Some investment options in a rate-cutting cycle
The latest action by the Fed can potentially signal a change in market dynamics
A MOST widely anticipated, yet hardest to predict, interest rate cut has finally happened. At its September meeting, the Federal Reserve went big with a 50 basis point cut in a bid to support the economy, particularly the labour market which has been cooling over the last few months.
It was a preemptive cut, and the Fed cautioned against assuming that this move set the pace and magnitude of easing policy going forward.
This is an important milestone. It is the first interest rate cut since the Fed embarked on its most aggressive rate-hiking cycle in over 30 years, and is also likely the start of a new rate-cutting schedule in the US and the rest of the world. In the case of the latter, many non-US central banks have been waiting for the Fed before embarking on their own respective rate-reduction cycles. These actions should begin to unshackle the US and global economies from this long period of elevated borrowing costs.
As is often the case, a new cycle can potentially signal a change in market dynamics. And investors should consider reviewing their existing portfolios.
Areas of opportunity
In a falling interest rate environment, several areas can do well. One is high-quality investment-grade (IG) bonds. IG bonds are typically defined as bonds that have a lower risk of default and receive higher ratings from credit rating agencies. They are usually assigned ratings of at least Baa by Moody’s or BBB or above by S&P and Fitch.
Currently, yields on IG bonds are at one of the highest levels over the past 15 years. Investors can still lock in these yields before more rate cuts happen. Besides that, IG bonds can also help to diversify portfolios during recessions as investors tend to rotate parts of holdings in riskier asset classes such as stocks to reinforce their portfolios.
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Another interesting area to consider are small-to-mid cap stocks. Often under-loved and overlooked, small-mid cap companies tend to rely on short-term borrowing, so lower rates are beneficial for their bottom lines. We have also started to see an acceleration in their earnings at a time when large-cap companies are experiencing slowing profit growth. A continuation of this would aid returns of this group of stocks and increase their valuations in a rate-cutting cycle.
Quality global dividend stocks are another area to consider. These stocks tend to have dividend yields that are higher than market averages. Quality global dividend stocks, such as staples or utilities, also tend to be relatively more resilient than the broader equity markets as these sectors are usually less economically sensitive.
Closer to home, Asian stocks could benefit. Rate cuts will likely cause the US dollar to depreciate, and Asian stocks have historically outperformed during periods of a weakening US dollar. The declining-rate cycle by the Fed will also provide room for Asia’s central banks to start easing local monetary policies, which can lend support to Asian equities.
Within Asia, dividend stocks – those with dividend yields higher than market averages – are among the more attractive areas. Besides exposure to Asia’s long-term growth, these stocks also tend to have attractive dividend yields often higher than cash rates; their yields can become more attractive as interest rates fall. There is also increasing regulatory support across the region for companies to deploy shareholder-friendly policies, which could further increase dividend payouts over time.
Beyond looking at areas that could do well in a falling interest rate environment, investors should also review their portfolios for areas that might see decreasing returns as interest rates decline. Cash, deposits and money market holdings are some examples. Holding on to them for a prolonged period could result in reinvestment risks and decreasing returns, and investors may consider redeploying some allocation into other high-quality investments.
The market expects further cuts for the rest of 2024 through to 2026 but the magnitude and pace of future rate cuts will be dependent on the state of employment in the US. The cycle is just beginning, and investors should continue to stay agile and vigilant.
The writer is client portfolio strategist, Fidelity International
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