03:27 PM EDT, 07/19/2024 (MT Newswires) -- The financials sector's performance is expected to benefit from a potential monetary policy easing by the Federal Reserve and prospects of a strengthening economy, Wells Fargo Investment Institute said Friday.

The firm upgraded its rating on the S&P 500 Index Financials sector to favorable from unfavorable, citing the potential for outperformance as interest-rate cuts "seem closer."

The central bank's Federal Open Market Committee tightened monetary policy by 525 basis points from March 2022 through July 2023 to tame inflation, but has since kept interest rates unchanged, with its latest pause coming last month.

Wells Fargo Investment rated the financials sectors unfavorable in January amid expectations that the interest-rate markets were "too optimistic" about cuts while inflation was sticky, the firm said in a Friday note to clients. Although the sector has lagged the broader benchmark equity index, its underperformance has likely "run its course," Wells Fargo Investment said.

The firm expects the start of potential Fed rate cuts to make credit cheaper and more accessible, thereby helping trigger an economic upturn next year. "If confidence improves, we anticipate loan growth should pick up while deposit interest costs decline," it said.

"A strengthening economy should allow the banks to reallocate capital that has been set aside against loan losses during the economy's weak period," the firm wrote. "Operating efficiencies have accompanied the loan-loss reserves and, together, these steps should position bank margins to benefit as an economic rebound materializes."

On Monday, Fed Chair Jerome Powell reportedly said policymakers won't wait for inflation to fall to 2% before reducing interest rates. On Wednesday, Fed Governor Christopher Waller said the FOMC is "getting closer" to cutting rates amid growing signs that inflation is easing, though the job is not done yet. Markets are widely expecting policymakers to hold interest rates steady July 31 and deliver a 25-basis-point cut in September, according to the CME FedWatch tool.

Wells Fargo Investment downgraded the consumer staples sector to unfavorable from neutral, saying the "typically defensive sector likely will struggle" if consumers change their spending focus to discretionary items from basics. The firm expects "stubbornly high" wage costs and a recovery in raw materials prices to continue pressuring companies in the sector.

While Wells Fargo Investment sees a low risk of a recession in the next 18 months, an economic downturn would tend to favor consumer staples over financials, according to the note.

"The economy still has pockets of strength, especially the jobs market and wage growth, but also on the corporate side -- manufacturing construction, for example -- that we expect to lend support," the firm said. "We believe the most likely scenario is that of a soft landing and falling interest rates during the coming months, which should allow the earnings recovery to broaden."

Wells Fargo Investment is a unit of a bank affiliate of Wells Fargo ( WFC ) .

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