This corner of the stock market is set to outperform once the Fed starts cutting interest rates, Goldman Sachs says

People sit outside the New York Stock Exchange (NYSE) in New York City, U.S., September 15, 2016.

There’s one area of the stock market that is likely set for outsized growth after rate cuts: the mid-cap shares.

Mid-cap equities have historically seen stronger growth in the year after rate cuts compared to large- and small-caps, analysts from Goldman Sachs say.

“Since 1984, the S&P 400 mid-cap index has typically outperformed both the S&P 500 and Russell 2000 during the 3 and 12 months following the first Fed rate cut,” the analysts wrote in a Tuesday note.

They forecast a 13% return on mid-cap shares in the next year, primarily driven by low starting valuations and a healthy environment for growth.

“A low starting valuation has historically been a significant predictor of forward mid-cap returns, particularly at extreme levels, unless the US economy enters a recession,” the analysts said.

They add that mid-caps offer “growth and quality at a discount price” compared to large-caps, which are currently trading just below record highs reached during the tech bubble and post-pandemic euphoria.

Consensus forecasts see mid-cap earnings growing 11% annually in the next two years, compared to 7% for the S&P 500, the analysts say.

Mid-caps also have better balance sheets and profitability than small-caps, the analysts said.

“Small-caps are even more sensitive to the economy than mid-caps,” the analysts said, adding, “10-year interest rates near 4% and the risk of renewed growth concerns suggest small-caps will likely struggle to outperform on a sustained basis.”

Goldman analysts say their expectations for strong mid-cap performance is largely dependent on strong, accelerating economic growth, which generates the strongest monthly mid-cap returns.

“The S&P 400 has typically generated positive returns as long as the US economy is expanding. Median monthly mid-cap returns are strongest when the economy is expanding and accelerating (+2%) but still solid when an expansion decelerates (+1%), which is the Goldman Sachs baseline forecast,” the analysts said.

Further weak labor data after July’s surprise unemployment increase could pose downside risks to mid-caps, they note, since the industrial and financial sectors are heavily weighted in the index.

The analysts say these risks “should be cushioned by lower valuations relative to large-caps and stronger fundamentals relative to small-caps,” though, and that there is low probability of a recession in the next year.

Goldman Sachs expects the Fed to cut interest rates by 25 basis points at its policy meeting next week, followed by 25 basis points in November and December.

That forecast is slightly more conservative than the general consensus. Investors are pricing in a 25 basis point cut for September, and cuts totaling between 100 and 125 basis points by the end of the year.

“In the near term, the performance of mid-caps relative to large- and small-caps will depend on the strength of the economic growth data and the trajectory of the Fed easing cycle,” the analysts said.