With the Federal Reserve increasingly likely to cut rates at its September meeting, some investments may be poised to rally, or at least hold up better than others in a market correction.
“To understand how rates affect these asset classes, we have to first understand the benchmark rate set by the Fed. Lowering that rate makes it easier for institutions to borrow money because it eases the money supply,” says Kevin Chancellor, CEO and financial advisor at Black Lab Financial Services in Melbourne, Florida.
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Broad market sentiment tends to lift stocks after a rate decrease, but Chancellor notes that lower rates affect some sectors more favorably than others.
Here are some sectors and types of stocks to add if interest rates decline:
— Technology stocks.
— Small-cap stocks.
— Consumer discretionary stocks.
— Real estate stocks.
— Financial stocks.
— Cryptocurrency assets.
— Commodity stocks.
Technology Stocks
So-called Magnificent 7 stocks Apple Inc. (ticker: AAPL), Microsoft Corp. (MSFT), Alphabet Inc. (GOOG, GOOGL), Amazon.com Inc. (AMZN), Nvidia Corp. (NVDA), Tesla Inc. (TSLA) and Meta Platforms Inc. (META) led the market to new highs in 2023.
While Nvidia and Meta Platforms are the only stocks from that group among 2024’s biggest year-to-date gainers, tech stocks as a whole have historically benefited from an interest rate decrease.
“Lower rates should pour fuel on the fire for tech stocks. Their valuations are heavily reliant on future earnings, which mathematically become more valuable as rates decline,” says Chris DeCarolis, senior investment analyst at Wealth Enhancement Group in Great Neck, New York.
Lower rates level the playing field between present and future earnings, he adds. Within the tech sector, DeCarolis says, a rate cut should especially benefit high-growth companies with low current earnings.
However, he said, tech giants like Apple and Alphabet, which hold massive cash reserves, may see diminishing returns on that cash as interest rates fall.
Small-Cap Stocks
Small companies often benefit from rate cuts, as lower borrowing costs help them raise capital for new projects and reduce costs for debt servicing.
“It is likely that the Federal Reserve will begin to cut interest rates and a new investment landscape will emerge. In this setup, it is possible that long-forgotten small-cap equities could have a chance for durable outperformance,” says Jordan Irving, portfolio manager at Glenmede Investment Management in Philadelphia.
Irving sees two main reasons why this may happen.
“First, small caps, as an asset class, carry higher debt burdens than their large-cap peers. A decline in rates will ease that burden and allow these companies to allocate capital to business needs as opposed to debt servicing,” he says.
Second, he adds, economic re-acceleration will happen when larger companies ramp up capital spending and merger-and-acquisition activity.
“Small caps tend to be the beneficiaries of these activities and tend to lead in the early stages of an economic recovery,” Irving says. “A lower-rate environment should jump-start this process.”
Consumer Discretionary Stocks
The largest holdings in the S&P consumer discretionary sector are Amazon and Tesla, both of which are tech-driven, despite their classification.
However, other heavily weighted sector components, such as Home Depot Inc. (HD), McDonald’s Corp. (MCD), Lowe’s Cos. Inc. (LOW) and TJX Cos. Inc. (TJX), are more vulnerable to higher rates, which could curb spending. A rate cut could boost consumer spending at those companies, though a recession could put a damper on the party.
“History shows that during volatile times, consumer discretionaries can be challenging,” says Jeff Sekinger, CEO and founder at trading software company Nurp, based in Miami. “Should the Fed start cutting rates, then this sector could be a compelling area to consider.”
Real Estate Stocks
Following a disappointing July jobs report that led investors to believe the Fed may slash rates further than expected, the real estate sector was one of the few gainers. It joined utilities and consumer staples, both traditionally considered defensive sectors.
The real estate sector could benefit from a rate cut for intuitive reasons: Lower borrowing costs make mortgages more affordable. That could increase demand for commercial and residential properties, boost home sales and increase the profitability of real estate investments.
“Real estate sector securities usually see a bump when rates decrease, since more development happens when borrowing money is cheaper,” Chancellor says.
Financial Stocks
The financial sector is in the unusual position of potentially benefiting from both rising and falling rates.
The higher-rate environment of the past few years drove banks’ net interest income. Banks were able to capitalize on the spread between the yield from their own investments and the rates they charged customers.
However, as rates fall, banks and other financial institutions can benefit as lending and refinancing activities pick up.
Financial companies’ own capital structures also affect their performance relative to interest rates.
“The financial sector usually carries the highest levels of debt-to-equity ratios of the different sectors,” Chancellor says.
Currently, the fed funds target rate is between 5.25% and 5.5%. That’s the range at which banks can borrow from other banks.
Chancellor notes that many banks are now offering certificate of deposit rates slightly below the benchmark, as it’s cheaper to borrow from their customers rather than from other banks.
“However, some financial stocks can benefit each way from a rate change,” he adds. As rates fall, stocks of financial companies such as banks, insurance companies and mortgage lenders may rise as banks are able to borrow more money at lower rates.
Cryptocurrency Assets
Stocks such as Coinbase Global Inc. (COIN) and MicroStrategy Inc. (MSTR), as well as spot Bitcoin (BTC) and Ether (ETH) exchange-traded funds (ETFs), may rise in a falling-rate environment.
Lower rates may reduce the appeal of other savings and fixed-income investments, sending less risk-averse investors to potentially higher returns in cryptocurrencies.
“Crypto stocks are speculative in nature but operate mostly like a growth stock, which is highly sensitive to interest rate changes,” Chancellor says.
“When rates rose in 2022, crypto was hammered as people sought cash or more risk-averse value investments,” he says, adding that a rate decrease should help cryptocurrencies to appreciate in value.
However, he adds, a healthy dose of caution is in order when considering crypto-related investments.
“Since they are speculative in nature, there is also a huge amount of sentiment that will drive one cryptocurrency versus another,” Chancellor says.
Commodity Stocks
Commodities typically show a low correlation to the broad equity market. For example, one of the largest commodity futures ETFs, the Invesco DB Commodity Index Tracking Fund (DBC), rallied in 2022 as stocks sank, but couldn’t keep pace in the equity market uptrend in 2023.
In a declining-rate environment, lower borrowing costs could make financing and expansion cheaper for commodity producers.
Also, a weaker dollar that stems from lower rates could boost commodity prices, increasing the attractiveness of equities tied to these assets.
Rate changes can directly and indirectly affect the prices of resources, such as agriculture, energy and metals, that are categorized as commodities.
“If there is a rate decrease, we can see an increase in the consumption of some of those goods due to the manufacturing costs going down to produce and store those raw resources,” Chancellor says.
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7 Types of Stocks to Add If Interest Rates Decline originally appeared on usnews.com
