates.

Before the jobs report, markets had been assigning a considerably higher probability to a September hike, which subsequently fell sharply. Following the latest inflation data, traders expect a 50% chance of a September hike, according to Reuters, down from about 58% a week earlier.

The recent market reaction reflects this dynamic. U.S. stocks moved higher as investors interpreted weaker employment and inflation data as reducing the probability of aggressive monetary tightening.

Easing Inflation May Cause a Less-Hawkish Fed Ahead

The inflation picture has also become more favorable. The annual Producer Price Index (PPI) inflation slowed to 4.7% from 5% in June. Along with this, the Consumer Price Index remained humble too. However, inflation remains above the Fed's 2% objective, and some components of PPI that feed into the Fed's preferred PCE inflation measure remained firm, per Markets and Economy quoted in Schwab.

That is why the scenario in September with respect to interest rates remains crucial and slightly ambiguous.

Hormuz Tensions Create Inflation Risks

Uncertainty over reopening the Strait of Hormuz has pushed oil prices higher as investors worry about supply disruptions. Brent crude recently traded around $87 per barrel, with geopolitical developments around Iran and shipping through the strait continuing to influence prices.

This is crucial for the Fed because oil is a major source of headline inflation. If higher crude prices persist, they can raise transportation, manufacturing and other operating costs. Companies may either pass those costs to consumers or absorb them through lower profit margins.

A prolonged oil shock could therefore lead to slower economic growth, alongside higher inflation, and Fed tightening could return, putting pressure on long-duration bonds like the U.S. Treasury.

ETFs in Focus

For ETF investors, falling interest rate expectations are supportive for growth stocks, small caps and long-duration Treasuries. However, if oil prices continue to rise, energy and oil-related ETFs will likely see gains and inflationary pressure will be built up all over again.

Growth & Tech ETFs

Lower rate expectations generally support growth and technology companies because their future earnings are discounted at lower rates.

Invesco QQQ Trust Series I QQQ is one of the most widely used ETFs for gaining exposure to large U.S. growth and technology-oriented companies. It tracks the Nasdaq-100 Index.

QQQ has assets under management worth $488.84 billion and an expense ratio of 0.18%. The fund trades at an average daily volume of 43.68 million shares.

Small-Cap ETFs

Small-cap companies tend to be more sensitive to borrowing costs, so a less hawkish Fed can improve their financing environment.

iShares Russell 2000 ETF IWM provides investors with broad exposure to a large number of U.S. small-cap companies through the Russell 2000 Index.

IWM has assets under management worth $81.68 billion and an expense ratio of 0.19%. The fund trades at an average daily volume of 24.87 million shares.

U.S. Treasury ETFs

Longer-duration Treasury bonds can benefit when markets anticipate lower interest rates, as bond prices generally rise when yields fall.

iShares 20+ Year Treasury Bond ETF TLT is one of the most widely traded U.S. bond ETFs. It provides exposure to long-term U.S. Treasury bonds with maturities of 20 years or more, making it a popular choice for risk-averse investors.

TLT has assets under management worth $45.25 billion and an expense ratio of 0.15%. The fund trades at an average daily volume of 27.55 million shares.

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This article originally published on Zacks Investment Research (zacks.com).

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